»The IBOR reform is a fundamental change for both markets and banks. It takes a second glance to reveal the full effects.«
Christian Behm, Partner LPA
In excess of 350 trillion dollars’ worth of contracts reference the LIBOR alone. Measured by the volume of affected contracts, the IBOR reform is the biggest change in the capital markets since the introduction of the euro in 1999.
The reform is not exclusively regulatory in nature (e.g. EU Benchmark Regulation). Rather, it is a change in market practice driven by different stakeholders and market participants. It is expected that the benchmarks of LIBOR and Euribor will be replaced in the coming years by a family of so-called risk-free interest rates (RFRs).
In the short term, however, Eonia in particular is the focus of attention since it must be replaced by the end of 2019. This will entail considerable and, in some cases, unexpected implications.
The EU Benchmark Regulation (BMR) has set a transitional period to 1 January 2020 for existing benchmarks. After the cut-off date of 1 January 2020, only benchmarks that have been approved under EU BMR will be allowed to be used in new contracts. For existing contracts, non-compliant benchmarks may be used, subject to a decision by the competent authority of the member state.
Currently the overnight rates in GBP (Sonia), JPY (TONAR), and CHF (SARON) are IOSCO/EU-BMR compliant, and are now classified as new Risk-Free Rates (RFRs).
As the administrator of Euribor and Eonia, EMMI announced in February 2018 that no further efforts would be made to reform Eonia in order to achieve compliance with the EU BMR. New business on this index will no longer be possible from 01. January 2020.
In June 2018, the ECB published the methodology for the new ESTER (euro short-term rate). ESTER is scheduled to go live in October 2019. The ECB working group on risk-free rate is currently deciding the new RFR and the successor to Eonia. In addition to ESTER, GC Pooling and the RepoFunds Rate are being examined.
USD FED Funds H15 / EFFR:
Currently the benchmark is IOSCO / EU-BMR-compliant. However, this benchmark is set to be replaced by the SOFR by Q2 2021. Details were announced by the New York FED.
The administrator EMMI is currently testing an updated method (“hybrid approach”). The goal is to achieve IOSCO / EU BMR compliance. The method must be approved by the competent regulator FSMA.
ICE LIBOR (USD, GBP, EUR, JPY, CHF)
The ICE / IBA has already successfully tested an updated method. According to the plan, the IOSCO / EU BMR-compliant “Evolved LIBOR” will be introduced successively and will be available from 2019 onwards. The method must be approved by the relevant regulator FCA.
»I hope it is already clear that the discontinuation of LIBOR should not be considered a remote probability 'black swan' event. Firms should treat it is as something that will happen and which they must be prepared for.«
Interest rate benchmark reform: transition to a world without LIBOR
Andrew Bailey, Chief Executive of the FCA, Speech 12.07.2018
»I'm not sure if there aren't certain one-off effects.«
About ESTER transition
Cornelia Holthausen, Deputy Head of the ECB's Market Operations Directorate-General, Börsen-Zeitung 06-06-2018
»The fallback is a parachute if you’re going paragliding … the fallback gives you survival certainty – it doesn’t give you painless certainty«
François Jourdain, chair of sterling RFR working group, risk.net 29.05.2018
»I and my colleagues have therefore spoken to all the current panel banks about agreeing voluntarily to sustain LIBOR for a four to five year period, i.e. until end-2021.«
The Future of LIBOR
Andrew Bailey, Chief Executive of the FCA, Speech 27-7-2017
»Let me stress this: we will all have to live with the strict schedules that this date imposes on us. The BMR will fully apply from early 2020 as stipulated by the co-legislators.«
Towards benchmark stability and integrity
Steven Maijoor, Chair of ESMA, Speech 31-5-2018
The alternative RFRs are being developed as IBOR fallbacks as well as potential IBOR successors. The central banks of the respective currencies are playing a leading role here. The development paths in each respective currency will be different. Presumably, the new benchmarks will be available after 2019 and will gradually become integrated into the markets. Since the FCA will no longer support participation in the LIBOR Panel from 2022 on, RFR-based markets must be established by that date at the latest. Alternative scenarios are also possible; it is conceivable that an IBOR fallback may be required at an earlier point in time.
Different methods can be used to create the RFR-based term rates, for example by means of OIS or repos. The USD LIBOR is a case in point. Concrete plans already exist to develop a USD LIBOR successor on SOFR basis. Initial SOFR OIS transactions have already been cleared at LCH (July 2018).
The transformation to a new system of reference rates based on RFRs represents a fundamental change for markets and market participants. The underlying end-to-end process for a wide rage of products will be impacted. Complexity arises, in particular, from the following aspects:
The definition of the new RFR-based benchmarks, which is significantly different from the IBOR family, makes seamless transition impossible. As part of the migration process, it will be necessary to estimate and negotiate the transition-induced valuation changes between counterparties. Furthermore, all internal processes will need to be screened to ensure that they support the transition. (valuation, risk management, FTP, hedge accounting, etc.).
The transition to the new benchmarks will, in many cases, be gradual. The associated parallel phase of existing and new benchmarks also induces new requirements in terms of processes and systems.
In the long term, however, the situation will be different. After completing the conversion to RFRs, basis risks may be reduced and thus processes simplified.
From a strategic perspective, it is important to assess the necessary enhancements in the product range.
It is a fair assumption that almost all areas or organizational units in a bank will be affected. This applies in particular to processes and IT systems of the following activities: