The future of the IBOR remains uncertain in the face of a range of challenges. Several issues have been identified, including transparency and reliability, and the impact on derivatives. This article explores these issues and provides some alternative reference rates. In addition, we discuss how to improve the IBOR market, such as introducing new transparency measures.
The benchmark London Interbank Offered Rate (IBOR) needs to be made transparent and trustworthy again. The market needs to be protected against manipulation and the rate should be regulated. Commissioners Barnier and Almunia spoke at a hearing on Monday about how the market can restore trust and integrity in the interbank lending benchmark.
The LIBOR benchmark has long been the source of controversy. Some banks have manipulated the rate to influence the market. This has led to lawsuits and fines. The UK government has proposed a new system, which would base LIBOR on actual transactions. This would eliminate the 150 separate rates used today.
IBORs have a long history, and their use is systemic across the financial system. However, their use will be phased out at the end of 2021. As a result, firms need to develop a transition plan to migrate their transactions and assess the impact across products, currencies, and systems. They will also need to engage in outreach activities with stakeholders.
The phaseout of the IBOR will radically affect the financial services industry. The interbank lending rate has been in place for 40 years and has set the benchmark rate for unsecured lending. It has also served as the basis for trade in many financial products, including bonds, loans, derivatives, and mortgage-backed securities. However, it is no longer sustainable. It will be phased out in 2021, and the Financial Conduct Authority is now considering an alternative reference rate.
The transition to a new reference rate has prompted several key developments in the global financial sector. First, there are numerous initiatives being undertaken to reduce exposure to the London interbank offered rate. Among these are new websites designed to help investors and lenders navigate this change. Moreover, the FHFA is taking steps to reduce post-2021 exposure to the LIBOR.
In recent decades, the interbank offered rate (IBOR) has served as a reference interest rate for the interbank lending market. However, the scandal involving the London Interbank Offered Rate (LIBOR) in the financial crisis has raised doubts over the long-term viability of IBORs as a benchmark for unsecured bank funding. Concerns have led to the Financial Stability Board (FSB) reviewing the reliability of major interest rate benchmarks.
Impact on derivatives
ISDA has published a document that addresses the impact of the IBOR on derivatives. The document contains information on fallbacks that will apply to both legacy and newly-cleared derivatives trades. These fallbacks will take effect on January 25, 2021. These protocols are aimed at preparing the derivatives industry for the risk-free reference rate. However, they will not solve all of the industry’s challenges. In some cases, they may not even be applicable to the products that are most traded.
IBOR transition will impact a wide range of industries, including exchanges, banks, asset managers, and central counterparties. The changes will also have a significant impact on the tax implications of these instruments. As a result, companies and institutions should prepare for the IBOR transition by analyzing their contracts to identify the most significant impacts.
Despite the risks associated with the change in the IBOR, the impact on derivatives may be minimal. While the Protocol does not affect the definition of swap rates, it can change the net present value of derivatives. For this reason, it is critical for banks to know how to properly calculate and justify fair value adjustments.
However, the changes will affect the IBOR’s role as a benchmark for loans. The upcoming fallback rates will not reflect the underlying market and will instead be adjusted versions of risk-free rates. This will affect the price of derivatives, particularly those tied to other financial products.
The UK and US are phasing out the IBOR, and will replace it with alternative reference rates in 2021. Many other countries are also planning to do the same. In the meantime, ING is implementing solutions to minimise the impact of the IBOR transition on derivatives. For example, it has provided relationship managers with tailored solutions for its clients and consulted on the transition options.
Since LIBOR is used in a variety of financial products, the changes in LIBOR will affect derivative transactions that hedge loan cashflows. It is vital that you consult with your financial advisers if you are planning to buy or sell such derivatives. It will also affect the treatment of derivatives in hedge accounting.
Alternative reference rates
With the global financial crisis, the need to find an alternative reference rate has increased. The infamous LIBOR rigging scandal has prompted the industry to look for a new benchmark. While the LIBOR system has been strengthened with the addition of the ICE Benchmark Administration, it is still subject to manipulation. Alternatively, financial institutions can look at the Sterling Overnight Interbank Average, which has been the benchmark since 1997.
The transition is not without its challenges. Those involved with financial markets must navigate a complex set of technical, governance, and operational issues. However, the financial industry is committed to addressing these challenges. HSBC is closely following developments and will provide additional perspectives as needed. To learn more, follow us on Twitter:
The Secured Overnight Funding Rate (SOFR) is a preferred alternative to the U.S. dollar LIBOR. This rate is based on overnight repurchase agreements backed by Treasury securities. It was first published on April 3, 2018. It is based on transactional data and will continue to evolve over time. The Chicago Mercantile Exchange is developing SOFR futures, which may become reference rates for LIBOR tenors.
Currently, alternative reference rates to IBOR are not a legal requirement. The ARRC has asked the Treasury and Service to issue proposed regulations that adopt ARRC recommendations. If they pass the ARRC’s approval, these will become effective January 20, 2021. However, the ARRC’s proposal may not be final until the ARRC receives comments.
Alternative reference rates to IBOR are an important tool for lenders. By adopting this mechanism, lenders can minimize the impact of a permanent discontinuity. ISDA’s IBOR Fallbacks Protocol has been updated and supervised by Mori Hamada & Matsumoto.
There are four types of alternative reference rates. The United Kingdom has a Working Group on Sterling Risk-Free Reference Rates (RFRWG) and the United States’ Alternative Reference Rates Committee (ARRC). For loans, O/N RFRs are based on the observation period, with weights based on the days of the interest period. In the UK, the RFRWG recommends a lookback period of five business days. This method can also be used for bilateral loans.
Another alternative to LIBOR is the Intercontinental Exchange (ICE) Libor. Historically, LIBOR has been the main interest rate benchmark for financial markets. It determines interest rates on financial contracts across the world. However, the ICE Benchmark Administration announced that three-month sterling LIBOR will permanently be discontinued on March 5, 2021.