Roadmap for the reforms of reference rates.
IBOR-Reform / News
30. May 2018

Roadmap for the reforms of reference rates.

The foundation of interest rate markets will be redesigned.

The pricing of many financial instruments and financial contracts depends on the accuracy and integrity of benchmarks. Serious cases of manipulation of interest rate benchmarks such as LIBOR and EURIBOR, as well as allegations that energy, oil and foreign exchange benchmarks have been manipulated, demonstrate that benchmarks can be subject to conflicts of interest. The use of discretion, and weak governance regimes, increase the vulnerability of benchmarks to manipulation. Failures in, or doubts about, the accuracy and integrity of indices used as benchmarks can undermine market confidence, cause losses to consumers and investors and distort the real economy. It is therefore necessary to ensure the accuracy, robustness and integrity of benchmarks and of the benchmark determination process.    

[ACT (EU) 2016/1011 of the European Parliament and of the council of 8 June 2016]

 

IOSCO published new “Principles for Financial Benchmarks” in 2013 [1] and thus started the regulatory reprocessing of the “LIBOR scandal” which has resulted in some banks having to pay billions in penalty fees. The EU implemented those principles via the acts EU 2016/1011 [2] and EU 2017/1147. Starting in 2020, new contracts are not allowed to refer to non-compliant benchmarks any longer.  The EU Benchmark Regulation (EU BMR) is particularly relevant to interest rate markets. The EU determined the reference rates EURIBOR[3], EONIA[4] and LIBOR[5] as critical reference rates under Art. 20 paragraph 1 of the act EU 2016/1011 through application of Commission Implementing Regulations 2017/1147[6] and 2017/2446[7]. Furthermore, none of these reference rates complies with EU BMR. Hence, an unchanged continuation of these reference rates is not possible.

This article provides a first overview of this complex topic. Considering the importance of this issue and the continuous flow of relevant information, we keep you updated. Therefore, in the coming weeks we plan to provide in-depth information on the following topics:

  • Methods for Evolved IBORs [8], successors of IBOR and associated basis risks
  • Current development of each reference rate [9]
  • Transition initiative of different institutions (e.g. ISDA protocol)
  • Bank internal transition

There is no easy solution.

Benchmark administrators are already working on IOSCO compliant solutions for today’s IBOR sets. Since there is a lack of sufficient liquidity in money markets underlying the IBORs, a robust fixing process based on real transactions is not possible. Hence, new methods are required (“Evolved IBOR”). An initial test phase of a compliant EURIBOR method has failed. Hybrid methods will be tested until 31 July 2018. An Evolved EURIBOR is expected to be available as of the fourth quarter of 2019. Currently it is unclear whether the implemention of a suitable method is possible. This has already failed for an Evolved EONIA which will be replaced by ESTER [10]. An Evolved LIBOR is expected to be available in the first quarter of 2019.

Even though a successful development of (compliant) Evolved IBORs is possible, in the medium term they might become less important. There are two critical questions:

  1. Will banks still participate in quoting to the EURIBOR / LIBOR panels?
  2. Is liquidity moving towards other markets such as instruments based on Risk-Free-Rates (“RFRs”), Overnight Index Swaps (“OIS”) or Repos?

In July 2017, Andrew Bailey, Chief Executive of the FCA (UK), said that the FCA would no longer compel a LIBOR quote by market participants from 2022 onwards [11]. He also prompted market participants to start planning and implementing the transition to alternative reference rates now. In a speech in March 2018[12], he continued, “I do not consider a synthetic LIBOR as an alternative to RFRs as the best benchmark for interest rate risk.” Thus, it seems clear that the FCA, as regulator in charge, does not view a reformed LIBOR as a long-term solution and rather wants to see it being replaced by RFRs. For EURIBOR the situation is such that the FSMA [13], as responsible regulator, can issue an obligation to participate in the panel, which in turn would be limited to a period of two years.

Outlook. 

Market participants face plenty of challenges due to the implementation of the Benchmark Regulation and the awaited changes in market practice. The main aspects are:

  1. High number of affected transactions
  2. Heterogeneous products and legislation
  3. Tight deadline until 2020
  4. Market practice will develop gradually
  5. Expected parallel phase of IBORs and RFR based reference rates
  6. Different basis of IBORs and RFR based reference rates

For more detailed information read here: https://www.l-p-a.com/risk-quant-consulting/ibor-reform/


[1] https://www.ecb.europa.eu/paym/initiatives/interest_rate_benchmarks/euro_unsecured_overnight_interest_rate/html/index.en.html

[2] https://www.fca.org.uk/news/speeches/the-future-of-libor

[3] https://www.fca.org.uk/news/speeches/recent-developments-financial-markets

[4] Financial Services and Markets Authority (FSMA): Belgische Finanzmarktaufsicht, Brüssel https://www.fsma.be/en

[5] https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf

[6] https://eur-lex.europa.eu/legal-content/DE/ALL/?uri=CELEX%3A32016R1011

[7] https://eur-lex.europa.eu/legal-content/DE/ALL/?uri=CELEX%3A32017R1147

[8] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32017R2446

[9] Euro Interbank Offered Rate (European Money Markets Institute (EMMI), Brüssel, Belgien, Aufsicht: FSMA)

[10] Euro OverNight Index Average (European Money Markets Institute (EMMI), Brüssel, Belgien, Aufsicht: FSMA)

[11] London Interbank Offered Rate (ICE Benchmark Administration (IBA), London, Vereinigtes Königreich, Aufsicht: FCA)

[12] Interbank Offered Rate

[13] EURIBOR und LIBOR sowie beispielsweise USD SOFR, GBP SONIA, JPY TONA, CHF SARON

Christian Behm
The author
Christian Behm

Christian Behm, CFA, is with LPA since 2004. He has broad experience in advising banks and has got a distinct capital markets focus. As Partner he is responsible for LPA’s Risk & Quant Consulting Practice and he covers large consulting mandates.

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Your partner for
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