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Transitioning to Risk Free Rates

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.

On the 5 March, 2021, the Financial Conduct Authority (FCA) made an announcement confirming that all LIBOR settings will either cease to be published by an administrator or be provided on a representative basis in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings immediately after 31 December 2021. The same will apply to the remaining US dollar settings after 30 June 2023.

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. 

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.

These efforts have resulted in the identification of Risk-Free-Rates (RFRs), for each of the LIBOR currencies, which are based upon overnight transactions; however, these are not the only identified alternatives. While it is expected that RFRs will become the norm for derivatives, securities and wholesale loans, regulators have highlighted the usage of other variable rates or fixed rates for some market participants. An example of this in the UK, is the Bank of England Bank Rate, which is already widely used in mortgages and for some retail lending where simplicity and transparency of the rate are seen as priority.

Currency Existing Rate Alternative Rate Transaction Type
USD LIBOR SOFR, Secured overnight financing rate Secured
EUR* LIBOR, EURIBOR €STR, Euro short term rate Unsecured
GBP LIBOR SONIA, Sterling overnight index average Unsecured
JPY LIBOR TONA, Tokyo overnight average Unsecured
CHF LIBOR SARON, Swiss average rate overnight Secured

For information on other key jurisdictions please download our world map (PDF 315KB)

The Euro Short Term Rate (“€STR”) is intended to replace the Euro Overnight Index Average (“EONIA”), at the end of 2021. No potential cessation date has been given for EURIBOR.

What is happening with EURIBOR & EONIA?

EURIBOR, (EURO Interbank Offered Rate) completed reforms of its methodology in Q4 2019. The European authorities believe reformed EURIBOR can exist beyond 2021, and no indication has been given that the benchmark is likely to cease anytime soon. However, EONIA, the Euro Overnight Index Average, became increasingly fragile in recent years. Consequently, the methodology was changed in October 2019 and EONIA became a tracker rate to €STR, the RFR identified by the Euro working group. It is expected publication of EONIA will cease on 3 January 2022.

What are Risk Free Rates?

The acronym “RFR” was introduced by the Financial Stability Board in their 22 July 2014 publication on benchmark interest rate reform.  The phrases ‘near risk-free rates’, ‘risk-free rates’ and ‘alternative reference rates’ are generally accepted as interchangeable and these should be considered to refer to the same: 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;
  • Some market participants have expressed the need for a RFR based term rate, in order to know the applicable interest rate in advance of any payments to be made. Each of the RFR working groups is considering if it will be feasible to produce a robust term rate. The Swiss group has stated it will not be possible in that market;
  • RFRs are based on a large number of overnight money market transactions, so the risks associated with expert judgment do not arise;
  • The underlying volumes representing the indices which 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 security repo markets.

Background, preparation, currencies, products and risks to consider

Select
  • 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

    • Barclays supports the benchmark interest rate reform agenda as set out by the Financial Stability Board in 2014 and subsequently driven by the international risk free rate working groups and relevant supervisory authorities.  We are actively engaged in the reform agenda and along with participating in various industry conferences and events discussing LIBOR transition, Barclays is a member of the US, EU, Japan and Singapore working groups. More prominently, Barclays chairs the Working Group on Sterling Risk-Free References Rates.
    • As instructed by the Bank of England Prudential Regulatory Authority and the UK Financial Conduct Authority, Barclays is planning for the base case scenario that LIBOR will no longer be available after 2021.
    • Barclays has mobilised an enterprise-wide programme with Senior Manager oversight, to coordinate its global efforts in relation to the transition.
    • Barclays is also aware that 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. 
    • Barclays expects that the timing of any transition away from relevant interbank offered rates to 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.

    In a communication recently sent to clients of the Corporate and Investment Bank, we highlight some of the risks market participants should consider and suggest steps to take now to prepare.

    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.

  • 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).

  • Risks to consider

    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
    • Barclays may, in accordance with the relevant rules or methodology of a Barclays index or other quantitative investment strategy, have rights to determine a replacement rate for interest rate benchmarks that feature as a component of such index or strategy and to make any necessary modifications to the methodology as a consequence. The use of a replacement rate and related adjustments may affect the performance of the index or strategy.
    • 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.

    Should you require further information on LIBOR transition, the other areas of the website contain a number of resources including FAQs and useful external links.

    Intermediaries and Distributors can click here (PDF 89KB) for information on the impact of RFRs on Floating Rate Note (FRN) coupon interest rate payments.

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

FAQs

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

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