Topics: Interest Rates indexes / Transition / Financial issues at stake
With the interest rate indices used in many currencies currently being reassessed, it seems like a good time to take stock of the financial issues raised by these significant manoeuvres to do with the ‘Ibor’ rates.
A brief historical outline
The widely covered scandal over the manipulation of the Libor rates, primarily relating to the period 2005-2010, has had a deep and lasting impact. The fraud consisted of using various means to try to distort the level of the published rates, allowing those concerned to profit directly or indirectly. Fines imposed by the regulators since 2012 have been as high as $2.5 billion in some cases, and financial penalties have affected more than a dozen banks and several leading brokers [1].
IOSCO (the International Organization of Securities Commissions) and the FSB (Financial Stability Board) therefore recommended in 2014 that the Ibor indices [2] should be made more robust, and that virtually risk-free indices based on an overnight rate and on actual transactions should be promoted at the same time. A new Benchmarks Regulation (BMR) was accordingly issued in 2018 with the objective of establishing indices by 2020 that would be more robust, more transparent and better controlled, and therefore give consumers and investors better protection.
Thanks to a number of working groups and the involvement of the central banks, various new overnight rate indices have been created, in particular the SOFR in US dollars in 2018 and the €STR (not to be confused with ESTER!) in euros in 2019.
The futur of the Libor indices beyond 2021 is not certain
Since July 2017, it has also been clear that the future of the Libor indices beyond 2021 is not certain, as banks will no longer be obliged to take part in the fixing of these controversial indices from 2022. This deadline was reaffirmed by the Bank of England and the UK regulators on 25 March 2020 after several articles had appeared in the press suggesting that it might be put back an extra year.
In April 2020, six years after the first official publications on index reform, progress has certainly been made towards reforming the indices, but the most difficult task remains to be done: how should the transition be arranged for existing operations, and how should the various contracts, processes and mechanisms bound up with the use of the Ibor rates be adapted?
Faced with the actors’ lack of preparation for the end of 2021, at which point the Libors may cease to be calculated and published, the regulators are growing concerned and issuing repeated warnings [3].
WHAT POINT HAS BEEN REACHED EXACTLY?
Euribor and the Libors have followed very different paths.
Euribor
For the euro, the regulatory authorities and the banks have chosen to reform the Euribor index in the most painless way possible for users of the index.
The so-called « hybrid Euribor [4] » has already replaced the pre-reform Euribor, virtually unnoticed. Hybrid Euribor is based on a highly standardised rate-fixing methodology consisting of using actual transactions as far as possible. The phrase ‘as far as possible’ is important here, as it is accepted that a very significant fraction – up to 80% of contributions at times – will still be expert input rather than being based on actual transactions. This method was authorised by the FSMA [5] in July 2019 and has now been implemented by the organisation in charge of its publication, EMMI.
For end users, the index is still called Euribor, no steps have to be taken to use the index, no amendments need to be made to existing contracts, everything has continued in the same way... yet this ‘new’ hybrid Euribor is the outcome of the reforms driven by the Benchmarks Regulation.
End of story ?
All that needs to be done is to specify contractually what would happen if hybrid Euribor were to be subsequently overhauled. It is therefore important to take a fresh look at the provisions of old contracts and draft fallback clauses in new ones.
The so-called « hybrid Euribor » has already replaced the Euribor
In new contracts, these fallback clauses will generally be drafted somewhat vaguely, as there isn’t really an operational plan B on which to rely at present. For derivatives, however, ISDA and then the FBF have published protocols or addenda that improve the legal certainty for counterparties in the event that the indices are transformed or disappear.
One thing is clear: for the euro, the outright replacement of Euribor by the €STR [6], along the lines envisaged for the Libors is no longer on the cards for the time being.
The Libors
For the Libors, the envisaged model for replacing the rates if pre-cessation or cessation of publication occurs in 2022 is the substitution of overnight rates compounded in arrears.
These overnight rates, which have been developed for varying lengths of time in different currencies, are the SOFR in USD, SONIA in GBP, SARON in CHF and TONAR in JPY.
However, such a move is not yet entirely certain, as numerous problems associated with the transition still need to be resolved, and a succession of market consultations have taken place without addressing all the questions that arise.
Despite the sword of Damocles that hangs over the Libor indices in the shape of the 31 December 2021 deadline, arrangements have not been finalised, and much of the market continues to favour Libor over compounded overnight rates, whether for swaps over more than two years or for debt instruments [7].
The sword of Damocles that hangs over the Libor indices
Leaving aside the US dollar SOFR and its struggles to establish itself as a liquid benchmark on the derivative markets and for cash instruments, it is clear that even where there is a mature index such as the sterling SONIA, the vast majority of swap transactions over more than two years remain indexed to the sterling Libor [8].
The Clarus Financial Technology study shows that in October 2019, SONIA-indexed 5-year transactions had gained no ground since 2018, representing a mere 10 to 15% of the total volume of swaps processed in sterling: Libor is far from dead for long maturities and SONIA-indexed long swaps have not taken off.
The greatest difficulty, however, lies not in adopting new indices for new transactions, but in migrating from the old index to a new index for existing transactions.
This migration firstly involves managing flows which are calculated very differently, given that Libor is a fixed rate whereas the compounded overnight indices are post-fixed rates.
In addition, with such a migration the question of the economic balance of transactions before and after the change of index has to be addressed. The financial crisis generated by Covid-19, which has seen a very sharp increase in spreads between the US dollar Libor and the fixed rates of swaps against SOFR of the same maturity, reminds us that the process of migrating from one benchmark to another is a complex and risky business. Preserving the economic value of contracts during migration is a complex matter for interest rate swaps, very complex for currency swaps and potentially extremely complex for options and structured products with market data relating to the volatility and correlation of the underlying securities.
For bonds and bank loans, the difficulties also derive – both now and in the future – from the operational management of transactions (parties’ consent, changes in flow management systems, etc.), especially as some existing clauses may be highly unsuitable. For example, for many variable-rate bonds issued before 2018, the legal documentation states that the disappearance of Libor would entail the use for the remainder of the term of the level of the last index fixed for all future periods; this would amount to transforming a variable-rate bond into a fixed-rate bond, at a level totally disconnected from the methods recommended to protect the economic interests of the parties.
Numerous issues still need to be sorted out in order to make an orderly transition from Libors to compounded overnight rates for a variety of instruments governed by a range of market contracts in different legal jurisdictions, and meanwhile the Covid-19 crisis has diverted the attention of banks, end users and lawyers to other matters presenting more immediate challenges.
And yet there were less complex ways of getting rid of the Ibors that would have been satisfactory.
What makes Ibor-type indices very different from “riskfree rates“ like SONIA or SOFR is that they are rates that include a credit risk and liquidity risk component – a characteristic which is potentially very significant in the event of a financial crisis. This is exactly what we are seeing today, with the USD 3-month Libor fixed at more than 100 basis points above the level it would be at in the absence of stress on banks’ USD financing over terms such as 3 months.
The regulators have also criticised Ibor rates on the grounds that, due to the low underlying volume of interbank loans over the different maturities, they are in fact largely expert-set rates as opposed to processed rates, which makes rate manipulation easier.
Managing a rapid and orderly transition from a Libor to overnight rates compounded in arrears is rendered particularly complex by the twofold difficulty of preserving economic value between two radically different rates and of moving from a fixed-rate to a post-fixed-rate approach.
Moving from a fixed-rate to a post-fixed-rate approach
The disadvantages of post-fixed rates include the fact that a compounded rate, bringing into play tens or even hundreds of rates from day to day, requires more data processing time to generate, is more complicated to calculate and control, and from the operational point of view has to be paid shortly after it is known. All these difficulties can be managed by the banks and most financial counterparties, but are hard for less sophisticated end users to handle, in particular small corporates and project companies.
It would have been simpler to keep a pre-fixed rate but to use the fixing of a swap rate against the overnight index instead of an Ibor-type deposit rate.
If the short-term swap market is active enough – a prerequisite for any transition – then the issue of the manipulation risk would have been resolved.
This solution, which was widely discussed, was considered less ideal than that of the compounded, post-fixed, one-day cash rate, and rejected by most respondents to ISDA’s surveys.
But the perfect is the enemy of the good, and we now find ourselves heading towards two completely different approaches with the Euribor and the Libors: the Euribor has kept fixed rates and an element of expert judgement, whereas the Libors are migrating towards post-fixed overnight rates, which will introduce a new element of complexity for cross-currency operations and operational management in IT systems.
In addition, despite official claims which are obviously intended to galvanise those concerned into action, it is reasonable to wonder how realistic the prospect is of ending Libor in 2022, given the amount of ground still to be covered on the market for loans to individuals, corporate bank loans and derivatives.
Even so, it is crucial for all actors concerned to identify all contracts affected by these index transitions, to include fallback clauses in the new contracts that protect their interests with as little impact as possible on the balance of power with their banking counterparties, to control any value transfers when the indices are eventually changed, to get management and information systems up and running for the indexed contracts, to check the accounting and tax effects of any index substitutions and, finally, to be aware of the issues and well prepared.
The index saga is far from over.
ESTER can of course provide you with assistance in these areas.
[1] https://en.wikipedia.org/wiki/Libor_scandal
[2] Five benchmarks were declared critical by the regulatory authorities: Libor (USD, GBP, CHF, JPY and EUR), Euribor (EUR), Stibor (SEK) and Wibor (PLN), as well as the Eonia index.
[4] https://www.emmi-benchmarks.eu/euribor-org/euribor-reform.html
[5] Financial Services and Market Authority.
[6] The €STR or € Short Term Rate is the replacement for the Eonia, which will be completely scrapped at the end of 2021.
[7] The Bank of England is the central bank most involved in eliminating Libor-indexed securities, as these will gradually cease to be eligible for Bank of England refinancing.
[8] https://www.clarusft.com/sonia-market-volumes-what-is-going-on/