Transitioning to Risk Free Rates

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. 

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.

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.

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.

The path to transition away from LIBOR is complex. The alternative reference rates are calculated on a different basis to LIBOR. Market and industry conventions for alternative reference rates are expected to vary between certain products and markets; these conventions continue to develop and may change over time. Various jurisdictions are at different stages of transition, and are moving at different speeds towards, potentially 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. The consequences of reform are unpredictable and may have an adverse impact on any financial instruments linked to, or referencing, any of these benchmarks.

Counterparties that hold and/or enter into transactions that reference interest rates benchmarks that are subject to reform or cessation may be exposed to potential risks. These risks include, but are not limited to, the following:

• The existing agreements may not fully cater for a scenario where the LIBOR benchmark permanently ceases or is no longer representative, including that the agreement may not have any express fallbacks or have fallbacks that are not effective
• The fallback interest rate calculation provisions of the relevant agreement may become operative, which may impact the expected performance of the transaction or product
• Some changes to contractual documentation may be required. This may include changes relating to the calculation of interest and other payments, which may impact the amount counterparties pay or receive and/or other terms of the relevant agreement that reference LIBOR
• Mismatches (including economic mismatches) may occur if the fallback wording for linked transactions differ: this could be in respect of the underlying reference rate the transactions fall back to and/or the timing of when fall back wording becomes operative. For example, an interest rate swap (hedge) may have different fallbacks to a loan (underlying transaction)
• Methodologies for determining an alternative reference rate and/or calculating a potential credit adjustment spread (which may be necessary for the transition to be as economically neutral as possible) may vary across different types of products and jurisdictions
• It may be necessary to implement new operational processes or systems and/or amend existing ones to support alternative reference rates
• The value of products may change or products may no longer serve the purposes or function as originally intended. For example, as liquidity in LIBOR falls due to to a decrease in the number of LIBOR-referencing underlying transactions, LIBOR and LIBOR-referencing products and transactions may become more volatile
• Alternative reference rates may be materially different from LIBOR interest rate benchmarks which could result in unexpected changes in the performance of the underlying products or transactions
• Barclays may have rights to exercise discretion to determine a replacement rate for interest rate benchmarks linked to a transaction or product
• Interest rate benchmark reform may also result in a variety of tax, accounting and regulatory implications
• Products linked to or referencing a Barclays proprietary index or strategy in which LIBOR represents a substantive component or signal may be significantly affected if no appropriate substitute benchmarks are available
• Market participants are encouraged to evaluate their individual circumstances and review their LIBOR-linked exposures. Except where we otherwise agree with you in writing, Barclays does not provide advice, or recommendations on the suitability of your product choice or financial solution. We encourage all market participants to develop a sufficient understanding of the latest developments in LIBOR reform, any exposure they may have to LIBOR benchmarks, along with any expected and potential changes as a result of LIBOR transition and how these changes may impact them and/or their organisation, using independent professional advisors (legal, accounting, financial, tax or other) as appropriate.

If you wish to discuss any of the risks associated with LIBOR transition in more detail, please reach out to your usual Barclays Corporate Banking point of contact.