The End of the Road for (L)IBOR

In 2014, the Financial Stability Board (FSA) recommended the adoption of risk-free rates (RFRs) in replacement for Interbank Offered Rates (IBORs) ¹. IBORs are determined by contributions from participating banks based on specific transactions covering a future term or period of time. They became tainted in 2012 when it emerged ² that LIBOR (the London Interbank Offered Rate) had in some cases been manipulated by contributors. Even before this, interbank lending volumes had been falling sharply following the 2008 financial crisis ³.

Since the 2008 crisis, many banks have relied more on customer deposits instead of short term interbank loans and repos for their shorter term funding. The move has been hastened by the rigorous capital and collateral requirements placed on interbank financing by the Basel III rules. In the United States (US), from mid-2008 to the third quarter of 2017, the proportion of bank funding accounted for by the combination of interbank borrowing and repo fell from 10.5 per cent to 1.4 per cent of assets, while deposits as a percentage of assets rose from around 60 per cent to over 75 per cent in the same period. ⁴

The FSA and national or regional regulators have set deadlines around the end of 2021 ⁵ for the transition away from IBORs, including LIBOR. In the United Kingdom (UK), the Financial Conduct Authority (FCA) has issued regular instructions to market participants, including the need for organisations to assume that LIBOR will not exist from 1 January 2022; the FCA has also indicated that LIBOR should not be used for lending after Q3 2020 ⁶. There has been discussion recently that, given the reduced availability of resourcing during the COVID-19 pandemic, these deadlines should be extended. The FCA has discussed the matter and has made some amendments to reporting requirements ⁷. There is a counter-argument to extending the timescale, that the lower activity levels aggravate the problem of reduced data contributions to LIBOR-setting, making LIBOR even less indicative of reality at an earlier stage than predicted, thereby supporting the view that the move away from LIBOR (and other IBORs) should in some circumstances perhaps be made earlier, not later, than end-2021.

IBORs and RFRs differ in fundamental respects. IBORs are determined by submissions from banks of their interbank offered rates for different terms. By contrast, RFRs are based on actual transactions data, and should therefore be less susceptible to manipulation. IBORs look forwards in time – RFRs look backwards. IBORs exist for various periods of time, or terms, but RFRs are overnight rates. IBORs incorporate unsecured bank credit risk whereas RFRs are eponymously (near) risk-free, and can be based on secured or unsecured lending. IBORs have been known, widely used and established as common practice for decades; by contrast, for widespread usage, RFRs will perhaps need learning about and testing at both personal and institutional level. Furthermore, although regulators have issued the requirement to replace IBORs, they have generally (and purposely) not stated what specific rates should be used as those replacements, relying instead on evolving market practice. Each of these differences poses issues to be overcome by regulators and the market in moving away from IBORs to risk free rates.

The absence of term rates for RFRs poses challenges, where some mathematics is needed to derive a series of term rates from the overnight RFR. As risk-free rates are overnight rates, and there is currently not a term structure for any of them (as there is in LIBOR) a daily interest rate will need to be used to calculate interest payments. For many products referencing the risk-free rates this will be calculated on a compounded basis over the interest period. This leads to the interest payment amount only being known at the end of the period. This calculation method is already used in the derivatives market, and for many floating rate notes that have been issued using risk-free rates. This is commonly referred to as compounding in arrears. An alternative approach is for the rate to be determined by compounding in advance, where the compounded risk-free rate over the previous interest period is used for the current interest period.

The possibility of security for a liability based on an RFR may also complicate the involvement of insolvency law in different jurisdictions. Under the current IBOR regime the liabilities are unsecured, and hence normally at the bottom of the creditor payout rankings in the case of debtor insolvency. The comparability of an RFR based on secured credit exposure may be affected by its ranking under local insolvency law.

Conventions for future use of specific RFRs are beginning to emerge, supported by regulators in some cases. Potential RFRs are typically overnight index averages such as SONIA (sterling or GBP), EONIA, or now ESTER (Euro short term rate), SOFR (USD Secured Overnight Financing Rate), SARON (CHF Swiss Average Rate Overnight) and TONAR (JPY Tokyo Overnight Averaging Rate). Liquidity across interest rates in particular currencies is likely to be one of the key drivers for clients when deciding when they should transition to RFRs.

Following on from these risk and liquidity considerations, it is typically the case that RFRs are lower than IBORs ⁸ for the same currency, due to a risk and liquidity difference between the two types of rate. Existing IBOR contracts are expected to transition to the alternative RFRs, with adjustments to mitigate potential value transfers between market participants. There have been industry consultations to define the calculation and implementation method for these adjustments. In addition, new terms may be added to existing contracts where appropriate, in order to determine which replacement rate and adjustments will be used when the IBOR referenced in the contract ceases to be used.

The impact of the reform will clearly be widespread, including within the securities services industry. Items affected will include bonds, loans, derivatives and contracts. In addition, IBOR-related hedges such as loans hedged by interest rate swaps and options, forward rate agreements and cross-currency swaps will also need to change. The move from IBORs may also affect classification and measurement of both assets and liabilities, and also fair value measurement and calculations depending on a discount rate.⁹ It is useful to consider the impact on loan-hedging alongside the FCA’s wish for interest rates on new loans after Q3 2020 not to use LIBOR – a possible implication is that the loan hedge will also need to depend on the new RFR if the hedge is to be adequately matched to the loan. This potential requirement will place an immediate burden upon credit institutions and their counterparties to establish, test and communicate their new RFR processes, documentation and systems for the many instruments used as loan hedges, including the derivative types listed above. A possible result is that some changes to IBORs across the world would need to be in place for loans and hedging derivatives by 30 September 2020.

In addition to the matters above, there are a number of other hurdles to be dealt with. An example is the lack of aligned approach between the different currencies in terms of timing and methodology of their RFRs, which will make the transition journey more complex for clients holding multiple products using different IBORs. There are operational challenges too: the dependence of many floating rate products on the current features of IBOR, the existence of different margins for different currencies, and the detailed challenges for IT systems which will need to be carefully evaluated. On the contractual aspects, the large volume of documentation to be changed (including legacy deals such as intra-group agreements) poses difficulties, and much work remains to be done to align the treatment of market segments within banks and corporate entities.

Finally, there may be tax consequences: any changes in reference rates which result in a transfer of value between the parties to the contract should generally be looked at from a tax perspective. With tax often following the financial statements, understanding the accounting treatment is likely to be the first step in determining the tax treatment. Helpfully the US ¹⁰ tax authorities have indicated in guidance that the change in an instrument’s terms due to the withdrawal of IBOR or similar rates could in some cases be viewed as a variation of the existing instrument as opposed to the creation of a new instrument. The UK tax authorities issued a market consultation on 19 March 2020 ¹¹ concerning the taxation impacts arising from the withdrawal of LIBOR. Certain more detailed tax questions remain however, including the tax nature of any one off payments resulting from the change in reference rates. Possible downstream impacts should also be considered, including for example any impacts on thin capitalisation ¹² and related agreements.

In conclusion, we can note the need to move away from interbank offered rates worldwide within a defined timetable, but the effort and uncertainty involved is still considerable. Despite the current pandemic, it seems unlikely that regulators will have much scope to slow the move from IBORs, as the move has now become a market trend as well as a regulatory mandate. In addition, some interest rate changes, such as those on hedges to term loans, have potential to occur earlier than the general end-2021 deadline. Market participants will need to keep engaged on the topic to understand fully the detailed scope of their necessary changes, and to ensure that they are resourced to make the changes soon.