Preparing for benchmark interest rate reform
Benchmark interest rates are widely used across the global economy for calculating interest rates and valuations in relation to a wide variety of financial contracts, such as derivatives, bonds, loans, consumer lending products.
Global regulators are concerned about the robustness of benchmark interest rates such as LIBOR and expect market participants to plan for no LIBOR publication after the end of 2021.
For several years, global regulators and central banks have been driving international efforts to reform key benchmark interest rates to make them more reliable. These reforms are happening in many jurisdictions, such as the United Kingdom, the Euro area, the United States, Switzerland, Canada, Japan, Hong Kong, Singapore and Australia.
A key focus of these reforms is to ensure that widely used benchmarks are credible and robust. Regulators have been clear that this means benchmarks should be based upon transactions to the greatest extent possible.
In July 2014, the Financial Stability Board, an international body that monitors and makes recommendations intended to promote financial stability, issued a report expressing concerns about the ‘reliability and robustness of existing interbank benchmark rates. The Financial Stability Board recommended a two pronged approach to reform benchmarks.
- Strengthen existing Interbank Offered Rates (IBORs) by underpinning them to the greatest extent possible with transactions data
- Develop alternative, nearly risk-free reference rates (RFRs)
The London Interbank Offered Rate (“LIBOR”) is a daily benchmark interest rate calculated as an average of panel bank submissions and provides indication on the rate banks pay to borrow unsecured money across five currencies (British Pound Sterling, Euro, Japanese Yen, Swiss Franc and US Dollar) and seven tenors (overnight, 1 week, 1, 2, 3, 6 and 12 months) and used for the purposes of financial contracts, as a reference rate; including for calculating interest. Its administrator, ICE Benchmark Administration (IBA), publishes LIBOR rates every applicable London business day. LIBOR is widely used across the global economy for calculating interest rates and valuations in relation to a wide variety of contracts, such as derivatives, bonds, loans and consumer lending products.
Despite reforms in the governance and submission methodology of LIBOR, which now anchor the benchmark in “transactions to the greatest extent possible”, few transactions in the short-term money market actually occur now as banks have changed the way they fund themselves. Regulatory measures implemented after the 2008 financial crisis, to strengthen banks’ balance sheets, have reduced the utility of unsecured interbank borrowing in the money markets. These are the same transactions upon which LIBOR submissions are based.
Regulators’ concerns about the continued use of LIBOR remain elevated. In a key regulatory speech in 2017, the Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey, clearly articulated the continuation of LIBOR was at risk: “Our intention is that, at the end of , it would no longer be necessary for the FCA to persuade, or compel, banks to submit to LIBOR. It would therefore no longer be necessary for us to sustain the benchmark through our influence or legal powers.”
More recently at an Alternate Reference Rate Committee Roundtable speech in 2019, Randal Quarles, Chair of The Financial Stability Board, stressed that the “ Clarity on the exact timing and nature of the LIBOR stop is still to come, but the regulator of LIBOR has said that it is a matter of how LIBOR will end rather than if it will end, and it is hard to see how one could be clearer than that.”
Global regulators formed currency-specific working groups to assess market conditions, examine alternatives and consider next steps. Members of these working groups include banks, asset managers, insurance companies, and corporates. Industry bodies and trade associations representing various segments of the market are also actively engaged.
These efforts have resulted in the identification of RFRs, for each of the LIBOR currencies, which are based upon larger numbers of transactions. They also have some structural differences to LIBOR.
SOFR, Secured overnight financing rate
€STR, Euro short term rate
SONIA, Sterling overnight index average
TONA, Tokyo overnight average
SARON, Swiss average rate overnight
*The Euro Short Term Rate (“€STR”) is intended to replace the Euro Overnight Index Average (“EONIA”), at the end of 2021. No potential cessation date has been given for EURIBOR
For information on other key jurisdictions please download our world map (PDF 315KB)
EURIBOR, the Euro Interbank Offered Rate, is undergoing reforms which are expected to complete in Q4 2019. The European authorities believe reformed EURIBOR can exist beyond 2021, and no indication has been given that the benchmark is likely to cease anytime soon. However, EONIA, the Euro Overnight Index Average, became increasingly fragile in recent years. Consequently, the methodology was changed in October 2019 and EONIA became a tracker rate to €STR, the RFR identified by the Euro working group. It is expected publication of EONIA will cease on 3 January 2022.
The acronym “RFR” was introduced by the Financial Stability Board in their 22 July 2014 publication on benchmark interest rate reform. The phrases ‘near risk-free rates’, ‘risk-free rates’ and ‘alternative reference rates’ are generally accepted as interchangeable and these should be considered to refer to the same: reference rates which are being developed by international, central bank led working groups as alternatives to LIBOR.
RFRs have a number of differences when compared to LIBOR, including:
- Each currency has its own distinct RFR and administrator;
- RFRs are overnight rates, not rates for a longer term such as three or six months. As such, there is very little perceived credit risk or term premium associated with RFRs;
- Some market participants have expressed the need for a RFR based term rate, in order to know the applicable interest rate in advance of any payments to be made. Each of the RFR working groups is considering if it will be feasible to produce a robust term rate. The Swiss group has stated it will not be possible in that market;
- RFRs are based on a large number of overnight money market transactions, so the risks associated with expert judgment do not arise;
- The underlying volumes representing the indices which determine the RFRs are much higher than LIBOR;
- Whilst all LIBORs are unsecured rates not backed by any exchange of collateral, two of the five RFR working groups selected secured, or collateralised, rates for their respective currencies based on transactions in their respective government security repo markets.
Barclays supports the benchmark interest rate reform agenda as set out by the Financial Stability Board in 2014 and subsequently driven by the international risk free rate working groups and relevant supervisory authorities. We are actively engaged in the reform agenda and along with participating in various industry conferences and events discussing LIBOR transition, Barclays is a member of the US, EU, Japan and Singapore working groups. More prominently, Barclays chairs the Working Group on Sterling Risk-Free References Rates.
As instructed by the Bank of England Prudential Regulatory Authority and the UK Financial Conduct Authority, Barclays is planning for the base case scenario that LIBOR will no longer be available after 2021.
Barclays has mobilised an enterprise-wide programme with Senior Manager oversight, to coordinate its global efforts in relation to the transition,
Barclays is also aware that transition to RFRs is at different stages depending on the jurisdiction, and moving at different speeds. This also applies to the potential development of RFR-based term rates.
Barclays expects that the timing of any transition away from relevant interbank offered rates to take into account liquidity in the replacement RFR, the potential development of robust RFR-based term rates, development of any relevant industry conventions and the speed with which participants in the various derivative, bond and lending markets transition away from LIBOR.
Given the use of LIBOR in relation to many financial products, any potential cessation of publication could have a financial and operational impact. It is therefore important that market participants seek to understand how this may affect them. This may be achieved by taking some initial steps, including (though not necessarily limited to):
- Identify which products they use that reference LIBOR;
- Identify what amount of exposure these products have to LIBOR, including which mature after the end of 2021;
- Examine and, if necessary, amend existing products to ensure there is robust language in place that sets out the steps to be taken, or the interest rate to be applied, in case LIBOR is no longer available (note the process for amending a particular financial product will depend on its terms and may require a consent process);
- Ensure appropriate documentation is in place to adequately disclose or mitigate risks associated with the discontinuation of LIBOR;
- For new products consider using RFRs and, if using LIBOR, again consider if there is robust language in place that sets out the steps to be taken, or the interest rate to be applied, in case LIBOR is no longer available;
- Produce an inventory of relevant systems used (e.g. trade booking, risk systems) that may be affected should LIBOR no longer be published in the future, and consider making changes that will allow those systems to use alternative rates.
We encourage Market Participants to stay up-to-date on the latest developments and to consider how these changes may impact their organisation and the products in which they transact, using independent professional advisors (legal, accounting, financial, tax or other) as appropriate.
Market participants are also encouraged to participate in industry consultations and engage with the regulators and other stakeholders in the various RFR working groups to express their views and to better understand the expectations of the regulatory community, particular challenges and any recommended next steps.
This is not intended to be an exhaustive list but instead, some initial steps market participants may want to consider as a starting point. Further information is available from the PRA/ FCA’s feedback to their Dear CEO letter sent to supervised entities in September 2018, which asked for details of preparations and plans for transition from LIBOR to RFRs.
The path to transition away from LIBOR is complex. The alternative rates are calculated on a different basis to LIBOR. The various jurisdictions are at different stages of transition, and are moving at different speeds towards, in all likelihood, different outcomes. It is difficult to imagine a ‘one size fits all’ approach or solution.
Transition will affect both new and existing products referencing these key interest rate benchmarks, and in different ways. The consequences of reform are unpredictable and may have an adverse impact on any financial instruments linked to, or referencing, any of these benchmarks.
The transition itself may have potential risks associated with it;
- Changes to contractual documentation,
- Adaption of new and/or amended operational processes,
- Changes to the value of products or the possibility of products no longer serving the purposes for which they were intended.
Market participants are encouraged to evaluate their individual circumstances and review their LIBOR-linked exposures. Participants should also develop a sufficient understanding of any expected and potential changes as a result of LIBOR transition and how these changes may impact their organisation, using independent professional advisors (legal, accounting, financial, tax or other) as appropriate.
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