In a follow up to their October article, Simon Richards and members of the IFoA Working Party on LIBOR reform give feedback on the latest consultations and explain their potential consequences
Interbank Offered Rates (IBORs) are used to determine interest payments and settlements on hundreds of trillions of dollars in notional derivatives, loans and other financial products globally. In asset management, they are often used as a performance benchmark for investment funds and, in insurance (as they underpin the Solvency II risk-free bases), as discount rates to value trillions in liabilities.
In 2017, the Financial Conduct Authority (FCA), which supervises the publishing of IBOR rates, suggested that these interest rate series might be discontinued beyond 2021, and encouraged market participants to plan for their withdrawal and transition to new reference rates. The central bank of each currency bloc concerned has since been coordinating in its respective market, working in partnership with industry to bring about an orderly and smooth transition. For example, in the UK, the Bank of England established a working group of industry participants tasked with catalysing a broad-based transition to using the Sterling Overnight Index Average (SONIA) as the primary sterling interest rate benchmark in bond, loan and derivatives markets.
Reference rate fall-backs for derivatives
The International Swaps and Dealers Association (ISDA), a trade organisation of participants in the market for over-the-counter derivatives, is planning to amend its standard contract documentation to implement 'fall-backs' that would apply if a certain IBOR was permanently discontinued. The ISDA consultation was intended to seek input on the convention for setting the interest rate on the floating leg of swap contracts in the event the fall-back is triggered, using the new reference rates (SONIA for the GBP market) and what spread adjustment was required for it to be a fair IBOR substitute.
The feedback from the consultation showed overwhelming support for the 'compounded setting in arrears rate' as the methodology for the floating leg interest fixing. A significant majority also favoured the spread adjustment being calculated under a historical average approach, with a consistent methodology to be used across all benchmarks. While this will reduce any opportunities for abuse, it could lead to a change in value once the fall-back is triggered - or sooner, if the market anticipates this happening.
The details of the historical look-back period are still under consideration, including whether the calculation should be based on a mean or median approach and the appropriate length of the period. Figure 1 shows how the basis has varied historically, and demonstrates how the calculated spread value will change depending on the length of the look-back period chosen.
The ultimate decision on these parameters is expected to be known in the first half of 2019. Not all markets were covered in the recent consultation, so other benchmarks, such as US LIBOR and EURIBOR, will be covered in a future consultation at the beginning of 2019. For more details on this, go to bit.ly/2DdkKOr or bit.ly/2WMBswV. The ISDA Board Benchmark Committee intends to incorporate fall-backs for inclusion within the standard definitions, based on the above approaches.
Term SONIA Reference Rates
This consultation concerned the ongoing requirement for term risk-free rates (that is interest rates for any period beyond overnight) in the GBP market, given the new reference rate. SONIA is an overnight rate, whereas financial products in the UK typically reference three-month or six-month LIBOR. While derivative participants are comfortable with payments being calculated on the average of daily realised rates (compounded in arrears), end users in the loan and debt capital markets typically seek certainty of future cash flows and hence seek term rates.
Term SONIA Reference Rates (TSRR) would seek to represent the market's expectation of the average value of SONIA over a specified tenor. Key observations from the consultation on the need for forward-looking TSRRs were as follows:
- A TSRR would facilitate the transition for some cash market segments, particularly syndicated lending and securitisations, as well as loans/mortgages and floating rate notes
- SONIA-referencing derivatives could form the basis for a TSRR but would need a step change before such a measure would be sufficiently robust
- Alternatively, an approach using a consistent methodology with inputs from both futures contracts and Overnight Index Swap (OIS) contracts could be used. An OIS is an interest rate swap whose floating leg is tied to an overnight interest rate, compounded over a specified term
- A robust TSRR would benefit from development and growth in OIS and SONIA futures markets, to support hedging
- There is a need to ensure that the production of TSRR includes appropriate governance and controls. The International Organization of Securities Commissions (IOSCO) principles are based on three objectives of securities regulation: protection of investors; ensuring that markets are fair, efficient and transparent; and reducing systemic risk.
- Finding ways to avoid the systematic usage of TSRRs in derivative markets will be essential as TSRRs develop
- Consistency across currencies is considered desirable.
A TSRR was viewed as important for loan and securitisation markets, providing cash-flow certainty and thereby helping to facilitate the move from LIBOR to SONIA. However it was not considered to be important for the GBP derivatives market as the transition to SONIA OIS is already taking place (bit.ly/2SdaCzy).
What do investors need to do?
Investors seeking to use derivatives to manage interest rate exposures will have some key decisions to make in the short term:
- Whether to transition existing derivatives at a known price from an IBOR to the relevant risk free rate (RFR); the FCA appears to be encouraging this activity
- Whether to adopt the fall-back provision for existing derivatives or not. For this to be effective, this will also require the counterparty agreeing to do the same. While adopting the fall-back means the derivatives will continue to work if (or when) IBORs cease to be published, it could result in the value changing in a detrimental fashion if the fall-back is, or is expected to be, triggered
- Whether to implement new transactions that reference IBOR or execute derivatives that reference the new alternative risk-free rates.
For some participants, this decision might be complicated by other regulation, for example, insurers who currently report under Solvency II, which uses IBOR as the basis for the relevant liability discount curve. In order to progress this issue, the Pension Funds and Insurance Companies sub-group of the Bank of England Working Group has contacted the European Insurance and Occupational Pensions Authority, the body responsible for setting the SII risk-free basis, with the intention of highlighting some of the key implications for Solvency II of the RFR transition.