Libor Reform 2022
The London Interbank Offered Rate (LIBOR) has been used extensively as a reference rate in a range of financial products and instruments for more than 40 years. However, the financial crisis triggered significant changes in the financial markets and some Interbank Offered Rates (IBORs) could not stay intact. In 2013, the International Organisation of Securities Commissions (IOSCO) introduced a set of principles underpinning the calculation of a benchmark rate. In 2014, the Financial Stability Board (FSB) sets out recommendations in order to:
- Strengthen IBORs by anchoring them to a greater number of transactions
- Improving the processes and controls around submissions
- Identifying alternative near Risk Free rates (RFRs)
- Encouraging derivative market participants to transition new contracts to an appropriate RFR
RFRs: Alternative reference rates
LIBOR’s weaknesses have led regulators to decide a transition away from LIBOR to alternative reference rates (RFRs). National Working Groups were established to create new rates, based on recommendations of the Financial Stability Board, an international body monitoring the global financial system.
- For CHF Libor , SARON Swiss Average Rate Overnight
- For USD LIBOR, SOFR Secured Overnight Financing Rate
- For JPY Libor, TONA Tokyo Overnight Average
- For GBP Libor, SONIA Sterling Overnight Index Average
- For EUR LIBOR, €STR Euro Short Term rate
They are considered as risk free rates as they are derived from a large volume of overnight transactions. They are not Forward looking (or Term rates) as Libor, where rate for the interest period is known in advance, hence term rates are created based on these overnight rates on a backward looking basis (various methodologies apply).
Libor Submissions are history
Financial Conduct Authority in UK (FCA) announced on March 5, 2021 that LIBOR panel Bank Submissions will cease immediately after December 31, 2021 for all GBP, EUR, CHF, JPY settings as well as for the 1-week and 2-month USD settings. The FCA also announced that the remaining LIBOR settings for USD will cease on June 30, 2023.
ISDA Approach – Fallback Rates
To create a replacement rate otherwise a Fallback Rate, the term adjustment will be based on the “compounded setting in advance rate”, where the relevant Alternative Reference Rate (ARR) is observed over the relevant IBOR term (e.g 1M) and compounded daily over the relevant period
The spread adjustment (ISDA) will be the “historical median approach” based on the median spot spread between the IBOR and the adjusted ARR calculated over a five-year lookback period prior to the relevant announcement. The spread adjustment is ‘Static’ for each tenor.
The fallback rate will equal the term-adjusted ARR plus the spread adjustment.
The need for a transition strategy
The change was not meant to happen in one day – a transition strategy has to be established. Through this strategy, financial Institutions need to ensure a) the readiness to offer new products, instruments and services referencing to new RFRs and b) the remediation of legacy transactions referencing. Considering that Libor has been one of the most popular benchmarks for corporate lending the criticality of such a strategy becomes quite apparent.
Our Experience in a Libor Reform Project
- Conduct a product exposure analysis to determine the LIBOR-linked exposures for each line of business (by asset class, tenor and maturity) including off-balance sheet exposures such as lines of credit
- Identify core functions and processes for each business line that are impacted from Libor Reform
- Document requirement analysis and functional specifications for
- Identification of replacement index (fallback rate) for each asset category. Different treatment may apply for legacy portfolio and new lending business.
- Replacement approach to new fallback rates to legacy portfolio, what will be the triggering event for the replacement
- System configuration and product customization to adopt new alternative rates.
- Rate feeds update and synchronization with new fallback rates submission
- Identify accounting impact
- Coordinate activities to prepare a comprehensive inventory of contracts by contract type, product and client segment for assessment and identification of contractual amendments needed.
- Identify customer pools that need to be aware of the reform and identify communication form and channels
Analytix, based in Athens – Greece, was established in 1997 as an IT consulting company, focusing in the broader financial services industry. Since its foundation, Analytix actively participates in various information systems projects in Greece and Cyprus, Europe, the Americas and the middle East, covering a wide range of services.