The global reform of interest rate benchmarks including the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), the Euro Overnight Index Average (EONIA) and certain other Interbank Offered Rates (IBORs) is set to dramatically impact the global financial markets in terms of how these benchmarks perform and are being used. The IBOR reform is the biggest change in the capital markets since the introduction of the Euro at the start of the 21st century.
Regulatory authorities and public and private sectors are working together in several jurisdictional working groups (e.g. the Working Group on Euro Risk-Free Rates, the Sterling Risk-Free Rates Working Group, and the Alternative Reference Rates Committee) to discuss alternative benchmark rates to replace or reform IBORs. In some currencies – notably GBP and USD – the focus of these efforts is now gradually shifting towards supporting a sustainable transition to the alternative RFRs and the development of new products referencing them. For the eurozone, the main focus currently lies on finding adequate fallback provisions to be used in contracts referencing EURIBOR.
More specifically, in the Eurozone, the Euro Interbank Offered Rate (EURIBOR) and the Euro Overnight Index Average (EONIA) are considered critical benchmarks. In September 2018, the ECB’s Euro Risk-Free Rate Working Group recommended that the Euro Short Term Rate (€STR) should replace EONIA, while also providing the basis for developing fallbacks for contracts referencing EURIBOR. With the planned discontinuation of EONIA on 3 January 2022, preparation for the transition to €STR is well underway, including the launch of €STR swaps and the recent euro discounting switch at the clearing houses.
Differences between IBORs and RFRs
LIBOR, EURIBOR and most other IBORs are intended to measure unsecured interbank lending rates and therefore include or imply a credit spread. The proposed RFRs are based on short-term wholesale transactions for unsecured RFRs (i.e. SONIA, TONA and €STR) and repurchase or “repo” transactions for secured RFRs (i.e. SOFR and SARON). As a result, RFRs do not require such a credit spread due to their overnight and near risk free nature. RFRs are, therefore, in most cases expected to be lower than their IBOR equivalents.
IBORs are “term rates”, which means they are published for different periods of time such as 3 months or 6 months and are “forward looking”, which means they are published at the beginning of the borrowing period. Due to IBORs “forward looking” nature it incorporates a term premium to compensate for the risk of default and liquidity risk over the term for which it is calculated. Most RFRs are “backward-looking” overnight rates based on actual historic transactions. They are published at the end of the overnight borrowing period. RFRs therefore do not incorporate any term premium which is imbedded in the IBOR calculation due to lending to another bank on a longer-term basis. It is important to note that RFRs are not completely free of risk, hence they are considered “near risk-free”. RFRs can rise or fall as a result of changing economic conditions and central bank policy decisions.
To transition existing contracts and agreements that reference IBORs to the alternative benchmark rates, adjustments for credit and term differences need to be incorporated and applied to the alternate rate. Industry working groups are reviewing methodologies for calculating these so-called “spread adjustments” and are considering whether robust forward-looking term versions of the RFRs can be developed.
ABBL actions as part of the transition
Besides providing technical discussions and support on the implementation of the European Benchmarks Regulation and the participation by ABBL to the General Assembly of the European Money Markets Institute (EMMI), the ABBL is working closely with other industry bodies to ensure that members have full access to the latest developments on the topic, and actively participates in the ongoing industry consultation process towards the ECB and other European authorities.
The ABBL is, in particular, closely cooperating with the Euro-RFR working group set up by the European Central Bank (ECB) through its Luxembourg Ambassador, Mr. Thomas Schröder (European Investment Bank), who will be actively participating in the ABBL working group and has initiated a number of thinking processes as to how the Luxembourg market can be best prepared for the transition:
“Luxembourg official institutions and industry associations play a crucial role in the communication and mobilisation efforts with respect to the interest rate benchmark reforms. ABBL is working with us intensively on various initiatives to foster a sound implementation of the reform. I am grateful that ABBL invited us to join their own working group on benchmarks reform for that matter.”
Thomas Schröder, Working Group on Euro Risk-Free Rates
The challenges of creating alternative benchmarks and their corresponding markets, and for our members to successfully adapt their processes and systems are enormous. The difficulty of addressing the full legal and operational complexities within the given timeframe, and market concerns that the remaining time to transition to €STR is insufficient are only two key topics, among a breadth of issues, ranging from technical and legal problems to communication and client relationship management.
The ABBL and its industry partners stand ready to help the Luxembourg financial sector to make the IBOR transition a success.
By Gilles Walers