For more than three decades, interbank offered rates (IBOR) have been a cornerstone of daily business in the global financial services industry and the most important interest rate benchmarks. They were the basis for anything from derivatives to loans, from bonds to securitizations. But now the time has come to bid them farewell.
In 2013, the G20 governments commissioned a review and reform of the system, because for some years IBORs had been tainted by notions that the method for setting the rates was flawed. Especially during periods of stressed markets, the system had a tendency to deliver distorted results, much to the concern of regulatory bodies. Their worries were amplified by attempts to manipulate LIBOR, the London-based version and oldest of the reference rates, in the wake of the financial crisis.
Alternative benchmarks in future based on risk-free rates
Hence a new system was developed with the aim of improving transparency, fairness and the effectiveness of the markets.
In 2017, the UK's Financial Conduct Authority (FCA) decided that it would no longer require banks to submit LIBOR quotes beyond 2021. The move triggered an industry-wide search for alternative benchmarks. National committees were established to develop new rate systems, based on recommendations of the Financial Stability Board (FSB), an international body monitoring the global financial system.
A wide range of currency areas are now in the process of revising their systems, most envisaging a switch by the end of 2021. These include the euro area, the USA, the United Kingdom, Switzerland, Japan, Hong Kong and Singapore. The changes will thus affect most major currencies and their benchmarks. LIBOR, but also the euro area’s EONIA, will eventually be phased out, while EURIBOR was fundamentally reformed.
The aim of the changes is to increase the reliability as well as the robustness of variable reference rates. The designated replacements of IBORs, risk-free rates (RFRs), differ markedly. Whereas IBORs have always been calculated depending on the market assessments of a limited number of panel banks, RFRs are based on actual transactions. Another difference is that IBORs are term rates while RFRs are overnight rates. New methods are required in order to use RFRs as a basis for the determination of longer- term interest rates. Many of those methods involve interest payments that can no longer be projected, but will only be known retrospectively, at the end of the interest rate period.Because of these structural differences, if applied to the same use case, the RFR will always deviate from the IBOR.
How are clients impacted by the IBOR transition?
Today, IBORs underpin well over USD 350 trillion in financial products. The challenge of the transition is twofold: Firstly, banks, insurers and other financial institutions need to switch to the new benchmarks for all newly introduced products, a process which is slowly gaining traction.
Secondly, vendors of financial products with contracts extending beyond 2021 may need to consider potential modifications, as terms may change when LIBOR is abolished. Adjustments will be required along the entire value chain, affecting various market segments as well as their downstream services such as settlement, risk and finance.
Most variable-rate products will be impacted. Some fixed-rate products may also be partially dependent on the relevant benchmarks. Clients may be affected if they hold assets directly linked to indices which are not compliant with the new benchmark regulation (BMR), or if instruments use non-BMR compliant indices for discounting, collateralization or foreign exchange forward calculations.
Corresponding processes, systems, models and contracts – existing and new – will have to be reviewed and, if necessary, modified. This may include reviews of legal documentation, risk and liquidity management and bonds with floating rate indices. IT infrastructure and processes may also be affected, as well as communication.
How is Commerzbank preparing for the IBOR reform?
Commerzbank constantly analyzes the potential impacts of the various scenarios for the benchmark transition and continuously monitors developments.
As a Commerzbank customer, you will receive information on technical and economic implications as market and regulatory clarity develops. In its different departments, the bank is operationally preparing for these changes and a potential temporary lack of reference rates during the transition period.
As always, Commerzbank is committed to support you throughout the transition. We will monitor industry developments and keep you informed about progress and outcomes.
Which critical benchmarks will be impacted?
Working groups have been established by global regulators and central banks in the different jurisdictions. Their aim is the reform of overnight and term rates. As of yet, not all details have been finalized. The following graph shows the main affected benchmarks:
The European Short Term Euro Rate (€STR) is a reference rate for the Euro. It is administered by the European Central Bank. The unsecured rate monitors overnight wholesale deposit transactions. Publication started on 2 October 2019.
The Secured Overnight Financing Rate (SOFR) is administered by the Federal Reserve Bank of New York. The secured interbank overnight rate covers multiple overnight repo market segments in USD. Its publication started in April 2018.
The Bank of England manages the Sterling Overnight Index Average (SONIA). This unsecured overnight rate for indexed swaps covers overnight wholesale deposit transactions in GBP. Publication of the reformed SONIA started in April 2018.
The Euro Interbank Offered Rate (EURIBOR), a daily reference rate, is derived from submissions by a panel of banks. Operated by the European Money Markets Institute (EMMI), it is based on the average interest rates at which eurozone banks offer to lend unsecured funds to other banking institutions.
The London Interbank Offered Rate (LIBOR) is an interest rate average calculated from estimates submitted by a panel of banks in London. LIBOR rates are calculated for five currencies and seven borrowing periods ranging from overnight to 12 months. They are administered by the ICE Benchmark Administration (IBA) and regulated by the Financial Conduct Authority (FCA).
Which major economies prepare a transition to alternative benchmark rates?
Major economies are in the process of transitioning to alternative benchmark rates which include1:
- The US, USD LIBOR will most likely transition to SOFR (Secured Overnight Financing Rate);
- Europe, from EUR LIBOR to €STR (Euro Short Term Rate);
- The UK, from GBP LIBOR to SONIA (Sterling Overnight Index Average);
- Switzerland, from CHF LIBOR to SARON (Swiss Average Rate Overnight); and
- Japan, from JPY LIBOR to TONA (Tokyo Overnight Average Rate).
1Transition to the noted alternative rates by region are not final and are subject to change. This information is being provided for informational purposes only.
How are the expected changes likely to unfold?
FAQ about IBOR transition
1. What is the purpose of the European Benchmarks Regulation?
The European Benchmarks Regulation (BMR) is intended to protect consumers and investors. It increases transparency and governance requirements on all firms that provide, contribute to, or use a wide range of interest rates, currency, securities, commodities, and other indices or reference prices. The BMR is a key element of the EU’s response to the LIBOR scandal and the alleged manipulations of foreign exchange and commodity benchmarks.
2. What does the BMR apply to?
The BMR applies to the “provision of benchmarks, the contribution of input data to a benchmark, and the use of a benchmark within the Union.”. It applies to “supervised entities” (such as credit institutions, investment firms, insurance companies and others specifically defined in the BMR) that use a benchmark in the EU. Also affected are administrators who have control over the provision of benchmarks for use in the EU, and contributors who provide input data for the calculation of benchmarks.
Note that the BMR applies to benchmarks used in the EU regardless of whether the administrator for such a benchmark is located within or outside of the EU, but not to benchmarks published by government bodies. So, in addition to EURIBOR’s administrator EMMI (European Money Markets Institute), other administrators such as the ICE Benchmark Administration (IBA) for LIBOR, the Swedish Bankers’ Association for STIBOR or ACI Polska for WIBOR will have to comply with the regulation.
3. What is a benchmark?
Any reference index which determines the amount payable under a financial instrument or a financial contract, or which is used to determine the value of a financial instrument, can be referred to as a benchmark. They are generally defined by the BMR.
Interest rate benchmarks such as EONIA, EURIBOR or LIBOR are subject to the BMR. But – a fact that is less well known – the regulation also applies to equity indices, FX rates and commodity indices. Benchmarks published by government bodies are exempted from the new regulation and may still be used without amendments.