IBOR Transition

Interbank Offered Rates (IBORs) are interest rate benchmarks aimed at representing the level at which banks exchange funds in the short-term unsecured money market. They are currently used to determine interest rates and payment obligations for a variety of products such as floating-rate notes, business loans, consumer loans, mortgages, securitizations, and derivatives. Historically, the IBORs most widely used worldwide are EURIBOR (the Euro interbank offered rate) and LIBOR (the London interbank offered rate). It is estimated that EURIBOR underpins more than EUR 180 trillion worth of contracts, while, according to an estimate made in 2021, financial contracts referencing USD LIBOR accounted for more than $200 trillion.

Sources:

https://www.emmi-benchmarks.eu/euribor-org/about-euribor.html 

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report

In recent years, a number of Central Banks, regulators and financial market authorities worldwide have been steering a vast process of reform and revision of interest rate benchmarks. After the financial crisis of 2007, profound economic and regulatory evolutions reshaped the way banks fund themselves on wholesale markets. The decline in the volume of transactions in unsecured money markets undermined the confidence in the reliability and robustness of existing interbank benchmark rates. 

Concerns that IBORs may pose a source of systemic risk for the global financial stability led the G20 to task the Financial Stability Board (FSB) with reviewing and reforming major reference rates in 2013. In July 2013, the International Organization of Securities Commissions (IOSCO) published the fundamental principles of interest rate benchmarks for their use in financial markets. This was followed in 2014 by the FSB proposals on the implementation of the IOSCO principles by benchmark administrators. The FSB recommendation was to strengthen IBORs by anchoring them to a greater number of transactions, where possible, and to identify alternative near-risk free rates (RFRs).  RFRs are robust overnight rates, anchored in active, liquid underlying markets and, over the years, they have been selected by regulators  and working groups  to replace IBORs in case of their discontinuation.

Sources:

https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf 

https://www.fsb.org/2014/07/r_140722/

EURIBOR is the IBOR rate which expresses the cost of obtaining wholesale funds in euro in the unsecured money market by credit institutions in the EU and EFTA countries.  

EURIBOR, the rate prevalent in the Eurozone, has been reformed after the introduction of the EU Benchmark Regulation (BMR), which has set a new and enhanced regulatory framework for interest rate benchmarks in Europe. The new Euribor calculation methodology, based on the so-called “hybrid approach” makes EURIBOR compliant to the BMR.

EONIA, another important reference rate for the Eurozone, which represented the level at which bank exchanges overnight loans on the interbank market, has been involved as well in this widespread process of revision. Since 1 October 2019, the European Central Bank started to publish €STR, the new RFR for the Eurozone, which reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. Since January 3^rd, 2022  €STR  replaced the EONIA rate - which used to represent the level at which bank exchanged overnight loans on the interbank market – discontinued for being no longer compliant to  the new regulations.

Historically, the London Interbank Offered Rate (LIBOR) was published for seven interest periods, ranging from overnight to 12 months, and for five currencies (USD, GBP, EUR, JPY and CHF); it was therefore used in different jurisdictions worldwide. It was based on quotes received from the LIBOR panel banks, which provide their cost of borrowing funds on the wholesale money market.

On March 5, 2021 the FCA (Financial Conduct Authority, the UK financial regulatory body), announced that GBP, EUR, CHF, JPY Libor and 1 week and 2 months USD Libor would have either ceased to be provided or become no longer representative immediately after December 31, 2021.  For the remaining USD Libor settings,  the date of June 30, 2023 was established as a final term for the representativity of such indexes. The FCA , acknowledging that the conversion of all existing contracts would not be feasible before the cessation dates, in order to assure the continuity of existing contracts linked to 1,3 and 6 month tenors of GBP, JPY and USD LIBOR, required the benchmark administrator (IBA) to continue publishing such tenors on a “non-representative”, “synthetic” basis (i.e. based on RFR rates) for a limited period of time and solely for utilization in existing contracts, confirming that these rates are not applicable to new contracts. 

In the proximity of these dates, the so-called “fallback” arrangements will be triggered in existing contracts. Fallback arrangements are legal clauses included in financial contracts which indicate the replacement rate or the calculation methodology to be applied to determine the replacement rate in case of temporary non-availability, discontinuation or declaration of non-representativeness of the contractual rate by a competent authority.

The FCA’s announcement of March 5^th,  2021 triggered the calculation of the Spread Adjustments to be used in derivatives fallback clauses, as outlined by the ISDA (International Swaps and Derivatives Association) protocol. The ISDA spread adjustments are typically recommended by Working Groups for inclusion in the fallback clauses of business loans indexed to Libor and not amended before the Libor cessation dates.

See our Section “What are the changes for derivatives contract?” and “What are the main developments in the US and in the UK”  for more information on this point.

The table below displays the main RFRs and the actors involved in their determination across the main jurisdictions where our Group is active.

In September 2021, the FCA , acknowledging that the conversion of all existing GBP and JPY Libor contracts would not be feasible before the end of 2021, in order to assure the continuity of existing contracts linked to 1,3 and 6 month tenors of GBP and JPY LIBOR, required the benchmark administrator (IBA) to continue publishing such tenors on a “non-representative”, “synthetic” basis (i.e. based on RFR rates) till the end of 2022. These rates are not applicable to new contracts. 

Sources:

https://www.fca.org.uk/publication/documents/future-cessation-loss-representativeness-libor-benchmarks.pdf

https://ir.theice.com/press/news-details/2021/ICE-Benchmark-Administration-Publishes-Feedback-Statement-for-the-Consultation-on-Its-Intention-to-Cease-the-Publication-of-LIBOR-Settings/default.aspx

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Press_Release_Endgame.pdf

RFRs are different in nature compared to IBOR rates. First of all, they are all overnight rates, while IBORs exhibit a term structure (meaning they are published across multiple tenors, from overnight up to 12 months); this fact entails that RFRs credit risk component (i.e. the risk that a borrower may fail to make the required contractual payments) is negligible. This is due to the very short maturity of RFRs compared  to IBORs, which usually exhibit a risk component linked to the longer maturities.

In addition, RFRs determination is based solely on effective transactions, while IBORs may incorporate estimates on the level of market rates made by the contributing banks. 

Given such differences between IBORs and RFRs, transitioning away from LIBOR is an articulated process, impacting a wide variety of financial and banking products.

US: In 2017, the ARRC, the US working group tasked by the FED with identifying robust alternatives to USD LIBOR, selected the Secured Overnight Financing Rate (SOFR) as its preferred alternative to USD LIBOR. SOFR is a secured interest rate measuring the cost of borrowing cash overnight in the repo market, collateralized by U.S. Treasury securities. The liquid and active market underpinning SOFR makes the rate robust according to international standards.

The ARRC has led the transition away from USD LIBOR, publishing recommendations for the fallback language to be adopted in existing contracts, as well as best practices outlining key recommended milestones that market participants should aim to achieve to be prepared for the transition.

Among the  most relevant developments, in July 2021 the ARRC formally recommended the use of SOFR Term Rates published by CME Group. Such rates can be used in the fallback clauses of existing contracts and in some specific type of new contracts, as indicated in the ARRC guidelines. In particular, ARRC supports the use of SOFR Term Rate for specific business sectors where adopting SOFR overnight could be difficult, e.g. multi-lender facilities and trade finance loans. (see ‘Sources’).

Similarly, US legislative authorities acted to ensure a smooth transition to the new benchmarks, especially for the so-called “tough legacy” contracts maturing after June 2023 and lacking a robust fallback language. The main institutional pillars are the Libor Legislation, signed into law in the New York State on April 7, 2021 and the inclusion of the “Libor Act” in the Consolidated Appropriations Act, bill passed by the Congress on March 14, 2022 and signed into law on March 15, 2022.

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Press_Release_Term_SOFR.pdf

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Scope_of_Use

UK: In the United Kingdom, the Bank of England convened in 2015 the Working Group on Sterling Risk-Free Reference Rates (RFRWG) to select an alternative reference rate for sterling markets. In April 2017, the Working Group recommended the SONIA benchmark as its preferred RFR. SONIA is a fully transaction-based rate and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions and other institutional investors. SONIA, introduced in March 1997, has been administered by the Bank of England since 2016 and reformed in 2018, to make it compliant with international best practices for financial benchmarks. The RFRWG, besides setting key milestones to guide market participants toward a smooth transition away from GBP LIBOR, is producing specific recommendations and best practices.

Unlike the US case, the UK RFR Working Group indicated to the market to adopt SONIA compounded in arrears as the prevailing choice for both fallback clauses of existing contracts and new contracts. The use of Term SONIA has been limited to a narrow group of financial products, specified in dedicated guidelines (see Sources). 

https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/rfrwg-term-sonia-reference-rate-summary.pdf

A crucial aspect customers should familiarize themselves with is the “backward looking” (i.e. defined in arrears) nature of interest rate payments when LIBOR will be replaced by RFRs. IBOR rates are by definition “ forward looking” rates, meaning that the interest payment requested to a client is known in advance (for example, currently in the case of a contract referencing to the 3 month LIBOR rate, such contract entails that the interest payment requested at the end of the three month period is known at the beginning of the interest period). In the future, interest payments for RFR-indexed contracts will be determined only at the end of the interest period, since those payments will be calculated averaging the overnight RFRs observed during the interest period. In the near future, in particular for some specific financial instruments (syndicated and bilateral loans, floating rate notes, swaps, mortgages) market participants are converging towards conventions for averaging RFR fixings so that the interest rate is known slightly in advance compared to the end of the interest period.

For other products, which require the interest rate to be determined well in advance (e.g. discount of receivables), some market participants have declared their preference for the development of a forward looking RFR term structure; such forward looking RFRs have been developed in all main jurisdictions worldwide and are subject to specific guideline for their utilization (See the section “What are the main developments in the US and the UK?”)

Furthermore, it is important to highlight that IBOR rate levels (which represent the cost of borrowing for banks) include a bank credit and liquidity premium, while RFRs do not; such premia takes into consideration the fact that a bank which is borrowing funds might not have enough liquidity to repay the loan at  maturity.  

Therefore, when transitioning to the new RFRs in a fallback triggering event, the addition of an adjustment spread has been envisioned by the industry to avoid transfer of economic value between counterparties in a contract. Working Groups have recommended the use of historical median spread between the IBORs and the relevant RFRs for this purpose.

Derivative products are generally governed worldwide by the rules lined out by the International Swaps and Derivatives Association (ISDA). ISDA launched recently the new IBOR Fallback Protocol for existing uncleared derivatives contracts and the IBOR Fallback Supplement for new uncleared contracts, to provide derivatives contracts with a hardwired fallback language, which will be triggered at the time of an IBOR discontinuation or, in case of  LIBOR, if the FCA declared that the rate is no longer representative of the underlying market.

The announcement of March 5, 2021 by the FCA regarding the future cessation and loss of representativeness of the LIBOR benchmarks represented an “index cessation event” under the ISDA definitions. Therefore, the spread adjustments for legacy Libor derivatives have been fixed on that day and the derivatives fallbacks (i.e. the risk-free rate plus spread adjustments) will automatically occur for all outstanding derivatives contracts that incorporate the IBOR Fallbacks Supplement or are subject to adherence of the ISDA 2020 IBOR Fallbacks Protocol after the respective LIBOR cessation or loss of representativeness dates. 

Source:

https://www.isda.org/2021/03/05/isda-statement-on-uk-fca-libor-announcement

Since 2016, Intesa Sanpaolo S.p.A. has been actively participating to various working groups and has evaluated the impacts of the interest rate benchmarks reform, preparing itself for the transition  through a dedicated internal project, aimed at monitoring regulatory and market evolution on this matter, with the purpose of taking all appropriate actions to ensure the transition to alternative or reformed benchmark rates globally.

Besides adopting RFRs as default reference rates for all new contracts, Intesa Sanpaolo has enacted a plan of reduction and repapering of the existing Libor-based contracts, in accordance to the milestones set forth by international Regulators.

US: https://www.newyorkfed.org/arrc

UK: https://www.bankofengland.co.uk/markets/transition-to-sterling-risk-free-rates-from-libor

CHF: https://www.snb.ch/en/ifor/finmkt/fnmkt_benchm/id/finmkt_reformrates

EUR: https://www.ecb.europa.eu/paym/interest_rate_benchmarks/WG_euro_risk-free_rates/html/index.en.html

JPY : https://www.boj.or.jp/en/paym/market/sg/index.htm/