Hamilton Perspectives Newsletter

IBOR Transition: What you need to know

Significant ef­forts are un­der­way to amend and in some cas­es re­place the in­ter­bank of­fered rate (IBOR) for key glob­al cur­ren­cies. In the UK, the Financial Conduct Authority has is­sued un­equiv­o­cal state­ments im­plor­ing par­ties to con­sid­er LIBOR un­avail­able af­ter 2021. In the EU, the Benchmarks Regulation[1] (BMR) has im­posed a hard dead­line for ad­min­is­tra­tors of bench­mark rates with­in the EU to reg­is­ter and com­ply with new rules on bench­mark rate set­ting by 1 January 2020. Existing IBORs will need to be amend­ed to com­ply with the BMR, and those that are not in com­pli­ance by the dead­line will be sus­pend­ed. This could re­sult in se­ri­ous dis­rup­tion to mar­kets and con­trac­tu­al arrange­ments that have not oth­er­wise put in place con­tin­gency plans.

What is IBOR?

IBOR rep­re­sents a fi­nan­cial in­sti­tu­tion’s bor­row­ing cost for ob­tain­ing un­se­cured fund­ing of a par­tic­u­lar cur­ren­cy and term in the in­ter­bank lend­ing mar­ket. Notable IBORs in­clude LIBOR for GBP, EURIBOR for EUR and STIBOR for SEK. IBORs are a per­va­sive fea­ture in glob­al fi­nance con­tracts, from loans and bonds to de­riv­a­tives (among oth­er things). For ex­am­ple, IBOR of­ten un­der­pins in­ter­est rates in com­mer­cial lend­ing arrange­ments and forms the ba­sis for end-of-day val­ues for par­tic­u­lar hold­ings in de­riv­a­tive trans­ac­tions.

IBOR re­form and al­ter­na­tive rates

IBOR re­form has been a top­ic of dis­cus­sion since re­ports first emerged of the mar­ket ma­nip­u­la­tion of LIBOR in 2008. Like many IBORs in­clud­ing STIBOR, the rate-set­ting mech­a­nism for LIBOR re­lies on sub­mis­sions from a pan­el of par­tic­i­pat­ing banks of trans­ac­tion da­ta (if avail­able) or “ex­pert” es­ti­mates. The scan­dal re­vealed that deal­ers con­tribut­ing to the LIBOR rate-set­ting mech­a­nism were col­lud­ing to make sub­mis­sions that ben­e­fit­ted their trad­ing po­si­tions, re­sult­ing in dozens of banks pay­ing out to­tal penal­ties of up­wards of 10 bil­lion U.S. Dollars.

The marked de­cline in the num­ber of in­ter­bank trans­ac­tions has al­so un­der­mined the re­li­a­bil­i­ty of cer­tain IBORs. In some cas­es, reg­u­la­tors have had to com­pel banks to con­tin­ue to sub­mit rates. However, reg­u­la­to­ry in­ter­ven­tion may be end­ing for some IBORs: in 2012, the UK’s Financial Conduct Authority an­nounced that it would no longer com­pel pan­el banks to sub­mit rates for LIBOR af­ter 2021 and has since ac­tive­ly pushed mar­ket par­tic­i­pants to iden­ti­fy a re­place­ment rate. Similarly, un­der the BMR, na­tion­al au­thor­i­ties on­ly have the pow­er to com­pel con­tri­bu­tions (and on­ly for cer­tain crit­i­cal bench­marks) for a two-year pe­ri­od.

To ad­dress these is­sues and en­sure an or­der­ly tran­si­tion away from IBORs, reg­u­la­tors have pur­sued a “mul­ti­ple-rate ap­proach” which com­bined re­form­ing and strength­en­ing IBORs for ex­ist­ing con­trac­tu­al arrange­ments while al­so push­ing pri­vate par­ties to tran­si­tion away from IBORs and es­tab­lish al­ter­na­tive ref­er­ence rates for ma­jor cur­ren­cies in the long-term.

In the EU, the BMR has tight­ened the con­trols over how rates are set. The BMR in­cludes sweep­ing prin­ci­ples for how bench­mark ad­min­is­tra­tors, con­trib­u­tors and users with­in the EU man­age con­flicts of in­ter­est and im­prove the qual­i­ty of in­put da­ta and method­olo­gies used in de­ter­min­ing bench­mark rates. For ex­am­ple, for in­ter­est rate bench­marks, ad­min­is­tra­tors are re­quired to es­tab­lish in­de­pen­dent over­sight com­mit­tees to reg­u­lar­ly scru­ti­nise the cal­cu­la­tion method­ol­o­gy, in­put da­ta and wider gov­er­nance arrange­ments. All in­ter­est rate bench­marks reg­is­tered with the BMR are al­so sub­ject to a bi­en­ni­al in­de­pen­dent ex­ter­nal com­pli­ance au­dit. Entities that pro­duce or con­trol a bench­mark, such as the Swedish Banker’s Association in re­la­tion to STIBOR, in some cas­es have had to over­haul their in­ter­nal pro­ce­dures to meet these new re­quire­ments. The BMR’s com­pli­ance re­quire­ments al­so have an ex­tra-ter­ri­to­r­i­al im­pact where­by non-EU bench­marks can on­ly be used in the EU if au­tho­rised un­der the BMR (sub­ject to lim­it­ed ex­cep­tions).

In ad­di­tion to these IBOR re­forms, across all ma­jor ju­ris­dic­tions, work­ing groups were formed to se­lect al­ter­na­tive ref­er­ence rates. Some of these al­ter­na­tives in­clude the Secure Overnight Funding Rate (SOFR) for USD, the re­formed Sterling Overnight Index Average (SONIA) for GBP, Tokyo Overnight Average (TONA) for JPY and Swiss Average Rate Overnight (SARON) for CHF. These so-called risk-free rates are based on his­tor­i­cal da­ta and there­fore less sus­cep­ti­ble to ma­nip­u­la­tion com­pared to the for­ward-look­ing IBORs.

What’s next?

Market par­tic­i­pants need to be aware of the scale of their ex­po­sure to IBORs in their ex­ist­ing con­trac­tu­al arrange­ments and should start plan­ning how to re­duce their re­liance on IBORs and tran­si­tion to new al­ter­na­tive rates as they be­come more wide­ly adopt­ed.

Some is­sues for par­ties to con­sid­er in­clude:

  • whether their lega­cy con­tracts have suf­fi­cient fall back lan­guage to en­sure that a per­ma­nent end to an IBOR does not re­sult in con­trac­tu­al dis­rup­tion and frus­tra­tion;
  • if con­trac­tu­al amend­ments are re­quired, what con­sent thresh­olds are re­quired for such amend­ments;
  • whether new risk fac­tors should be in­clud­ed in of­fer­ing doc­u­ments to ad­dress the tran­si­tion from IBOR;
  • how to ad­dress any pric­ing gap be­tween IBOR (which in­cludes bank cred­it risk) and an al­ter­na­tive rate (many of which are so-called risk-free rates) and which con­trac­tu­al par­ty is best suit­ed to ab­sorb the dif­fer­ence;
  • how to match the term pe­ri­ods for IBORs (giv­en that some al­ter­na­tive rates on­ly re­flect the rate of overnight trans­ac­tions); and
  • the po­ten­tial im­pact on ac­count­ing stan­dards.

Parties are al­so ad­vised to mon­i­tor guid­ance is­sued by the rel­e­vant reg­u­la­tors and in­dus­try as­so­ci­a­tions such as the Association of Financial Markets in Europe (AFME), Loan Market Association (LMA), and the International Swap and Derivatives Association (ISDA). The Hamilton Banking and Finance team is al­so avail­able to an­swer any ques­tions you may have.

[1]Regulation (EU) 2016/1011 of the European Parliament and the Council of 8 June 2016 on in­dices used as bench­marks in fi­nan­cial in­stru­ments and fi­nan­cial con­tracts or to mea­sure the per­for­mance of in­vest­ment funds and amend­ing Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014.