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 CIBC FirstCaribbean doing to support the LIBOR transition?

CIBC FirstCaribbean 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. 

 

Will COVID-19 impact LIBOR transition?

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 2021.45 CIBC FirstCaribbean is following this guidance and, as such, continues to advance its transition program efforts.​

 

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 legal advisors on the possible effects of LIBOR reform. CIBC 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

Alternative rate

Potential Discontinuation Date

USA

USD LIBOR

SOFR (Secured Overnight Financing Rate)

Jan 2022

UK

GBP LIBOR

SONIA (Sterling Overnight Interbank Average Rate)

Jan 2022

Europe

EUR LIBOR

€STR (Euro Short Term Rate)

Jan 2022

Switzerland

CHF LIBOR

SARON (Swiss Average Rate Overnight)

Jan 2022

Japan

JPY LIBOR

TONA (Tokyo Overnight Average Rate)

Jan 2022

 

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

 

Key Milestones

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

Topic

Comment

Anticipated Completion Timeframe

Cash Product
Fallback
Language

Fallback language has been drafted for most cash products and exists in two forms. One option is to use language which can be reviewed & renegotiated by parties before the transition (Amendment Fallback language). The other option is to use language which dictates a course of action once the transition happens without requiring further negotiation (Hardwire Fallback language).

  • Amendment Fallback language Completed
  • Hardwire Fallback language in development stage – 2H20

Cash Product
LIBOR to RFR
spread
adjustment

ARRC is currently gathering feedback from market participants regarding the appropriate spread adjustment which will ensure that the transition from LIBOR to SOFR does not create any economic winners or losers.

  • Consultation ongoing. Final recommendation likely in May/ June 2020.

ISDA
Amendment
Protocol/
Supplement

The International Swaps and Derivatives Association (ISDA) is currently working with market participants to identify: a) a fallback replacement rate, b) the LIBOR to RFR spread, and c) contract fallback language for the permanent cessation of LIBOR. The protocol will apply to new trades, while the supplement will provide the option to incorporate the fallback language into legacy trades.

  • April/ May 2020

Central
Counterparties
(CCPs) Switch
to RFR

CCPs such as LCH & the Chicago Mercantile Exchange (CME) to switch price alignment interest (PAI)/Discounting from LIBOR to SOFR in 2020

  • Oct 2020

Accounting,
Tax &
Regulatory
Impacts

Various regulatory and industry bodies such as the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB), the U.S. Internal Revenue Service (IRS), and the U.K.’s HM Revenue & Customs (HMRC) are working with market participants to develop mechanisms to support the transition to RFRs. For example, where a contract is updated to replace references to LIBOR with the alternative RFR, it will not be considered a modification of the contract which thereby limits any regulatory, accounting or tax implications.

  • FASB final guidance published
  • IASB guidance to be released Q3/Q4 2020
  • CRA/ IRS/HMRC has released proposed guidance. Final outcomes to be completed Q3/Q4 2020, in line with final Accounting guidelines

Forward-
looking term
structure

Regulators, industry bodies, and vendors are working together to develop RFR forward-looking term curves. However, until significant market liquidity develops, it is not yet possible to create a credible curve.

  • Ongoing - likely 2021

Pre-cessation
Trigger

ISDA and LCH are currently gathering feedback from market participants in order to decide whether to include a pre-cessation trigger in derivative fallback language which would account for the scenario where regulators declare LIBOR “non-representative” earlier than January 2022. ARRC has already embedded this feature into its recommended fallback language for most cash products.

  • April/May 2020

RFR Index &
Official
Compounded
Averages

ARRC has recently published a daily SOFR index and 3/6/9 month compounded averages on the Federal Reserve Bank of New York (NYFED) website. The Bank of England (BOE) is working on a similar SONIA golden source index. This will help to calculate compounded interest payments until the appropriate systems, models, and curves are available to perform these required calculations.

  • SOFR – already available9
  • SONIA – July, 2020

 

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.

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