LIBOR Transition Background

What is IBOR?

Interbank Offered Rates (IBORs) are the average rates at which banks can borrow in the interbank market and range in maturities from overnight to 12 months. The rates are calculated using submissions from a number of panel banks.

What is LIBOR?

The London Interbank Offered Rate (LIBOR) is the most commonly used IBOR. It is an unsecured interbank borrowing rate. LIBOR is not set by supply and demand, nor is it set by the market or the government. Instead, it relies on the banks involved to accurately report the interest rates they would have to pay to borrow from each other. LIBOR is based on five currencies (US Dollar, European Euro, British Pound Sterling, Japanese Yen, and Swiss Franc) and seven different maturities (overnight/spot next, one week, and one, two, three, six, and twelve months). The combination of the five currencies and seven maturities creates a total of 35 different LIBOR rates that are calculated and reported each business day. The official LIBOR interest rates are published at 11:55 a.m. London time by the ICE Benchmark Administration (IBA).1

How are LIBOR rates used?

As of mid-2018, about USD $400 trillion worth of global financial products are tied to LIBOR.2 LIBOR is widely used as a reference rate by market participants across nearly all asset classes, including: derivatives, bonds, loans, and other financial instruments. Some of these financial products are further detailed below:

 

  • Loans: Commercial products like syndicated loans, business loans, floating/variable rate notes, and variable rate mortgages, as well as consumer loan-related products like individual mortgages and student loans.
  • Derivatives: Forward rate agreements (FRAs), interest rate swaps, cross-currency swaps, interest rate futures/options, swaptions.
  • Bonds & Securities: A wide variety of accrual notes, callable notes, and perpetual notes, floating rate notes (FRNs) and securities like collateralized debt obligations (CDOs), and collateralized mortgage obligations (CMOs).

 

Why LIBOR rates are changing

In July 2017, the UK's Financial Conduct Authority (FCA) announced that it will no longer compel LIBOR panel member banks to contribute to the benchmark after 2021. While LIBOR may still be published for some time beyond 2021, the production of LIBOR is not guaranteed. Regulators have indicated a desire to move away from LIBOR and move towards alternative reference rates because LIBOR no longer fits its purpose. Due to changes in the regulatory framework, there has been a significant decline in the interbank unsecured funding markets in the last decade. Stringent liquidity rules since the 2008 financial crisis have made it far less attractive for banks to lend to other banks through short-term unsecured markets. Consider the three-month USD LIBOR rate – the most heavily referenced rate, which has a daily unsecured funding volume of around US$ 500 million but underpins over US$ 200 trillion in outstanding USD LIBOR based contracts.3 Given the limited activity in the unsecured lending market, LIBOR submissions are becoming more of a judgment call and thus there are increasing concerns about LIBOR’s long-term sustainability.

To improve durability, robustness, and sustainability of the underlying interest rate benchmark, regulators are encouraging the industry to move to alternative rates: rates that are lower risk and based on transactional data.

 

WHAT IS THE TIMELINE FOR LIBOR CESSATION?

The ICE Benchmark Administration (IBA), the UK Financial Conduct Authority (FCA), as well as, the Financial Stability Board (FSB), have released statements confirming that the transition from LIBOR remains a key priority and that firms cannot rely on LIBOR being published beyond 2021 (non-USD LIBORs; USD LIBOR settings on 1W and 2M) and beyond June 2023 (remaining USD LIBOR settings). FirstCaribbean is following this guidance and, as such, continues to advance its transition program efforts.

 

WHAT HAPPENS WHEN LIBOR CEASES TO BE REPORTED?

Most contract documents that reference LIBOR contemplate a temporary cessation of a benchmark rate but not a permanent cessation. Therefore an amendment of the embedded LIBOR fallback language is needed. In the case of derivatives, ISDA has published the amendments but, because the definitions are incorporated into the Master Agreements, parties will either need to amend existing Master Agreements or adhere to a Protocol that will address the changes.

 

What is CIBC FirstCaribbean doing to support the LIBOR transition?

FirstCaribbean through collaboration with CIBC has mobilized a comprehensive Enterprise-wide IBOR Transition Program which addresses every aspect of the benchmark reform globally. The key work streams that run through all business units and infrastructure groups have been identified and are focused on areas such as communication, operational readiness, and product strategy and transition management. ​​​​​

 

What may clients expect?

The discontinuance of LIBOR may affect products and services that you have previously purchased or entered into and it is not yet clear how alternative reference rates will apply to any such products and services. You should consult with your own financial and legal advisors on the possible effects of LIBOR reform. FirstCaribbean will continue to monitor the market and communicate updates taking place during the transition away from LIBOR.

 

Alternative rates across the globe

What are the LIBOR alternative replacement rates?

Regulators around the world have tasked committees comprised of market participants to identify and recommend a successor rate in each country. These successor rates are outlined below.6

 

Country

IBOR

Potential Discontinuation Date

Alternative rate

Target for cessation of new use of LIBOR

USA

USD LIBOR

Jan 2022 (USD LIBOR settings on 1W and 2M)

July 2023 (remaining USD LIBOR settings)

SOFR (Secured Overnight Financing Rate)

Dec 31, 2021

UK

GBP LIBOR

Jan 2022

SONIA (Sterling Overnight Interbank Average Rate)

April 01, 2021

Europe

EUR LIBOR

Jan 2022

€STR (Euro Short Term Rate)

Guidance not provided by industry bodies.

Switzerland

CHF LIBOR

Jan 2022

SARON (Swiss Average Rate Overnight)

 

Japan

JPY LIBOR

Jan 2022

TONA (Tokyo Overnight Average Rate)

 

In Canada, the Canadian Alternative Reference Rate (CARR) working group selected the Canadian Overnight Repo Rate Average (CORRA) as the risk-free alternative to CDOR. CORRA is an existing Canadian overnight risk-free rate that is transaction-based and has been published since 1997. The Bank expects that, over time, CORRA will be adopted across a wider range of financial products and could become the dominant Canadian interest rate benchmark, particularly in derivatives markets.

IBORs in other jurisdictions - BBSW (Australia), Euribor (Europe), HIBOR (Hong Kong), TIBOR (Japan), and Fed Funds (US) - are also expected to continue post 2021.

 

What are synthetic LIBOR rates?

The Financial Conduct Authority, the LIBOR regulator, now has the powers to compel the publication of a benchmark for up to 10 years and impose new methodology requirements on the benchmark administrator, the ICE Benchmark Administrator (IBA) to keep a synthetic version available. The FCA will consult on GBP and JPY, requiring IBA to continue to publish them on a ‘synthetic’ basis and for JPY, if published, will only be until 31 December 2022. FCA will continue to monitor progress in the transition away from USD LIBOR to determine if a synthetic rate for 1m, 3m or 6m USD LIBOR would be viable and necessary. FCA has indicated that such synthetic rate would equal a term RFR + ISDA fallback spread.

 

What are the key differences between LIBOR and Risk-Free Rates (RFRs)?7

Criteria

LIBOR

SOFR

SONIA

€STR

SARON

TONA



Transaction
based?

No – bank
submission
based on
expert
judgement
(Unsecured)



Yes – Repo
transactions
(Secured)


Yes – Money
Markets
(Unsecured)


Yes –
Money
Markets
(Unsecured)



Yes – Repo
transactions
(Secured)


Yes –
Money
Markets
(Unsecured)



Term
Structure

Yes – 7
maturity
tenors
(Forward-
looking)

No –
Overnight
rate
(Backward-
looking)

No –
Overnight
rate
(Backward-
looking)

No –
Overnight
rate
(Backward-
looking)

No –
Overnight
rate
(Backward-
looking)

No –
Overnight
rate
(Backward-
looking)



Includes
credit risk?

Yes –
Bank lending
rate (includes
credit risk)



RFR (no
credit risk)


RFR
(minimal/no
credit risk)

RFR
(minimal/
no credit
risk)



RFR (no
credit risk)

RFR
(minimal/
no credit
risk)

 

How would interest rates be calculated in the absence of forward-looking term structures?

Using backward-looking RFRs, a simple or compounded interest rate can be calculated. Under a simple interest calculation, the additional amount of interest owed each day is calculated by applying the daily rate of interest to the principal borrowed with the payment due at the end of the period being the sum of those payments. Under a compound interest calculation, the additional amount of interest owed each day is calculated by applying the daily rate of interest to both the principal borrowed and the accumulated unpaid interest. Market participants may also use this concept, both in arrears or in advance, to price financial instruments. ​

 

Impact of LIBOR transition

What are some of the key challenges market participants would likely face during and post transition?

  • Lack of forward-looking term structure in RFRs: The RFRs are backward-looking; therefore, systems, models and curves would be required to calculate compounded interest in arrears. Also, clients will not know the interest rate in advance of payment.
  • Lack of credit risk in RFRs: Overnight RFRs would be lower than LIBOR rates; therefore, a spread would need to be added to ensure economic indifference as we transition from LIBOR rates to RFRs. Also, overnight RFRs have shown to be volatile at quarter-end and year-end.
  • Lack of RFR market liquidity: Currently, there is not sufficient liquidity in RFR financial instruments as the volume of transactions referencing the new RFRs remains low, leading to less incentive to transition existing IBOR portfolios to RFRs.8
  • Multi-currency products: Where market conventions for alternative reference rates in a relevant currency are yet to be settled, parties should assess whether successive amendments will be required and whether different pricing should apply to different currencies.

Is there any progress with regard to the development of forward-looking RFRs?

In the UK, the ICE Benchmark Administration and Refinitiv launched their respective Term SONIA benchmarks. Both benchmarks are available in 1-month, 3-month, 6-month and 12-month tenors. However, the regulators recommends use of SONIA Term Rate to be limited to select products (trade finance – which require a term rate from a pricing perspective) and client types (smaller corporate, wealth and retail clients for whom simplicity and/or payment certainty is a key factor). BoE SONIA Use Case Consultation

In the US, the ARRC has set a goal of developing a robust, IOSCO-compliant forward-looking term rate that could be used in commercial contracts but it is dependent on the growth and depth of SOFR derivatives markets. ARRC SOFR Term Rate Administrator RFP

 

What is the ISDA credit spread adjustment for legacy products?

As a risk-free (or near risk free) rate, RFR’s will be lower than LIBOR, which necessitates a spread adjustment to compensate for the lack of credit & term risk in RFRs and neutralize the transition economically as best as possible. ISDA, after extensive consultation, have recommended the use of a consistent approach to calculate and apply a spread adjustment when transitioning LIBOR products to RFRs. ARRC and Bank of England Sterling RFR Working Group have agreed to match the value of ISDA’s spread adjustments when transitioning LIBOR lending products to RFRs. Credit spread adjustment will be based on a historical median over a five-year period, calculating the difference between LIBOR and respective RFRs. When the FCA announced on March 5, 2021 that LIBOR has or will be discontinued, or is unrepresentative, the spread adjustment was finalized and fixed from that day onwards. Bloomberg is the official source for these fixed credit spread adjustments.

 

What is the current spread adjustment between LIBOR and RFRs? 

The spread adjustment between LIBORs and RFRs have now been fixed on a permanent basis and is available through Bloomberg. Bloomberg LIBOR/ RFR Spread Adjustment Values  

 

Is there any progress with regard to the development of a RFR dynamic credit spread? 

In the US, Bloomberg and IHS Markit, are planning to publish daily credit spread adjustment for SOFR to address the concern that in times of market distress, USD LIBOR will tend to widen whereas SOFR will tighten without a credit spread adjustment. This credit risk component must also move in line with market dynamics so that credit exposures are properly captured in financial instruments over time. BLOOMBERG & IHS Markit join race for sofr credit add on

 

Is there any source to track development of RFR liquidity? 

ISDA publishes RFR trading data on a monthly basis. As of January 2021, ~12% of traded interest rate derivatives was based on RFRs. While the rate of RFR trading has been increasing over past few quarters, it is still quite low. Data can be accessed here: ISDA IRD RFR Data

 

Total IRD Notional Traded per Month

 

With regard to loans, there have been very few RFR loans to date. The Loan Market Association (LMA) tracks RFR loans: RFR Loans Tracker  

How would a contractual rate change when it is based on RFR as opposed to LIBOR?

As discussed earlier, there are inherent structural differences between the LIBORs and RFRs. Adjustments are therefore needed to the RFRs to ensure contracts originally negotiated to reference a LIBOR continue to meet the original objectives of the counterparties to the maximum extent possible once a fallback takes effect. The RFRs will be compounded over the relevant LIBOR period and a spread adjustment will be added to the compounded rate. The spread adjustment will be based on the median over a five-year period of the historical differences between the LIBOR in the relevant tenor and the relevant RFR compounded over each corresponding period. While the economics of RFR transactions will clearly be similar to those under the existing LIBOR product, it is impossible to say that on any particular day that they will be identical. A fixed rate loan is another alternative.

 

KEY DEVEOPMENTS & MILESTONES

Regulators and industry bodies have been working together to deliver on the following milestones:

  • Derivatives: The International Swaps and Derivatives Association Inc. (ISDA) has published its 2020 IBOR Fallbacks Protocol and a related Supplement to the 2006 ISDA Definitions. The Supplement amends the 2006 Definitions to provide a LIBOR fallback mechanism for new derivatives transactions that incorporate the 2006 Definitions. The Protocol provides a uniform market-wide mechanism for parties to voluntarily amend existing derivatives contracts to address LIBOR discontinuation.
    • Where can you find the Protocol? It can be found on this link: ISDA Fallback Protocols & Supplement
    • How to sign up for the Protocol? Link for adherence: ISDA Fallback Protocol
    • Industry stance: The relevant industry bodies - ISDA, The Alternative Reference Rate Committee (ARRC), The Financial Stability Board (FSB) as well as various central banks, tax authorities and accounting boards - strongly encourage widespread and early adherence to the Protocol by all affected financial and non-financial firms. As of today, more than 13,500 firms have signed the Protocol.

 

    • Derivative Product Transition Guidance: ISDA has provided details on how fallbacks would function for various derivative products. RFR Conventions and IBOR Fallback Product Table (including guidance on how fallbacks operate for non-linear derivatives)
    • Action recommended: FirstCaribbean recommends that you review the details of the Protocol with your professional advisors and contact your Relationship Manager to take the course of action that best suits your requirements. A bi-lateral amendment to ISDA docs will take place prior to the cessation date for Clients that elect to not adhere to the Protocol.
  • Lending Products FirstCaribbean in consultation with legal advisors has formulated fallback language for newly issued USD LIBOR-denominated business loans and will rely on the ARRC recommended fallback language to determine fallback language for FCIB participated USD LIBOR-denominated syndicated and bilateral loans.
    • Where can you find these documents? Alternative Reference Rate Committee Announcements  
    • Spread adjustment: The ARRC recommended methodology is based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR. This is the same approach used by ISDA for derivative products and this spread is now fixed.
    • Impact on hedging: Transition activities may have an adverse impact on the effectiveness of derivative trades that are used to hedge cashflows of loans. If the timing of the activation of the fallback rate in either product differs, this could result in the derivative no longer being an effective hedge for the underlying loan.
    • Action recommended: FirstCaribbean recommends that you review the details of FCIB formulated fallback language to fully understand the implications on your business from a commercial, legal and operational standpoint. We also recommend (in the case of hedged loans) that you review and amend both the loan and swap contracts at the same time to avoid potential basis mismatches. FirstCaribbean will contact you in due course to review our mutual contracts and update them to meet industry best practices.
    • LIBOR/ RFR Spread adjustment methodology: ISDA and ARRC have confirmed the fallback spread adjustment methodology for lending and derivative products. It will be the “historical median approach” based on the median spot spread between the LIBOR and the adjusted RFR calculated over a five-year lookback period prior to the relevant announcement. The fallback rate will equal the term-adjusted RFR plus the spread adjustment. Bloomberg Index Services Limited (BISL) has been selected to calculate and publish the fallback rates on a delayed basis. Bloomberg Fallback Rates
    • Accounting guidance: International Accounting Standards Board (IASB) has finalized International Financial Reporting Standards (IFRS) guidelines to deal with accounting issues arising from the replacement of LIBOR, including hedge accounting issues. International Accounting Standards Body (IASB) LIBOR Transition Guidance  
    •  

    • U.S. Tax guidance: U.S. Internal Revenue Service (IRS) has provided interim guidance on transitioning away from LIBOR to RFR. Internal Revenue Service (IRS) LIBOR Transition Guidance
    • CCP discounting switch: LCH/ CME completed the switch of discounting from Fed Funds to SOFR CCP Discounting Switch. CCP Discounting Switch  

 

Below is a timeline representation of key upcoming relevant developments:

 

libor timeline

 

 

Additional Resources

Following table provide additional resources for information about the transition.

  • Alternative Reference Rate Committee (ARRC)
  • The Working Group on Sterling Risk-Free Reference Rates
  • Working group on euro risk-free rates
  • Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks
  • National Working Group on Swiss Franc Reference Rates
  • Canadian Alternative Reference Rate working group (CARR)
  • International Swaps and Derivatives Association, Inc. (ISDA)
  • Chicago Mercantile Exchange (CME)
  • Financial Stability Board - Official Sector Steering Group (OSSG)

·  Financial Conduct Authority (FCA)

  • ICE Benchmark Administration (IBA)

 

 

Have questions?

If you have any questions, please contact us at our Libor Mailbox.

  1. Intercontental Exchange
  2. Bank of International Settlements
  3. Alternative Reference Raters Committee
  4. Financial Conduct Authority
  5. Financial Stability Board
  6. Financial Stability Board
  7. Bank of Canada
  8. ISDA
  9. Federal Reserve Bank of New York

Disclaimer

1 Intercontinental Exchange 2 Bank for International Settlements 3 Alternative Reference Rates Committee 4 Financial Conduct Authority 5 Financial Stability Board 6 Financial Stability Board 7 CIBC analysis 8  ISDA9  Federal Reserve Bank of New York