“End of IBOR”:
End of IBOR
Better be “forward-looking” than “backward-frustrated”!
The discontinuation of the once dominant London interest calculation was sealed with the EU Benchmark Rate Regulation (BMR) of 2016 as the new legal base.
The existing IBORs, with the exception of the “revised” EURIBOR, must be either reformed or replaced by RFRs by the end of 2021 since they will no longer be published as from the beginning of 2022:
- Australia: Bank Bill Swap Rate --> AONIA
- Euro area: EURIBOR / EONIA / EUR-LIBOR --> €STR
- United Kingdom: GBP-LIBOR --> SONIA
- Hong Kong: HIBOR --> HONIA
- Japan: JPY-LIBOR / TIBOR --> TONA
- Canada: CDOR --> CORRA
- Switzerland: CHF-LIBOR --> SARON
- USA: USD-LIBOR --> SOFR
The EURIBOR, the EONIA and the USD-LIBOR account for the major part of all IBOR-relevant transactions.
What is the current status as regards the introduction of new Risk-Free Rates and Term Rates?
According to the ECB’s current planning, the EONIA will be discontinued on 3 January 2022 and replaced by the Euro Short-Term-Rate (€STR). Since 2 October 2019, the EONIA has been computed as €STR plus a fixed spread of 8.5 basis points – due to this change in the calculation method, the EONIA’s interest rate level at the transition date was maintained and linked directly to the new RFR. The €STR is published on each TARGET2 business day based on transactions conducted and settled on the previous TARGET2 business day. The €STR is based exclusively on unsecured deposit transactions with a transaction volume over EUR 1 million performed by the reporting banks and their financial counterparties. The advantage of the new RFRs and the €STR is that they represent the interest rate situation of each currency and not the interest rates available on the interbank credit market.
First €STR products such as interest rate swaps are already being traded, but their market share is currently still very low.
The currency-specific LIBOR rates and the EURIBOR are Term Rates for which the interest rate to be paid for a 1-month, 3-month or 6-month interest period is calculated at the beginning of the latter. Since these Term Rates are future-oriented they are also called “forward-looking”.
On the contrary, the new RFRs represent exclusively Overnight Rates. These are generally suitable as part of a “backward-looking” approach, i.e. the calculation of the interest rate in a 1-month, 3-month or 6-month interest period occurs only at the end of the latter based on the observed Overnight Rates. However, some derivative products such as Forward Rate Agreements, Caps and Floors as well as certain cash and credit products are considered to be incompatible with the “backward-looking” approach of the RFRs.
For this reason, the EURIBOR was reformed in 2019 to align it with the regulatory requirements set out in the BMR. After a long period of hesitation regarding an alternative calculation approach, a hybrid methodology was decided upon. According to the latter, the calculation of the EURIBOR is based firstly on market transactions and in a second step on the appraisals of qualified experts should there be no relevant unsecured money market activities. Consequently, this methodology is also referred to as the “waterfall approach”. Following a test phase, the hybrid methodology was introduced at the end of 2019, and the approval of the “revised” EURIBOR as a benchmark-compliant reference interest rate was granted. The EURIBOR benchmark can thus be used also after 3 January 2022 for new and old contracts. However, if market participants increasingly switch to €STR-based products over time, it might no longer be possible to calculate the EURIBOR due to the low level of liquidity. Consequently, we recommend to plan the integration of a fallback solution both in the contracts and in the Treasury Management System (TMS) also for the EURIBOR.
Besides the EURIBOR, there are further initiatives for other currency areas in order to determine “forward-looking” Term Rates. For example, the “Working Group on Sterling Risk-Free Reference Rates”, in collaboration with four private providers, has developed a Term Rate based on the SONIA, the so-called Term SONIA Reference Rate (TSRR). In this respect, it is already clear that the various approaches followed by the providers resp. the future administrators will lead to marginally differing Term Rates, which raises the question of which rate should be used. In this respect, the market data provider Refinitiv already introduced in July 2020 a prototype for a SONIA Term Rate with 1-month, 3-month and 6-month durations.
However the regulatory authorities are refraining from issuing an explicit recommendation concerning the application of new Term Rates.
Where do things stand regarding the current fallback planning?
With the entry into force of the EU Benchmark Rate Regulation (BMR), it is mandatory to include fallbacks for all contracts concluded after 1 January 2018 and linked to a reference interest rate. According to the currently applicable fallbacks of the 2006 ISDA Definitions (International Swaps and Derivatives Association), if the respective IBOR were not available, an Agent Quote would need to be obtained from major traders in order to determine a fallback rate. If the IBOR were no longer available in the long term, it is likely that traders would not be able to provide such Quotes. Upon the discontinuation of the respective IBOR, a consultation would thus not produce any result.
Consequently, the ISDA has determined, with the “Floating Rate Option” of the 2006 Definitions, that the existing consultation will be replaced by an RFR plus a spread. To this end, the ISDA will issue a protocol allowing the parties to adapt their existing frameworks with the new fallback by mutual agreement. The new fallback of the ISDA Amendment is calculated based on a combination of the respective “compounded in arrears” RFR and an additional spread resulting from the historical 5-year median of the differences between the respective IBOR and the RFR. The compounding formula is based on the formula that can also be found in Overnight Index Swaps (OIS). In case of a definitive discontinuation of the respective IBOR, this “all-in fallback rate” (compounded RFR plus spread) would take effect as fallback. To this end, the ISDA has selected the market data provider Bloomberg Index Services Limited (BISL) in July 2019 in order to calculate and publish the “all-in rate”. In the future, the latter will thus be the official source for the relevant “Floating Rate Option”.
What measures should be implemented now due to the transition?
Firstly, all the financial contracts existing within a company that relate to the EONIA, EURIBOR or LIBOR must identified. The conclusion of bilateral agreements and the adjustment of the existing contracts between the counterparties allow to overcome many obstacles at an early stage and reduce risks when transitioning to the new RFRs.
In order to settle payments, the potential specific fallback mechanism must be known for each financial contract. Since these are often processed electronically, for example using Treasury Management Systems, the respective fallback must also be implemented in the system at the date when it takes effect. This can be achieved for example by calculating a compounding “backward-looking” mechanism or by switching to the “all-in rate” of BISL. This proves to be all the more difficult that the fixing date depends on the contractually defined Day Count Convention.
The existing market data connections and the corresponding contracts with the market data providers must continue to be examined as part of a requirement analysis. The Identifier Code of the EONIA, for example, currently remains unchanged for most market data providers and is provided as €STR plus the mentioned spread premium. It is highly likely that the Identifier Code will change at the latest upon the discontinuation of the EONIA at the beginning of 2022. At Refinitiv, the existing Reuters Instrument Code (RIC) will change from “EONIA=” to “EUROSTR=”. Further changes must be implemented regarding the RFRs of other currency areas, Term Rates and other discounting curves that are influenced by EONIA, EURIBOR or LIBOR and must continuously be taken into account in the transition planning given the current developments and the respective existing portfolio.
For example, various approaches are possible for the design of a secured discounting curve during the transition period:
- an EONIA curve composed of (sufficiently liquid) EONIA-based instruments;
- a "shifted” EONIA curve that was derived from the existing EONIA curve through a parallel shift of -8.5 basis points;
- an €STR curve that was designed using (sufficiently liquid) €STR instruments;
- a "shifted” €STR curve that was designed based on the existing €STR curve through a parallel shift of +8.5 basis points.
New derivatives based on RFRs must be able to be represented and processed by the TMS. Consequently, corresponding times and budgets must also be planned for the transitions and updates of the existing TMS.
Due to the mentioned wide-ranging effects and risks resulting from the change of reference interest rates, a comprehensive requirement analysis and the subsequent implementation of contract adjustments in the TMS are necessary. The experts of KPMG’s Finance and Treasury Management Team can help you in this process by sharing their extensive know-how with you.
Source: KPMG Corporate Treasury News, Edition 103, July/August 2020
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