LIBOR Transition

Beyond LIBOR The world of interest rate benchmarks is changing. Here is what you need to know.

Investment Bank

This section of the LIBOR transition website is not intended for wealth management, corporate or institutional client nor asset management clients of UBS. The document below aims to give our clients an understanding of the LIBOR transition and highlights the practical considerations that should be taken into account.

Information available on this site is provided for existing Investment Bank clients with existing LIBOR-referencing positions or products only.

Key highlights of the Practical Guide

Facts and Figures

Facts and Figures

Discounting Risk

Discounting Risk

Forecasting Risk

Forecasting Risk

Facts and Figures

  • 5 ARRs have been identified to replace the 5 LIBOR currencies
  • Each ARR is an overnight rate
  • The ARRs are backward looking rates
  • An adjustment (to address the term and credit differences) may be required to replace LIBOR with an ARR

Discounting Risk

  • Discounting rate and interest paid on collateral usually aligned
  • Switch in discounting rates to ARRs by CCPs is likely to be a key driver for increased adoption of ARRs across the industry
  • Any changes to the margin annex for a derivative contract should reference the new ARR to replace existing cash margin rate

Forecasting Risk

  • Updated ISDA definitions expected Q3 2020
  • Differences in fallback methodology across different product types may impact hedge effectiveness across transactions believed to be linked
  • Evaluation of current contractual fallback provisions may lead to increased bilateral discussion

Practical considerations checklist

  • Understand what this change means for you:
    – Analyse the exposure you currently have to LIBOR and assess the potential financial impact
    – Ensure you know where you have transactions which you believe to be linked (see Forecasting Risk Section)
    – Review the fallback language in your Legal Documentation (see Forecasting Risk Section)
  • Review your readiness:
    – Evaluate whether you need to make any changes to your risk management systems
    – In addition, consider any operational processes you may need to update, for example ensuring all reference data sources are updated accordingly
    – Consider consolidating your LIBOR exposure to reduce the number of bi-lateral transitions required

LIBOR Transition background

The London Interbank Offered Rate (LIBOR) is calculated from submissions by selected "panel" banks of the rates they either pay or would expect to pay to borrow from one another.
LIBOR is a widely-used interest rate benchmark. Rates are determined daily by the LIBOR administrator, the ICE Benchmark Administration (IBA), for various currencies (USD, EUR, GBP, CHF, JPY) and tenors (Overnight, 1w, 1m, 2m, 3m, 6m and 12m).

Size of IBOR market in 5 major currencies

According to IBA, LIBOR is used to determine periodic interest payments for many hundreds of trillions of notional of financial products globally, and is used for example in derivatives, bonds, structured products, securitised products and loans.

Just over a decade ago, the market's perception of an increase in inter-bank credit risk inherently contained within LIBOR led to a widening of the basis between LIBOR and short-term interest rate futures. Financial institutions began to switch from using LIBOR to Overnight Index Swap rate (OIS) for discounting purposes, which was seen as being closer to a risk-free rate. At the same time, liquidity in the unsecured lending market, which underpins LIBOR, declined as banks became increasingly unwilling to lend to one another on an unsecured basis. The concern was that a lending rate, based on an increasingly less liquid market, was being used to reference many multiples of financial contracts. As a result, in 2017, the FCA announced that the market should transition to alternative reference rates based firmly on transactions, with panel bank support for current LIBOR agreed only until the end of 2021.

In response to these concerns on LIBOR, the Financial Stability Board's (FSB) review produced the basis for the 19 principles developed by the International Organization of Securities Commissions (IOSCO) . One of the key IOSCO principles was that a new "representative" benchmark reference rate should wherever possible be based on transactions and not expert judgement.
Since the initial FCA statement in 2017 , national working groups (see Forecasting Risk section) have been set up with the support of regulators and central banks with broad industry and market representation. These working groups have recommended alternative benchmarks for each of the LIBOR currencies. These alternatives are viewed as more robust benchmarks, compliant with IOSCO principles and are underpinned by larger volumes of observable transactions.

Alternative Reference Rates

Different jurisdictions have developed different methodologies for their new ARRs, and as illustrated in the timelines in the appendix, these are all at different stages in terms of market liquidity and development. These ARRs are managed by different administrators, as outlined below.

Jurisdiction

Jurisdiction

Working Group

Working Group

Legacy Reference Rate

Legacy Reference Rate

Target ARR

Target ARR

Underlying transactions

Secured vs Unsecured

Underlying transactions

Secured vs Unsecured

Rate Administrator

Rate Administrator

Comments

Comments

Jurisdiction

US

Working Group

Alternative Reference Rates committee (ARRC)

Legacy Reference Rate

USD LIBOR

Target ARR

Secured Overnight Financing Rate (SOFR)

Underlying transactions

Secured vs Unsecured

Secured

Rate Administrator

Federal Reserve Bank of New York

Comments

 

Jurisdiction

UK

Working Group

Working group on Sterling Risk-Free Reference Rates

Legacy Reference Rate

GBP LIBOR

Target ARR

Sterling Overnight Index Average (SONIA)

Underlying transactions

Secured vs Unsecured

Unsecured

Rate Administrator

Bank of England

Comments

 

Jurisdiction

Euro Area

Working Group

Working Group on euro risk-free rates

Legacy Reference Rate

EONIA1

Target ARR

Euro Short Term Rate (€STR)

Underlying transactions

Secured vs Unsecured

Unsecured

Rate Administrator

European Central Bank

Comments

Reformed EURIBOR is expected to continue alongside €STR as a multiple rate approach. The European Commission has expressed confidence in EURIBOR for the medium term

Jurisdiction

Switzerland

Working Group

The National Working Group on Swiss Franc Reference Rates

Legacy Reference Rate

CHF LIBOR

Target ARR

Swiss Average Rate Overnight (SARON)

Underlying transactions

Secured vs Unsecured

Secured

Rate Administrator

SIX Swiss Exchange

Comments

 

Jurisdiction

Japan

Working Group

Study Group on Risk-Free Reference Rates

Legacy Reference Rate

JPY LIBOR

Target ARR

Tokyo Overnight Average Rate (TONA)

Underlying transactions

Secured vs Unsecured

Unsecured

Rate Administrator

Bank of Japan

Comments

Multi rate approach planned with TIBOR (but Euroyen TIBOR may discontinue)

The ARRs are structurally different from LIBOR and are not economic equivalents.

Components

LIBOR

ARRs

Methodology

Based on a waterfall methodology incorporating real transactions but also expert judgement

SOFR, SONIA, €STR, SARON and TONA are anchored in real transactions

Term

Published for 7 maturities from overnight up to one year

Currently only available overnight

Credit Risk Adjustment

Includes a risk adjustment to account for interbank credit spread and tenor

There is minimal credit spread adjustment as the ARRs are overnight rates and some ARRs are secured

Rate

The rate is set at the beginning of the period

The rate is based on daily observations and is only known at the end of the period

Settlement Conventions

Paid at end of period

There are a variety of conventions used in the calculation of cashflows dependent on backward looking rates:

·       Compounding of the overnight ARR over the payment period

·       Averaging of the overnight ARR over the payment period

·       Lockout

·       Backward Shift or Lookback

Please see Appendix Overnight Index Swap Industry Definitions for further information on the above

Some of the ARRs are secured rates, i.e. calculated from observed repos collateralized by government bonds. This applies to SARON for CHF and SOFR for USD. The others are unsecured like LIBOR, i.e. based on unsecured borrowing with no actual underlying security. LIBOR differs from these unsecured ARRs in that it is based not only on observed interbank borrowing transactions but also expert judgement.

The ARRs developed to date are overnight rates. There are several ongoing efforts looking to develop term structures for the ARRs, but they may not be fully available for use by 2021. Methods under consideration include compounding the overnight rates over a period and attempting to derive appropriately robust forward looking rates based on overnight index swaps and futures.

The initial focus has been on the five ARRs detailed above. In due course other alternative rates may be developed. See appendix Other IBORs Benchmark Rates for selected examples of those currently under review.

Changes to discounting

The derivative contracts portion of the hundreds of $trillions of contracts are held in portfolios of trades that were either executed bilaterally between market participants (under ISDAs and if collateralized with a Credit Support Annex (CSA)) or intermediated by Central Clearing Counterparties (CCPs). Many of these bilateral CSAs reference Effective Federal Funds Rate (EFFR) or EONIA as the benchmark used to determine the interest paid on cash collateral posted. The CCPs currently use EFFR and EONIA to determine the margin interest rate (known as Price Aligned Interest4   (PAI) rate) for USD and EUR activity respectively.

Whilst the expected value of LIBOR drives the expected payments referencing LIBOR, the cashflows themselves need to be discounted back to the present value / price for a contract or security respectively. In this case, the change in the discounting curve on the valuation is referred to as Discounting Risk. Prior to the financial crisis, in the derivatives market, the rate used to discount these cashflows was LIBOR. Subsequently many market participants adopted an approach that aligned the discounting rate used with the interest rate paid (cash margin rate) on the type(s) of collateral specified (known as Eligible Collateral) in the underlying CSA. Any change in the discounting curve will not only change the Discounting Risk but also create a value transfer.

To reflect the eligible collateral, the current overnight benchmarks for the major currencies are used to pay PAI. For example the EFFR is used as the PAI rate on the posting of USD cash collateral. This rate is generally used as the discount rate to value the trade. Similarly, when it comes to posting of EUR cash collateral, EONIA is the PAI rate and the discount rate. EMMI has announced that EONIA will be withdrawn at end of the 2021. CSAs referencing this rate can be updated before that date, for example, by replacing with €STR.

For CSAs where non cash collateral is used, e.g. government bonds, margin interest is not transferred between counterparties, therefore there is no need for any renegotiation to change the discounting rate used to value the trade. The discounting rate used to value the underlying derivative contracts of these CSAs is aligned to the funding rate for this collateral in the secured funding market. As an example, if US Treasuries are the only eligible collateral, this could currently mean that the discount rate used is EFFR for the CSA. This rate could change to SOFR once the secured funding market adopts SOFR as the funding rate instead of EFFR.

The CSA changes are likely to accelerate post the switch from EFFR to SOFR and from EONIA to €STR when the CCPs make the change in 2020. The switch in discounting rates is a significant milestone for LIBOR transition as it is expected that market participants will look to switch their discounting risk thereby establishing hedging and re-hedging requirements in transactions referencing these ARRs: a key driver for adoption of ARRs as the market standard floating rate.

LCH and CME have disclosed their plans to adopt SOFR in place of EFFR as the PAI rate and discounting rate for all USD discounted contracts held in the exchange. In order to minimize the resulting discounting risk basis, it is expected that some market participants will seek to renegotiate their CSAs referencing EFFR to SOFR as close as possible to the CCP timelines. For details on the switch from EFFR to SOFR as the PAI rate and discounting of USD activity at LCH and CME, please see the table below:

EFFR->SOFR

EFFR->SOFR

LCH5

LCH5

CME6

CME6

EFFR->SOFR

Date of
Change

LCH5

October 2020

CME6

October 2020

EFFR->SOFR

Scope

LCH5

All USD discounted products

CME6

All USD discounted products

EFFR->SOFR

Proposal Summary

LCH5

·       Cash and Risk compensating (EFFR/SOFR Basis) swaps for Members

·       Clients can opt for Cash only & an auction process will take place to ensure LCH remains flat risk/cash

CME6

·       All Participants take Cash and Risk compensating (EFFR/SOFR Basis) swaps

OR

·       For participants that do not want Basis swaps, CME intends to engage third party providers to facilitate an auction and/or transfer mechanism

Increased Bilateral Negotiation of CSAs driven by Discounting

In addition to the negotiations mandated by the "Margin requirements for non-centrally cleared derivatives" regulations (with the first phase effective 1st September 2016 and final phase due 1st September 2021), CSA renegotiations driven by LIBOR transition are expected to be a major exercise. Given the majority of OTC contracts referencing LIBOR are cleared, there is an expectation that market participants may want to ensure that both current regulatory mandated and non-mandated bilateral CSAs are in line with CCP discounting and PAI.
The industry has largely been through the transition from using LIBOR to overnight rates for discounting. The expectation is that the transition from current overnight rates (EONIA, EFFR) to ARRs (€STR, SOFR) will not be as challenging as the transition from LIBOR to ARR for forecasting. Forecasting changes will be discussed in the next section.

Forecasting changes

LIBOR is widely applied as the floating interest rate benchmark referenced in a derivative (such as a swap floating leg), coupon on a bond or used to determine the interest rate on a loan. The valuation of such contracts or securities is driven by the change in the expected value of LIBOR—this is expressed as Forecasting Risk.
Active LIBOR transition is where market participants switch out of LIBOR referenced contracts into ARR referenced contracts as market liquidity allows, rather than waiting until the end of 2021. This activity would see ARR forecasting risk gradually replace LIBOR forecasting risk.
The ARR forecasting curve is generally lower than the LIBOR equivalent.

For any contracts referencing LIBOR when it is discontinued, the parties will, in the absence of changes to the terms, have to rely on the contractual terms that exist to determine the post—cessation rate. The effectiveness and prevalence of these fallback provisions varies across products and markets. These provisions, depending on when drafted, may have the components listed in the following table. Market participants should review existing derivative contracts and current positions in all LIBOR-referencing financial contracts (that expect to be held beyond 2021) for provisions determining the reference rate in the absence of LIBOR, or what steps will be taken to frame an alternative. Various groups (specifically ISDA for derivative contracts) are coordinating inputs from the industry to arrive at fallback language for impacted financial products addressing permanent LIBOR cessation.

Term

Term

Definition

Definition

Term

Fallback Language

Definition

Fallback language refers to the legal provisions in a contract that apply if the underlying reference rate (e.g. LIBOR) in the product is not published (whether on a temporary or permanent basis).

Term

Fallback Rate

Definition

The reference rate replacing LIBOR upon the Fallback Trigger Event. There are multiple approaches adopted in existing contracts to calculate a fallback rate, including replacing a floating rate with the last LIBOR setting for all post-cessation fixings or referencing the lenders' costs of funds.

Term

Spread Adjustment

Definition

As noted LIBOR is different to the ARR applicable in each jurisdiction and there may need to be a spread adjustment applied to the ARR replacing LIBOR to account for differences in the construction of LIBOR and the ARR.

Term

Fallback Trigger Event

Definition

Set of events relating to the original reference rate which may trigger the fallback to a new Reference Rate.

There are different defined triggers and fallbacks for different products. In bonds, for example, a common fallback in existing documentation is to use the last available published rate. Thus in the event of LIBOR cessation, these securities would essentially become fixed rate products. In loans, a common ultimate fallback is to lenders' costs of funds. In a derivative, on the other hand, the alternative to LIBOR may be subject to calculation by agents (e.g. a dealer poll undertaken by calculation agent or to some other method).

For OTC derivatives, ISDA is consulting widely on updated definitions to incorporate fallback language for implementation in derivative contracts, with the final form due in Q3 2020.These changes will become effective for new contracts traded three months after the publication. These definitions are expected to include pre-defined ARRs based fallbacks for LIBOR and certain IBORs replacement rates and new trigger definitions. An alternative is to implement ISDA's Benchmark Supplement , which sets out a contractual process aiming to agree an alternative rate, but does not pre-define the actual rate. The Benchmark Supplement does not therefore provide economic certainty.

ISDA is also expected to publish an IBOR Fallback protocol that market participants may choose to sign up to that will apply these updated definitions to existing derivative contracts. The ISDA Protocol is expected to be drafted deliberately broad to cover transactions governed by ISDA Master Agreement or other forms of master agreement (e.g. FBF, Rahmenvertrag, Swiss Master Agreement) if they incorporate 2000 or 2006 ISDA Definitions.
If market participants choose not to sign up to protocol or do not adopt the provisions through a bilateral negotiation then the existing contracts will remain on the current fallback provisions as stipulated in the contract which when written probably did not envisage a permanent cessation of LIBOR. ISDA's Benchmark Supplement also provides the option to implement a contractual process for existing contracts. However, both parties to the contract need to elect to implement for existing contracts for this to take effect.

CCPs have indicated they will look to apply the updated ISDA IBOR Fallback definitions for all contracts (contracts executed under updated definitions as well as existing contracts).

Certain contracts which reference LIBOR (including bonds, structured products, securitized products, loans and a subset of existing contracts) may have characteristics that impede smooth transition such as product mechanics for material amendments, non-linearity, illiquidity or act as hedges to products with different fallback methods.
Other derivatives not documented under ISDA documentation may need to be reviewed to determine an approach. Generally, this approach is likely to involve market participants being requested to sign documentation agreeing to the transition to the relevant replacement rate.

It is hoped that products other than OTC derivatives referencing LIBOR may also include fallback language or other provisions aimed at easing the transition to the relevant replacement rate as and when industry standards develop.

Differences in fallback methodology across different product types have added more complexity to the transition for linked transactions. For example the hedge effectiveness of a swap hedging the LIBOR component of a bond or loan may lose some efficacy upon the triggering of differing fallback methodologies. Market participants may need to discuss any linked or hedged transactions and evaluate contractual fallbacks in place. The market uncertainty in entering into new contracts referencing LIBOR beyond 2021 are summarized by the Commodities, Futures Trading Commission (CFTC) .

In parallel to the consultation on the IBOR Protocol, ISDA has been consulting with the industry to determine a market consensus on the methodology used to calculate the adjustment spread to address the term and credit differences between LIBOR and the ARR. The adjustment part of this consultation has progressed to a Final Consultation on the following two choices:

  1. Median over five year lookback period from date of announcement/publication of information regarding cessation.
  2. Trimmed mean over ten year lookback period from date of announcement/publication of information regarding cessation.

It should be noted that ISDA has selected Bloomberg to be the calculation agent at the time of fallback trigger.

Terms

Terms

Definition

Definition

Terms

Cessation Event

Definition

Event whereby a reference rate is discontinued or unavailable permanently, triggering Fallback. A typical LIBOR cessation event would occur if there were no longer sufficient panel banks contributing to calculation of LIBOR

Terms

Pre-Cessation Event

Definition

An event which impacts the reference rate but does not prevent its publication. With respect to LIBOR, such an event could be where the FCA deems LIBOR unrepresentative per IOSCO principles (via EUBR legislation) thus preventing EU regulated market participants from entering into new contracts referencing LIBOR

Increased Bilateral/ Multilateral Negotiation Driven by Forecasting Risk

Due to the increased complexity introduced by the differences between asset class fallbacks and product amendment mechanics, the industry is expected to need to perform a significant review of contractual documentation before agreeing to change terms on their existing trades. Amendments to existing trades will be a challenging exercise if market participants have to amend a significant volume of trades across the different products on a bilateral or multilateral basis. Securitized products could involve more than two parties.

Contact us

Please do not hesitate to contact us if you have any further questions relating to the LIBOR Transition. Alternatively, please reach out to your usual UBS contact