The interest rate benchmark LIBOR is being wound down at the end of 2021. End dates have been announced for all LIBOR term lengths and new alterative reference benchmarks have been developed. Firms, financial organizations, insurers and governments should be taking appropriate action to review their operations and transition contracts to the alternative rates to ensure the end of LIBOR does not lead to market disruptions, business challenges, or harm to consumers. ICIEC will be prepared for the transition, will you?
What is LIBOR?
LIBOR is the London Interbank Offered Rate. It was intended to provide the interest rate at which banks could borrow funds from other banks in the wholesale market and since became an important interest rate reference point for contracts and business transactions around the world. LIBOR has been produced in 7 tenors or term lengths (overnight/spot next, one week, one month, two months, three months, six months and 12 months) across 5 currencies – the US dollar, euro, UK pound, Japanese yen, and Swiss franc. LIBOR is managed through regular submissions provided by a panel of 20 banks to a U.S.-based regulatory authority, the ICE Benchmark Administration Limited. These submissions were intended to reflect the interest rate by term and currency at which banks could borrow money on unsecured terms in wholesale markets.
Why move away from LIBOR?
There are a number of reasons why LIBOR has become a problem. First, financial markets have changed, and LIBOR has not been able to keep up. After the 2008-09 financial crisis, banks turned away from accessing funds by using the interbank market, where LIBOR set the interest rate for transactions. Therefore, the international interbank market which underpins LIBOR has since dwindled substantially.
Second, the eurocurrency markets that helped to drive LIBOR no longer exist as a distinct entity. Over time, LIBOR instead has been used to price much of the interest rate derivatives market, even as that derivatives market expanded far beyond the euromarkets. Logically, a risk-free benchmark rate should have been used rather than LIBOR, but that evolution never took place.
Third, banks do not often lend to each other at present on an unsecured basis, and that market is not returning. As a result, LIBOR is no longer measuring anything that resembles real transactions; it has become the rate at which banks are not actually borrowing from one another. This reality raised serious questions about the future sustainability of the LIBOR benchmarks. Both the Bank of England and UK financial regulator (the FCA) noted in 2017 that it was increasingly apparent there was an absence of active underlying markets for actual LIBOR transactions, which undermined the use of LIBOR as a market-based metric.
And fourth, the system for quoting rates, and thus constructing LIBOR, was contained and even fragile, making it more vulnerable to misconduct and illegal activity — as has unfortunately occurred on occasion.
The coming transition
After much discussion among various global banks and national financial regulators, in March 2021 the ICE Benchmark Administration Limited (IBA), the administrator of LIBOR, confirmed that the panels for sterling, euro, Swiss franc and Japanese yen LIBOR will cease operating at end-2021, as well as the panels for 1-week and 2-month US dollar LIBOR. The remaining US dollar LIBOR panels will cease to operate at end-June 2023. The LIBOR panel banks will continue to submit to LIBOR until end-2021, and to end-June 2023 for US dollar LIBOR, to enable time for the market to transition away from LIBOR.
A new representative rate for each LIBOR currency
Working groups in the United States, the EU, United Kingdom, Japan, and Switzerland have been discussing the development of alternatives to LIBOR over a number of years. These alternatives have now been established and, while generally similar, they will have subtle differences among them. The key difference compared to LIBOR is that the new reference interest rates reflect actual transactions in repos, wholesale deposits and overnight call markets in the five currencies being used.
The new reference rates are:
U.S. dollar: Secured Overnight Financing Rate (SOFR): Secured rate that covers multiple overnight repo market segments.
Euro: Euro short-term rate (ESTR): Unsecured rate that captures overnight wholesale deposit transactions.
UK pound: Sterling Overnight Index Average (SONIA): Unsecured rate that covers overnight wholesale deposit transactions.
Swiss franc: Swiss Average Rate Overnight (SARON): Secured rate that reflects interest paid on interbank overnight repo rate.
Japanese yen: Tokyo Overnight Average Rate (TONAR): Unsecured rate that captures overnight call rate market.
Each reference rate will be administered by a national authority for their respective currency –the Federal Reserve Bank of New York, European Central Bank, Bank of England, SIX Exchange for the Swiss franc, and Bank of Japan.
The Federal Reserve Bank of New York was the first institution to begin publishing SOFR data, and SOFR futures made a fast start with about US$5 billion in daily volume of trading in the first year (2017). Interest in the SOFR futures market grew and quickly reached over 12 thousand contracts in the first year.
The first SARON transactions took place on a bilateral basis in April 2017, with clearing of SARON-referencing swaps being established in autumn 2017. While notional volumes were initially small, growth in transaction numbers has been encouraging and is a valuable pre-requisite for transition.
Foundational European financial institutions have taken steps to build the new market segments. The European Investment Bank (EIB) issued an initial £1 billion SONIA-linked bond, the first SONIA floating rate note issued. It was significantly oversubscribed. The European Central Bank’s Governing Council then began publication in 2019 of an overnight euro rate, called ESTR, based on wholesale unsecured overnight borrowing transaction data collected by the euro system.
Overall, significant progress has been made across all five currencies toward implementing the new reference interest rate system administered by a national authority for each currency. The transition away from LIBOR is well under way, and there will be no turning back.
Implications of the transition
At the end of 2021 (and June 2023 for most USD LIBOR tenors), the LIBOR benchmark will no longer be sustained through the current mechanism used by its regulators, and banks on the panels will not be obliged to stay part of the system. Ensuring an orderly transition by businesses, financial institutions and governments from LIBOR to the alternative interest rate benchmarks would minimize disruption and help contribute to financial stability.
At this stage, all market participants will need to take appropriate action to remove dependencies on LIBOR. This means taking reasonable steps to ensure the end of LIBOR does not lead to markets being disrupted, business affected or diminished, or harm to consumers. The smoothest and best pathway for this transition is to move away from LIBOR in all new contracts, instead selecting one or more of the five alternative reference rates.
In terms of legacy contracts (i.e. those still in force at end-2021 and referencing LIBOR), users of LIBOR should be making plans to either switch contracts from the current basis for LIBOR to the new benchmarks, or by ensuring that contracts have robust fallbacks in place that allow for a smooth transition when current LIBOR data points cease to be published. The most desirable approach to transition for legacy contracts would be to amend contracts to reference one or more alternative rates. All firms (even those that are not banks, insurers or asset managers) that currently make use of LIBOR in some manner should be taking action on these fronts.
Ideally, firms, financial institutions, and governments should conduct an end-to-end inventory of their LIBOR exposure. This inventory should cover the full range of processes and systems, including pricing, valuation, risk management and financial accounting. It should cover contracts with clients, counterparties, creditors, employees, suppliers and others. For critical inhouse and contracted financial systems, firms should seek confirmation from their service providers of timely software upgrades in order to be able to use alternative rates.
Where LIBOR transition issues are identified that require amendment or renegotiation, firms should communicate with affected clients or service providers in a timely manner. This communication should describe to the customer or service provider the risks associated with LIBOR ending, recognizing the risk that some customers may not fully appreciate the implications.
Implications for Islamic Finance
With the upcoming transition, there are a number of implications for Islamic banking facilities. First, they will need to consider if any fallback provisions that apply after the transition away from LIBOR are appropriate and satisfactory. Second, LIBOR is a forward-looking term rate, whereas the proposed replacement rates are backward-looking. Banks’ operational systems are generally set-up on the basis of forward-looking term rates and may therefore need to be adapted to function effectively. The timing and basis of calculating profit rates will also need to be amended where new rates are implemented. New forward-looking term rates may be developed for some currencies, but it is still uncertain if these will be available prior to the cessation of LIBOR and their use is likely to be restricted to specific markets and circumstances.
A third concern is in relation to value transfer and spread adjustment. The new rates will be based on the overnight deposit rate of the relevant central bank and do not include the term liquidity premium and bank credit risk that are inherent in LIBOR. Simply replacing the LIBOR with the new rate without any spread adjustment would reduce the overall financing cost and reduce the economic value of the financing arrangement to the bank. Where an existing facility will transition from LIBOR to the new rates, it will need to be determined how to build in term liquidity premium and bank credit risk to avoid value transfer as much as possible. This will generally mean that a spread adjustment will need to be added to the existing margin or profit rate to compensate the bank or financier for what is otherwise likely to be a lower overall rate.
A fourth area of concern is the implication of structural issues for Islamic banking facilities. Islamic banks will face specific challenges in adapting to the use of backward-looking rates due to the fact that they typically use cash flows to generate a mark-up, that must, under Shari’ah principles, be determined at the time the provision of services is agreed. One possible solution to this is to calculate the return on a backward-looking basis and add it to the following profit period. However, the general preferred solution is to agree on a fixed rate of return payable in advance for a set contract or calculation period. At the end of each period, the bank would then calculate the actual profit return using the new rates and grant the obligor a rebate of any difference between the fixed profit mark-up that was previously charged and the actual profit determined by the backward-looking rates.
Overall, Islamic banking facilities will need to consider what changes need to be made for their existing or legacy transactions which will continue after December 2021 and on what basis to facilitate new transactions going forward. There is opportunity for the transition away from LIBOR to result in the development of alternative standard benchmarks designed specifically for the Islamic finance market, but development in this regard remains to be seen. Flexibility to accommodate future market consensus will be key for Islamic banks.
Implications for the Insurance Industry
The transition away from LIBOR can have a significant impact on numerous aspects of an insurer’s business if not managed intentionally. As with Islamic banking facilities, insurers should consider if any fallback provisions that apply after the transition away from LIBOR are appropriate and satisfactory. In terms of balance sheet valuation being impacted by the transition, a small change in the discount rate could have impact on long-dated liabilities with a floating interest rate. Insurers should measure and analyze the impact of these changes on their overall capital position. If potential impact on cash flow and liquidity is determined, insurers should revisit their asset and liability matching. LIBOR is also the most used rate for interest rate swap transactions. The decommissioning of LIBOR could present issues for insurers hedging against risk. Additionally, the transition may affect insurers pricing for some of their long-duration products, such as any legacy contracts that are tied to LIBOR.
Regulators and rating agencies may examine insurers’ operational readiness for the transition process and their ability to adjust their products, provisions and contracts accordingly. To mitigate the possibility of negative implications for their ratings, insurers need to plan ahead. They can begin by identifying areas within their products, models, and systems that are affected by the transition and consider the impact. Insurers need to understand the approach needed to address the transition so that clear plan and governance framework for operational readiness can be developed. A plan will help prevent bottlenecks and avoidable delays during the implementation process. Insurers should also keep open communication with their board of directors and senior management throughout the transition. Additionally, speaking with clients and agents early will limit surprises and disruptions in the future.
ICIEC is currently in the process of preparing for the transition, keeping in close touch with clients and the board of directors along the way. An internal study is being conducted to determine the effect of the transition on ICIEC’s products, operations, and existing contracts. Once completed, ICIEC will prepare an action plan to manage and transition operations as necessary.
