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Transitioning to Risk Free Rates

01 November 2019
The FCA (Financial Conduct Authority) plans to phase out LIBOR (the London Interbank Offered Rate) by the end of 2021.
LIBOR will be replaced by new RFRs (Risk Free Rates), which are overnight rates derived from real transactions.
View the video transcript

Regulators are driving benchmark interest rate reform

Over the last few years, regulators around the globe have been engaging with the financial services industry to transition markets from IBOR based interest calculations to Risk Free Rates. This is being completed under a framework set out by the Financial Stability Board (an organisation made up of the world’s largest central banks and regulators).  

A key focus of these reforms is to ensure that widely used benchmarks are credible and robust. Regulators have been clear that this means benchmarks should be based upon transactions to the greatest extent possible. Perhaps the most commonly known of these benchmarks is LIBOR, which is referenced by trillions of dollars’ worth of financial products, used for calculating interest payments on bonds, loans and mortgages.

In the UK, the FCA (Financial Conduct Authority) has suggested that LIBOR should be assumed to cease as a practical reference rate by the end 2021, by which time new Risk Free Rates will need to have become effective.

Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.

John C. Williams, President & Chief Executive officer of the Federal Reserve, 2019

This represents one of the biggest changes in the financial services industry ever, with an estimated $300tr of LIBOR related activity globally, covering derivatives, loans bonds, trade, and working capital. All market participants – lenders and borrowers – will need to make changes over the coming months and years.

Developing alternative reference rates

Despite reforms in the governance and submission methodology of LIBOR, which now anchor the benchmark in ‘transactions to the greatest extent possible’, few transactions in the short-term money market actually occur now as banks have changed the way they fund themselves. Regulatory measures implemented after the 2008 financial crisis, to strengthen banks’ balance sheets, have reduced the utility of unsecured interbank borrowing in the money markets. LIBOR submissions are based upon these same transactions. 

In response to these concerns, global regulators formed currency-specific working groups to assess market conditions, examine alternatives and consider next steps. Members of these working groups include banks, asset managers, insurance companies, and corporates. Industry bodies and trade associations representing various segments of the market are also actively engaged. Barclays is supportive of, and is participating in, several of these working groups.

These efforts have resulted in the identification of alternative rates, so-called near ‘Risk Free Rates’ (RFRs), for each of the LIBOR currencies. These alternative rates are based upon larger numbers of transactions, and have some structural differences to LIBOR. 

In our view it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them.

Andrew Bailey, CEO of the FCA, July 2017

What are Risk Free Rates?

The acronym ‘RFR’ was introduced by the Financial Stability Board (FSB) in their 22 July 2014 publication on benchmark interest rate reform. The terminology ‘risk free rate’ or ‘nearly risk free rate’ has become generally accepted in Europe; however, other jurisdictions may refer to these as ‘alternative reference rates’. Both of these define reference rates which are being developed by international, central bank led, working groups as alternatives to LIBOR.

RFRs have a number of differences when compared to LIBOR, including:

Each currency has its own distinct RFR and administrator.

RFRs are overnight rates, not rates for a longer term such as three or six months. As such, there is very little perceived credit risk or term premium associated with RFRs.

RFRs are based on a large number of overnight money market transactions, so the risks associated with expert judgment do not arise.

Click here for Sterling Money Market Activity chart PDF†

The underlying volumes representing the indices that determine the RFRs are much higher than LIBOR.

Whilst all LIBORs are unsecured rates not backed by any exchange of collateral, two of the five RFR working groups selected secured, or collateralised, rates for their respective currencies based on transactions in their respective government.

Background, preparation, currencies and products

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  • Background and history

    Background
    The interbank markets allow banks to borrow wholesale deposits from other banks over a shorter term at a relatively low cost compared to bond or equity funding.

    Before the financial crisis of 2008-09, the IBOR markets were deep and liquid sources of interbank funding. A stark feature of the financial crisis was the demise of a number of financial institutions that had previously been considered robust; a catalytic factor was the inability to rollover short-term deposits once market confidence in an institution had been lost.

    Basel III 
    The post-crisis regulatory response, a suite of directives that came to be known as Basel III, attempted to address the root causes of the crisis by, amongst other things, reducing banks’ reliance on short-term funding. Less short-term, interbank funding would mean less systemic risk and therefore less risk of contagion in any future crisis.

    The amount of liquidity in the IBOR markets subsequently fell as banks responded to Basel III by moving their funding structures to longer-term instruments.

    The Wheatley Review
    One consequence of this falling liquidity was the opportunity for manipulation. This was the subject of the 2012 Wheatley Review, which brought a greater regulatory overview to the LIBOR markets. It reduced the number of currency and tenor points that banks were required to provide in their daily submissions - recognising that in many cases there was insufficient activity to constitute a liquid market with enough real trades to represent a cost of borrowing.

    In the years following the Wheatley Review, as bank funding has become less reliant on short-term wholesale deposits, liquidity has continued to fall – such that panel banks have to exercise more ‘expert judgement’ in order to comply with daily submission requirements.

    This is as unsatisfactory for panel banks as it is for regulators, and is the reason why, in March 2015, the Bank of England began consultations for the replacement for LIBOR. In July 2017, SONIA was identified as the Risk Free Rate for Sterling markets, with similar exercises being led in the other major currencies. 

  • Preparing for transition

    Barclays is playing an active role in the reform agenda and we’re here to help answer your questions. 

    • We support the benchmark interest rate reform agenda as set out by the Financial Stability Board in 2014, and subsequently driven by the international RFR working groups and relevant supervisory authorities. We’re actively involved in several of the national working groups.
    • As instructed by the Bank of England Prudential Regulatory Authority and the UK Financial Conduct Authority, we are planning that LIBOR will no longer be available after 2021.
    • We have mobilised an enterprise-wide programme to coordinate global efforts in relation to the transition. We’re aware that the transition to RFRs is at different stages depending on the jurisdiction, and moving at different speeds. This also applies to the potential development of RFR-based term rates.
    • We expect that the timing of any transition away from relevant interbank offered rates will take into account: liquidity in the replacement RFR, the potential development of robust RFR-based term rates, development of any relevant industry conventions and the speed with which participants in the various derivative, bond and lending markets transition away from LIBOR.

    The FCA maintains a website with useful materials on benchmark interest rate reform and LIBOR transition.

    Please get in touch with your normal Barclays contact if you have any questions.

    What are examples of potential risks market participants should consider?
    The path to transition away from LIBOR is complex. The alternative rates are calculated on a different basis to LIBOR. The various jurisdictions are at different stages of transition, and are moving at different speeds towards, in all likelihood, different outcomes. It is difficult to imagine a ‘one size fits all’ approach or solution. 

    Transition will affect both new and existing products referencing these key interest rate benchmarks, and in different ways. The consequences of reform are unpredictable and may have an adverse impact on any financial instruments linked to, or referencing, any of these benchmarks.

    The transition itself may have potential risks associated with it:

    • Changes to contractual documentation
    • Adaption of new and/or amended operational processes
    • Changes to the value of products or the possibility of products no longer serving the purposes for which they were intended.

    Market participants are encouraged to evaluate their individual circumstances and review their LIBOR-linked exposures. Participants should also develop a sufficient understanding of any expected and potential changes as a result of LIBOR transition and how these changes may impact their organisation, using independent professional advisors (legal, accounting, financial, tax or other) as appropriate.

  • Currency breakdown

    How do term rates vary between countries?
    Overnight RFRs have been identified for all major currencies, but the approach to IBORs varies between countries. Though LIBOR is expected to fall away, other term rates, such as EURIBOR, are expected to continue. However, their use could be limited over time.

    What’s happening in the UK? 
    SONIA, the Sterling Overnight Index Average, is published daily by the Bank of England. It represents the rate paid on overnight, unsecured deposits (greater than, or equal to, £25m) as reported to the Bank’s Sterling Money Market daily data collection. 

    As an overnight rate, it reflects minimal credit, liquidity, and tenor risk. It’s derived from real transactions with daily volumes of more than £50bn. Administered by the Bank of England, its governance is robust.

    The key features of the SONIA market - a high volume of real activity, minimal additional credit premia, and strong governance - make it the strongest candidate to be the replacement Risk Free Rate in Sterling.

    What can’t SONIA do?
    SONIA is a purer risk free, or near Risk Free Rate (RFR), for determining the cost of borrowing in Sterling, but it’s not a like-for-like LIBOR replacement.

    Crucially, SONIA only measures and prices overnight risk, whereas LIBOR quotes for tenors ranging from overnight to 12 months. It is not, for example, possible to set an interest period with a [3] month SONIA reference rate. It is, however, possible to set an interest period at [3] months based on SONIA by compounding the daily SONIA rates during the [3] months.

    What are other countries doing? 
    Other jurisdictions and regulatory bodies are making similar preparations under the Financial Stability Framework, but the timetable in which different currencies move to new RFRs may not be coordinated, and the nature of the replacement RFRs may not be equivalent.

    Numerous jurisdictions (for example the Euro Area, Canada, Australia, Japan) have taken a different strategy than that of the US and UK, and are adopting a two rate approach, an overnight rate and a term rate.  As an example, no indication has been given that EURIBOR, the Euro Interbank Offered Rate, is likely to cease anytime soon. Rather, the European Commission “expressed confidence that, with necessary reforms, the EURIBOR had good medium-term prospects.” EURIBOR, as a term rate will co-exist with the recently introduced €STR and service both the retail and wholesale product offerings.

    Borrowers with exposure to multiple currencies should be aware that there will likely be a transition period where markets, systems and documentation need to cater for new RFRs alongside existing LIBOR mechanisms.

    The table shows the variations in rates by country.
  • Loans, Trade and Working Capital

    Cash products, including loans, trade and receivable finance products are encouraged by regulators to use overnight compound in arrears rates.

    Term rate derivatives of Risk Free Rates (RFRs) aren’t certain and aren’t expected in all currencies. Their usage is expected to be limited to smaller corporate and consumer lending clients, as well as Trade and Working Capital, where cash flows are required to be fixed in advance.

    How might compound overnight rates work in the loan market?
    A compound RFR is an alternative to existing LIBOR contracts. It is expected that the majority of loans will replace LIBOR with compounded overnight rates. Using this method eliminates the admin heavy burden of paying interest on a daily basis. 

    However, unlike LIBOR (where the interest is known upfront), when using RFRs, the full interest amount will only be known towards the end of each interest period. Compounded overnight rates have already found favour in both the derivative and bond markets.

    Lookback periods
    The loan markets are expected to follow the SONIA floating rate bond market and implement a [5] day lookback to provide interest rate certainty to borrowers in advance of interest payment (though the number of days could be varied).

Key timelines

Barclays is playing an active role with relevant organisations to shape the future of the loan market and we are on hand to support our clients through the transition over the next 3 years, until the FCA no longer compels LIBOR submissions in 2021.

Full timetable for transition to Risk Free Rates.

The image is a timetable for the transition to the end of LIBOR rates.

For more detailed information on what’s happening during specific periods, please click below: 

    • October 2019: €STR, the EUR risk free rate, will be launched as a replacement of EONIA. EONIA is to remain published until the end of 2021, but will be calculated by adding 8.5bps to €STR. You can find more information here
    • November 2019: Term Rate Task Force will publish guidance on the expected use of compound in arrears rates versus alternative rates such as SONIA term rates, considering both client and product types. 
    • November 2019: The cash spread consultation aims to determine a fair means for determining the spread adjustment to convert an existing LIBOR contract to a SONIA based contract. The consultation aims to validate that the approach developed by ISDA for the derivative market earlier in 2019 is appropriate for the cash market such as loans.
    • November 2019: Key loan vendors are expected to launch new functionality to support Risk Free Rates from November 2019, though it could take up to 12 months for banks to implement this capability in their systems. Some pilot trades are expected in Q4 2019, with the commencement of new deal offering and conversion from existing deals from Q1 2020, though overall market readiness is not expected until Q2/3 2020.
    • December 2019: SONIA swap volumes are expected to overtake Sterling LIBOR volumes by end of 2019, and continue to ramp up in early 2020.
    • January 2020: New loan deals and start of stock conversion from existing deals. 
    • March 2020: A BETA version of a SONIA term rate is to be constructed by 4 vendors. 
    • TBC March 2020: Data vendors are expected to produce calculators to assist validating interest calculations from banks/agent banks. After requests from clients, the Working Group on Sterling Risk Free Reference Rates is considering whether a free-to-use service can be developed, which will be especially important for clients who do not have access to traditional market data systems.
    • September 2020: Go-live for the SONIA term rate tested in March 2020.
    • September 2020: Expected overall date for loan market readiness.
    • September 2020: The target date for no more Sterling LIBOR issuance, as decided by the Sterling Risk Free Rate Working Group.
    • TBC: The Alternative Reference Rate Committee (ARRC) has yet to commit to build a SOFR term rate, but if one is to be built it is not expected until Q4 2020 and up to early 2021.
    • December 2021: The FCA has said it will no longer compel banks to submit rates beyond the end of 2021. Regulators have said the market should work on the assumption that LIBOR will cease to exist beyond this date.

FAQs

More information can be found in our LIBOR Transition Frequently Asked Questions document.

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