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1. What is LIBOR ?
The London interbank offered rate (LIBOR) is the most commonly used benchmark for short-term interest rates varying from overnight to one year in several currencies. LIBOR is now offered in five currencies (the US dollar, the pound sterling, the euro, the Swiss franc, and the yen) and seven tenors (overnight or spot next, one week, one month, two months, three months, six months, and twelve months). LIBOR has played a key role, It is extensively used as a reference rate for financial contracts and as a benchmark to measure financing costs and investment returns for a wide range of financial products, such as adjustable-rate mortgages, floating-rate bank loans, and interest rate or cross-currency swaps. Furthermore, it is estimated that $200 trillion–$300 trillion in financial transactions are currently benchmarked on LIBOR.
2. When and Why is the LIBOR phasing out?
There are two main challenges with this process: first, the sample size used to calculate LIBOR has decreased significantly since the 2008 financial crisis. In the following, fewer panel banks have reported, while those who have, have reported fewer market-based quotes. Rather than that, LIBOR has relied more and more on what the Intercontinental Exchange Benchmark Administration refers to as "market and transaction data-based expert judgment" As a result, concerns have been raised concerning the degree to which LIBOR accurately represents market realities. In addition, LIBOR is very dependent on inputs from panel banks making it susceptible to manipulation leading to regulations discovering a variety of violations. In 2017, Andrew Bailey, the Chief Executive of the United Kingdom's Financial Conduct Authority (FCA), which regulates LIBOR, announced that the FCA would no longer encourage to submit LIBOR quotes after 2021 and that market participants should expect LIBOR to be phased out. Moreover, The Federal Reserve Board (FRB)published supervisory instruction encouraging banking institutions to immediately cease entering into new contracts using USD LIBOR as a reference rate, preferably by December 31, 2021.
3. How is LIBOR computed?
The administrator determines these rates by averaging the inputs of several panel banks. The bank’s responses are based on a combination of transactional data that they have access to, and assumptions established through expert judgment.
4. What is the impact of the transition vis a vis to BSF clients?
The termination of LIBOR may have a number of implications for the products or contracts you presently hold, including the following:
5. What are the alternative risks free rates proposed and what differs them from LIBOR?
Risk Free Rates (“RFRs”) are alternative reference rates proposed to be used in place of LIBOR. LIBOR differs from RFRs in a way that the LIBOR rate is a forward-looking term rate, whereas the RFR rate is a backward-looking overnight rate. In addition, LIBOR is generated from quotations submitted by panel banks as estimates of where they may borrow cash, but RFRs are typically based on a larger variety of actual transactions; Regulators from the five LIBOR currency countries have announced their recommended alternative reference rates, as indicated in the table below:
|Alternative Reference Rate
(Sterling Overnight Index Average)
|EURIBOR / EONIA
(Euro Short-Term Rate)
(Secured Overnight Financing Rate)
(Tokyo Overnight Average Rate)
(Swiss Average Rate Overnight)
6. How are the new alternatives rates calculated?
Alternative RFRs are issued by the appropriate local administrators, often the region's central bank, who have established their own methodology and publication schedules for each rate under their jurisdiction. They are based on real overnight transactions in highly liquid underlying markets.
7. How have alternative references rates performed during times of volatility?
By definition, ARFRs are less prone to credit risk than LIBOR, as they lack a credit risk premium that fluctuates depending on expert judgment from panel institutions. However, overnight rates in the repo market are more volatile than those in the underlying LIBOR market. As a result, daily ARFR rates are more volatile than their LIBOR equivalents. This tendency is adjusted out over time, as the volatility of ARFRs decreases when rates are averaged across time. When averaged over a long period of time, data shows that the volatility of ARFRs is comparable to or even lower than that of their corresponding LIBORs.
8. Is there a forward looking term rate similar to IBOR?
Given that LIBOR and other IBORs are forward-looking term rates available in a variety of tenors, working groups have shown interest in creating forward-looking term rates based from RFRs. In the UK, working groups specified a limited usage of the term SONIA in light of the UK government's desire for the market to pursue a broad-based transition to SONIA compounded in arrears. It is worth noting, however, that the WG's suggested Term SONIA may be appropriate for mid-sized businesses and retail, as well as trade and working capital and Islamic finance. In January 2021, some administrators in the United Kingdom, including Refinitiv Benchmark Services (UK) Limited and the IBA, started publishing forward-looking SONIA term risk-free rates. The Alternative Reference Rates Committee, in the US, has chosen the CME group as administrator of Term SOFR, which publishes forward-looking one-month, three-month, and six-month SOFR rates for use in cash market transactions.
9. What is referred to by “ Fallback Language “
Fallback language refers to document terms that are designed to facilitate the transfer to other reference rates in the event that LIBOR is no longer available. The discontinuation of LIBOR after December 31, 2021 and June 30, 2023 for key USD LIBOR settings may jeopardize the document's viability if sufficient backup language is not provided to enable the transition to a suitable replacement reference rate for interest payment calculations.
10. What happens if my contracts do not include fallback language in the event that LIBOR is no longer available?
Market participants should examine their contracts to determine whether they include adequate and robust fallback language to handle the discontinuation of LIBOR. In certain circumstances, although these will vary by contract, the absence of appropriate backup language may result in the contract continuing to reference the most recently published LIBOR rate. If no changes to existing contracts are made, these fallback provisions will take effect and the parameters unique to each financial transaction will be established.
11. What is a trigger event?
Trigger event is an event that triggers the fallback clauses and, as a result, shift from LIBOR to Risk Free Rates.
12. What is the difference between pre cessation triggers and permanent cessation triggers?
Permanent and pre-cessation triggers differ according to the manner in which LIBOR is announced. Permanent cessation triggers are triggered when an official party makes a public declaration or publication announcing that LIBOR has ceased or will stop permanently or forever, where as Pre-cessation triggers are triggered, when the UK Financial Conduct Authority declares LIBOR to be 'non-representative’. Both permanent and pre-cessation triggers have the potential to activate alerts and/or fallback language, depending on how the fallback language is written in the loan document.
13. How can I amend my IBOR-linked contract to reflect the new RFRs?
Changing an IBOR linked contract to reflect the new RFRs can be accomplished by modifying current contract to include a fallback clause, which may be accomplished bilaterally or via the use of appropriate ISDA protocols, or to replace the financial product with a new contract that incorporates the desired RFR. This will vary depending on the contract's features, such as the financial product and the contract's current fallback language.
14. What are the possible adjustments that will be made to the Bank's current contracts?
the possible amendments to be undertaken for the Bank’s current contracts include:
1. Rate Transition Provisions: These provisions allow for an automated switch to a pre-agreed RFR upon LIBOR termination, without the need for additional discussion or modification.
2. Replacement of Screen Rate: These clauses offer a method for the parties to agree on a replacement benchmark rate, which will then be negotiated between the parties.
3. Renegotiation Process Agreed Upon: Similar to 2. except that it requires the parties to agree, on a date sufficiently ahead of the end of 2021 regarding the adoption of a substitute benchmark.
15. What is the difference in the contract specification as per ISDA, CME and LCH?
|Payment Delay, Fixed Leg
|Payment Delay, Floating Leg
|Observation Period Shift
|Original trade/LIBOR Part
|ISDA Fallback Supplement
The LCH and CME consultations proposed a conversion of legacy LIBOR swaps to market standard OIS contracts, shortly before contracts are moved to ISDA Fallback upon actual LIBOR discontinuation. The market-standard RFR (e.g., secured overnight financing rate (SOFR) overnight indexed swap (OIS) rate) is based on a compounded in arrears rate with no observation shift and 2-day payment delay, is important to note that this may result in payment dates shifting by 1-2 business days.
16. What is the credit spread adjustment and why is it needed?
Considering LIBOR and RFRs are computed independently, there may be variations between the published rates for the two benchmarks. To account for observed differences and reduce value transfer, industry working groups propose the use of a credit spread adjustment. The recognized market method for credit spread adjustment is based on a historical median with a five-year lookback period, which estimates the difference between LIBOR and the alternative reference rate over a five-year period of daily data points.
IBOR’s have a number of extra components that Risk-Free Rates don't, such as a premium for banks credit risk, a premium for the term structure, and a premium for retaining liquidity over time. RFR levels are therefore predicted to be lower than IBORs in the majority of situations due to the absence of risk premia. A so-called credit adjustment spread (CAS) is required to bridge the gap between these benchmarks and to minimize the economic impact and value transfer during the transition of legacy products referencing IBORs in order for the move from IBORs to RFRs to be economically neutral. This CAS will, in most circumstances, be included in the total commercial margin and will not be identifiable separately for newly originated or refinanced RFR products. In order to arrive at the CAS, several methods are used, and we recommend following closely as possible RFR working groups recommendations
17. What will be the impact on spread adjustment with the switch from IBOR to ARR ?
The static spread published by Bloomberg on March 5, 2021 for all currencies and tenors of IBOR that may be applied to compounded ARR or term ARRs, as advised by ISDA fallback protocol, is the recommended approach for Credit Adjustment Spread in non-cash products. For cash products, the bank has the option of using a static spread or a dynamic spread modification method at its discretion. The ideal methodology for determining Credit Adjustment Spread, as recommended by ISDA, is to use the historical median approach, which uses the median of historical differences between the IBOR for that tenor and the Adjusted Reference Rate that corresponds to that tenor during a five-year lookback period. The trimmed mean approach over a ten-year lookback period is the next favored option.
18. What is the ISDA Protocol and when did it launch and take effect?
The ISDA Protocol was developed to facilitate the amendment of a substantial number of existing derivative contracts that reference IBORs that are anticipated to be phased out. The fallback provisions provide a mechanism for the transfer of derivatives contracts from IBORs to the new industry-agreed ARRs (plus spread adjustments). The ISDA 2020 IBOR Fallbacks Protocol was published On October 23, 2020 and became active on January 25, 2021
19. What is ISDA's approach for LIBOR's expected phaseout?
ISDA has revised some 'floating rate options' in the 2006 ISDA Definitions to incorporate fallbacks that would apply if certain important IBORs were permanently discontinued and if LIBOR was determined to be 'non-representative'. ISDA also updated some USD LIBOR-based floating rate options to include fallbacks that would apply if USD LIBOR was permanently discontinued or if a 'non-representative' USD LIBOR determination was made. For legacy derivatives that were in place before January 25, 2021, the 2006 ISDA Definitions will continue to apply. This means that the amended floating rate options with the fallbacks will not be included. While parties can use an ISDA protocol or bilateral discussion to incorporate the fallback into legacy non-cleared derivatives contracts, it is not required to do so. In accordance with the ISDA 2020 IBOR Fallbacks Protocol, firms can add the new floating rate options, and hence the fallbacks, into existing derivatives contracts with other parties who follow the protocol. Adhering to this protocol includes fallbacks similar to those found in new trades conducted into after January 25, 2021, that reference the 2006 ISDA definitions. It also important to mention, for cleared derivatives, central counterparties (CCPs) have incorporated the ISDA IBOR fallbacks in their rule books for both new and legacy contracts. Furthermore, despite increased trading activity in SOFR futures, the ARRC announced in March 2021 that it would not be able to recommend a forward-looking SOFR term rate by mid-2021 due to low liquidity in SOFR derivatives markets. This is one of few instances where the ARRC believes a term rate could be used.
20. Are there recommended best practices to transition from loans based on USD IBOR ?
Term SOFR can be used in loan agreements instead of LIBOR in the future, either as a replacement for LIBOR (whether it is used as a fallback clause or not) or in new contracts, as recommended by the ARRC. Short-term SOFR has limited applications due to concerns that trading in short-term SOFR could reduce overnight SOFR liquidity, rendering the rate less robust. ARCC believes that most loan agreement forms will not need to be extensively revised to replace LIBOR with Term SOFR because they are essentially similar. Loan conventions and use cases provided by the ARRC for the Term SOFR concept can be found here
21. How have lenders restructured the terms of new LIBOR loans in anticipation of LIBOR's demise ?
Three certain approaches addressing the above have been developed :
22. What are SOFR conventions for use in Loans ?
Daily Simple SOFR and Daily Compounded SOFR are the recommended structures. These conventions allow for daily interest accruals, but, unlike forward-looking term LIBOR rates, they are not preset in advance and do not remain constant throughout the interest period.
The AARC takes into account that syndicated or bilateral business loans may either be based on simple or compound interest. When compared to SOFR OIS, compound interest best represents the time value of money and will have less hedging basis relative to SOFR OIS, however simple interest is easier to calculate , and the difference in basis points between simple and compounded SOFR is often small. Compound or simple interest on arrears does not have a known interest rate at the beginning of the interest period. Rather, overnight SOFR would be pulled daily (and compounded based on the rate from the previous day in the case of Daily Compounded SOFR). The overnight SOFR rate is compounded daily during the interest period to determine the loan's interest rate for Daily Compounded SOFR. In the case of Daily Simple SOFR in arrears, SOFR is sourced daily and multiplied by the loan's outstanding principal
23. What is the Impact of the transition around Islamic products?
IBORs are utilized in a variety of various types of financial transactions. For instance, variable rate financings such as International Commodity Murabaha, Ijarah (lease), Musharaka, Mudaraba, Wakala, and Service Agency, or a combination of one or more of the aforementioned Sharia-designated financings. Additionally, investment contracts may utilize an IBOR as a benchmark for determining the customer's profit, rental, or return or incentive payments. In more sophisticated financial transactions, such as Sharia-compliant hedging products, a profit rate swap may be used in conjunction with an IBOR or other rates generated from IBOR. Certain Islamic goods' repayment terms or product characteristics may alter as a result of the IBOR transition. This may affect the time and regularity with which Islamic goods' pricing are determined, as well as the payment of installments, profit, and rents. Any planned or implemented modifications to current products will be subject to proper evaluation and approval by the Bank's Shariah Committee
24. What is the impact of the transition on the accounting treatment?
The International Accounting Standard Board (IASB) highlighted two categories of accounting problems that may impact financial reporting in light of the IBOR Transition. These are: Pre-replacement issues which concerns with financial reporting in the period before the reform and Replacement issues which concerns with financial reporting in the event that an existing interest rate benchmark is reformed or replaced. The International Accounting Standards Board (Board) amended IFRS 9 "Financial Instruments," IAS 39 "Financial Instruments: Recognition and Measurement," and IFRS 7 "Financial Instruments: Disclosures" in September 2019 to address as a priority issues affecting financial reporting in the period preceding interest rate benchmark reform, including the replacement of an interest rate benchmark (Phase 1 amendments). Phase 1 modifications offered temporary exemptions from some hedge accounting rules in light of the reform's uncertainties.
25. In what ways are SOFR and SONIA better than USD LIBOR and Sterling LIBOR?
Overnight transactions in the US government repo market determine the SOFR, or secured overnight financing rate. Federal Reserve Bank of New York-issued currency with significant depth that makes manipulation and influence nearly impossible. The currency is obtained through a dynamic, well-defined market. Instead than relying on estimates or models like LIBOR to establish interest rates, SOFR relies on actual, transparent transactions. To be sure, the US Treasury repo market held up well through the global financial crisis. As a result of the large volume of transactions that support SONIA, it's reliable and long-lasting. Since it does not include a term bank credit risk component, it is a better predictor of general interest rate levels than LIBOR. SONIA can also be compounded for usage in long-term agreements. RFR is used in sterling overnight index swap (OIS) which is already liquid, making the move easier.
26. What are the latest developments in regards to a forward looking rate similar to LIBOR?
Many working groups have turned their attention to using overnight RFRs (in arrears) to support a worldwide transition effort coordinated by the FSB. Forward-looking term rates are only to be used in specific products or under specific conditions, according to several working groups. To administer a term rate based on SOFR, the ARRC appointed CME Group in May 2021 and proposed to utilize it in fallback and other scenarios in July 2021 in the United States. There are two variations of Term SONIA accessible in the United Kingdom. Quick Corp. has released the TONA (for Japanese Yen) forward-looking term version. Considering even retail products such mortgages are shifting to in-arrears methods, the Swiss RFR Working Group will continue without a forward-looking term rate based on SARON.
27. Are there recommended best practices for using the SOFR Term rate?
It is recommended that market participants adopt backward-looking overnight SOFR for new transactions, especially in markets where SOFR transition has been relatively effective, such as floating rate notes, consumer loans and securitizations in the United States. ARRC, on the other hand, agrees that the adoption of backward-looking overnight SOFR has posed unique issues for the lending market in particular. The ARRC therefore encourages the use of Term SOFR alongside other SOFR types for commercial loans, such as syndicated facilities, middle market loans and trade finance. There are some securitizations that hold business loans or other assets that refer to Term SOFR, and ARRC recognizes that. Term SOFR, however, is opposed by ARRC because most derivatives markets already use backward-looking SOFR compounded in arrears (such as the ISDA 2020 IBOR Fallbacks Protocol) and because transitioning derivative markets to SOFR is necessary to ensure that the market for SOFR derivatives is sufficiently deep and liquid to support the development of Term SOFR in the first place. Because of this, ARRC suggests that Term SOFR derivatives be used only to hedge cash items (such as loans and bonds) that use Term SOFR as the reference. As for legacy transactions, ARRC points out that the recommended contract fallback provisions for floating rate notes, bilateral and syndicated business loans, and securitization transactions already place Term SOFR at the top of the fallback waterfall.
28. What are the latest developments for the use of SONIA Term rate?
A meeting of the Sterling Risk Free Rate Working Group (RFRWG) was set up in 2018 to discuss the SONIA Term Reference. After that, the Working Group agreed that some participants in the cash markets required a forward-looking term rate, as well as assistance with the transfer of certain legacy contracts. When it came time to publish the results of the SONIA Term rate consultation, the RFRWG released a statement requesting benchmark administrators interested in the development of new benchmarks to review it and offer their thoughts on it. Initially, three benchmark administrators made available Beta Term Risk Free Rates during 2020 that could be used for testing purposes. Subsequently, two of them, ICE Benchmark Administration and Refinitiv made them available for use in financial contracts. A broad-based transition to SONIA compounded in arrears, with limited usage of a SONIA Term rates, has been advocated by the RFRWG. Furthermore, "Task Force" was established by the RFRWG to determine where SONIA compounded in arrears is suitable and to provide advise where alternative measures, such as a TSRR, may be required for SONIA compounding in arrears.
29. What are alternatives to Term rates Risk Free Rates ?
Alternatives to the term SOFR include the BSBY and ICE BYI indexes, which are both available to the public. For instance, because the BSBY Index is based on a three-day average, it may lag behind strong one-day market movements, making it less useful to some users. Participants in the market are also concerned that the BSBY shares many of the same flaws as LIBOR. The CME term SOFR rates are therefore a suggested alternative rate method.
30. What are the differences between backward looking & forward looking SOFR term rates?
SOFR is a backward looking rate, based on the cost of borrowing overnight cash from the repurchase agreement market, which is collateralized by US Treasury securities. However, the SOFR Term Rate is based on transactions in the derivatives market and provides a forward-looking interest rate. Instead of referring to overnight performance, the forward-looking SOFR Term Rate denotes derivative market projections for the interest rate. Since the market is so large, this speculative interest rate closely tracks changes in market interest rates.
31. How can I find more information?
Central Bank-led ARR working groups developed, on the suggestion of the Financial Stability Board (FSB), dedicated websites to offer market participants with useful information about critical transition topics and steps.
|Working Groups Links
In addition, useful information has been published on the websites of the following industry organizations that serve as representatives of important stakeholders who will be affected by the LIBOR transition.
International Swaps and Derivatives Association
International Capital Market Association
Loan Market Association
Loan Syndications and Trading Association
Asia Pacific Loan Market Association
Association of Corporate Treasurers