IBOR transition: Benchmark reform background, Risk Free Rates and industry actions
Julien Rey from IHS Markit discusses benchmark reform and the IBOR transition
What is LIBOR and the impact of benchmark reform?
Today LIBOR underpins trillions of dollars of financial transactions, and it is used from the end consumer mortgages to your loans and more complex derivatives products. It is basically everywhere. So, why are we moving away from LIBOR and what is the problem with it? Why is everybody talking about it? So two things really the risk of manipulation and the lack of representativeness in terms of the cost of funding today. Risk of manipulation because the way LIBOR is calculated and published on a daily basis across all major jurisdictions, is based on a pool of banks submitting this number and their best estimate of the cost of funding on that specific day. In a way, although not the primary purpose of that exercise, it renders the benchmark easy to manipulate and this happens a couple of times in the past few years, unfortunately. But really, the main problem with LIBOR today is that it doesn't represent the cost of funding between the banks in what we call the inter banking markets, because most of the banks are using the overnight market to fund themselves and LIBOR is not an overnight rates. So this is really the key thing that pushes the industry to move away from LIBOR and in terms of timeline starting in 2013-2014, the Financial Stability Board and IOSCO looked at ways to strengthen LIBOR, but also at publishing a blueprint for new alternative benchmarks that would be more representative of the industry today. But really, it's only in 2017 when the Financial Conduct Authority announced that they would no longer compel the banks that are submitting to labor today to continue to do so after the end of 2021. And really, this is the key date that triggered an acceleration of the transition away from labor to these new benchmarks.
What are the latest development of Risk Free Rates?
As I've just mentioned, the industry is moving away from LIBOR and new benchmarks are being created or reformed to be better suited to the industry today. Really, if you look at what's happening in the US, we've got a new benchmark that has been published by the Fed for the first time a year ago. It's called a Secured Overnight Financing Rate or SOFR, and similarly in other jurisdictions, such as in Europe, we've got ESTR that will be published for the first time in October. This year, in the UK we've got SONIA who has always been around but has been repurposed and reformed to replace the existing benchmark there. All these new benchmarks are now being published and are available for trading except for ESTR. And we are seeing nascent liquidity in all of these. If we take as an example software in the US, it's been published, as I said, for the first time a year ago, we've seen some liquidity starting to build up in the futures markets. We are seeing issuers using it for floating rate notes and short-term debts. And we are also seeing some swaps and basis swaps in the derivatives markets, starting to trade especially between banks. But again, this is very new, very nascent liquidity and there is still a long way to go.
What are the concerns around transitioning to new RFRs?
So really, the concerns around the transition to RFR is the fact that they are effectively quite different to what LIBOR is today. The key difference is the fact that these are overnight indices versus LIBOR being a term index. And that makes them slightly more difficult to use, because the industry is not used to that type of benchmark. So just to give a couple of examples to use a new benchmark, such as SOFR or Sonia is quite difficult for such products such as loans or floating rate notes because people are used to receive coupons indexed to LIBOR on a three monthly basis or every six month. And the new benchmarks such as SOFR or Sonia are overnight benchmarks. So, the way you can translate these benchmarks into a three-month coupon is widely understood in industry as compounding them on a daily basis to the period of time you require it to be. So, we call that compounded in arrears. But the problem with this is not only it's a bit more complex, but it means that you don't know the value of your coupons until the end of the periods. And this is something that the industry will have to adjust to and it creates issues for treasurer, for end clients because this is not the way the industry has been walking onto today.
How to approach an IBOR transition program?
So in terms of moving away from LIBOR, whether you're a financial institution, an insurer or a smaller institution, not necessarily dealing with financial corporates, what you really have to do today is to run an inventory of your LIBOR exposure, whether it's contractually, whether it's from a valuation perspective, you want to know today, what you have in your portfolios, and what you need to look at in terms of transitioning this exposure, or keeping it but relying, for example, in fallback rights. So, doing an inventory is a key thing that everyone should do today, based on that inventory, you then have to make a decision on am I happy to keep that exposure as it is today? Or do I want to transition away from this and start using the new benchmarks and to make an informed decision, you will need to have a lot of data observability is going to be key to make decisions in that space because there are a lot of implications in terms of resources needed to move away legal implications. From a valuation perspective, there will be value transfer potentially from moving from one benchmark to another. So really starting with an inventory today, and then moving along the way, using reliable data to make informed decision is going to be key in the next few years.