LIBOR Find out more about LIBOR

The London Interbank Offered Rate (LIBOR) serves as a key interest rate benchmark across a number of financial products including derivatives, securities, loans and mortgages.

Libor Overview

Global regulators have signalled that firms should shift away from using the London Inter-bank Offered Rate (LIBOR) and switch to alternative overnight risk-free rates (RFRs). This is important because LIBOR underpins contracts affecting banks, asset managers, insurers and corporates, with estimated exposures totaling USD 350 trillion globally* on a gross notional basis. This figure underscores the extent to which market participants rely on LIBOR and the market disruption that its sudden and disorderly discontinuation could cause. Standard Chartered has responded to this situation by launching an IBOR Transition Programme, to help the Bank and our clients to navigate the many challenges resulting from the transition.

(* https://www.risk.net/derivatives/6004331/the-350-trillion-problem-too-big-to-solve)

What is LIBOR?

LIBOR is arguably the most important Inter-bank Offered Rate (IBOR) used in the global financial markets. It serves as a key interest rate benchmark across a number of financial products including derivatives, securities, loans and mortgages. LIBOR provides an indication of the average rate at which each LIBOR contributing bank can borrow unsecured funds in the London interbank market for a given period, in a given currency. It is calculated and published daily across five currencies (GBP, USD, EUR, JPY and CHF) and seven maturities (overnight, 1 week, and 1, 2, 3, 6 and 12 months) by the ICE Benchmark Administration. It is based on submissions by a panel of banks using available transaction data and their expert judgement.

Why is Reform Required?

Following the financial crisis, changes to bank capital requirements resulted in a significant decrease in transaction volumes in the unsecured inter-bank lending market - upon which LIBOR is based. With insufficient transaction data, LIBOR submissions have increasingly relied on expert judgement from the panel banks. Regulators have therefore grown increasingly concerned about the long-term sustainability of the benchmark and have decided to pre-empt any further possible deterioration by indicating their preference of an end to LIBOR.

It is not only regulators that are concerned. Panel banks have expressed discomfort about providing submissions “based on judgements with little actual borrowing activity against which to validate their judgements” and as a result, the UK’s Financial Conduct Authority (FCA) has “spent a lot of time persuading panel banks to continue submitting to LIBOR.”*

The FCA has received voluntary agreement from the LIBOR panel banks to continue to submit to LIBOR until the end of 2021. The FCA has also reminded all banks and other market participants that they need to have removed dependencies on LIBOR by this date if they are to avoid disruption when the publication of LIBOR ceases.

(*Source: Speech, Andrew Bailey, FCA, July 2017. https://www.fca.org.uk/news/speeches/the-future-of-libor)

What is the alternative?

Since 2014, a number of jurisdictions have set up working groups to identify alternative risk free rates (RFRs) to LIBOR. This was as part of a G20 initiative, delegated to the Financial Stability Board (FSB), to review and reform critical benchmark rates. The FSB established an Official Sector Steering Group (OSSG) to focus its work on the most fundamental interest rate benchmarks. The working groups focused on identifying rates that had markets of suitable size underpinning them and a robust governance framework for their calculation. Some of these rates were already in existence while others had to be created.

Whilst alternative RFRs for each of the LIBOR currencies have now been identified, the different jurisdictions are at varying stages of progress. In particular, the depth and liquidity of the market differs across the respective RFRs and product set (e.g. derivatives, bonds and loans).

The alternative RFRs are considered more robust and reliable interest rate benchmarks than LIBOR as their calculation is based on actual transactions in the underlying market. For example, while USD LIBOR has a daily average of USD 1 billion of underlying transactions, the chosen replacement, the Secured Overnight Financing Rate (SOFR), is underpinned by daily transactions of approximately USD 700 billion. Being based on actual transactions, instead of submissions using expert judgement, makes the RFRs more representative of the true cost of funding in the underlying markets.

What does the Transition Roadmap Look Like?

There are many challenges relating to the transition from LIBOR to the RFRs. We note the following, albeit non-exhaustive, set of important activities and milestones that will support an orderly transition.

There are currently differing levels of liquidity in each of the markets for RFRs, both in comparison to each other, and versus LIBOR. Liquidity in the RFR markets is anticipated to continue building in the period leading-up to 2021, with the potential for declining liquidity in respect of LIBOR markets.

The development of RFR markets requires a number of industry activities to continue to progress, including updates to key pieces of market infrastructure, such as those related to clearing and settlement of RFR-linked trades, continuing product development across derivatives and cash products, as well as the establishment of market conventions across products. Recently the market has seen growing RFR liquidity with the raising of new debt referencing RFRs, as well as the development of the related swaps and futures markets. There has also been the first issuance of a corporate loan referencing SONIA.1. Many participants, particularly in the loan markets, are also tracking closely the development of term rates based on the RFRs, with the working groups identified in table above undertaking work in this area, albeit targeting different timelines and potentially adopting different approaches depending on jurisdiction.

Many contractual agreements that reference LIBOR do not anticipate an event such as the permanent cessation of the LIBOR benchmark, and hence, lack contractual provisions for successor benchmarks. This raises the question of how to maintain contractual continuity for those contracts that will be affected by LIBOR transition.

There is ongoing work, including recent public consultations published, by industry bodies such as the International Swaps and Derivatives Association (ISDA), the International Capital Markets Association (ICMA), the Loan Market Association (LMA) and the Alternative Reference Rate Committee (ARRC) aimed at developing legal language (known as fallback language) that can be incorporated into affected contracts to cater for this eventuality.

Another important aspect to consider is the spread adjustment methodologies captured by the fallback language. RFRs are overnight rates, which are considered nearly risk-free, whereas LIBOR is a term rate and reflects perceived bank credit risk. The issue is further complicated as some RFRs are based off secured transactions, whereas others are based off unsecured transactions. Hence, when transitioning to RFRs, a spread methodology will need to be applied to avoid value transfer.

Making the necessary changes to existing contracts to update for the new RFRs, including updating for fallback language, is expected to be a burdensome process. In certain markets, notably the derivative markets, work is underway to develop an approach whereby contractual parties can more easily adopt changes to contracts through signing up to an agreed protocol. The aim is to avoid the need for mass repapering exercises of existing contracts.

However, whilst a potentially more efficient approach, this does not work for all markets, and even in derivative markets, not all contractual counterparties will wish to adopt a protocol developed by ISDA. In this case, each contract may need to be considered on a case-by-case basis for amendment.

Market participants have noted a number of potential accounting and tax issues that may arise as a result of the transition to RFRs, including those related to the areas of the recognition and derecognition of assets and liabilities, the measurement of assets and liabilities and hedge accounting.

In this regard, steps are currently being taken by accounting bodies to ensure that the market is consulted on the accounting issues and that potential reliefs are considered. For example, the International Accounting Standards Board (IASB) has published an exposure draft “Interest Rate Benchmark Reform (Proposed amendments to IFRS 9 and IAS 39)”* that constitutes a first reaction to the potential effects the IBOR reform could have on financial reporting.

(*https.//www.ft.com/content/1ce74182-99a9-11e9-9573-ee5cbb98ed36)

How is Standard Chartered preparing for the transition and what should our clients be doing?

There are many challenges relating to the transition from LIBOR to the RFRs. We note the following, albeit non-exhaustive, set of important activities and milestones that will support an orderly transition.

Standard Chartered recognises that the impact of the transition will be felt across our products, services and ultimately affect our clients and how we engage with them. Accordingly, we are actively participating in industry working groups and are continuing to stay close to all developments in this area. The Bank has established a global IBOR Transition Programme to consider all aspects arising from the transition and how any arising risks might be mitigated.

While uncertainties remain, Standard Chartered recommends that clients commence performing their own assessment of their affected contracts, products and services and to continue to familiarise themselves with the developments in the transition to the RFRs. Clients may also wish to consider seeking assistance from professional advisors to better assess their potential financial, legal and accounting risks.

For more information from us, such as our RFR product offering, please email us at: IBOR.Transition@sc.com

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