In June 2020, we published an article on the required move of interest rates away from Interbank Offered Rates (IBORs), the background for this change, the regulatory authorities’ expectations and some of the differences and issues to consider between IBORs and alternative interest rates such as ‘near Risk-Free Rates’ (“RFRs”)1. We particularly commented on the scheduled cessation of the London Interbank Offered Rate (LIBOR).

    This new article comments on recent announcements by regulators and more advanced preparatory work carried out by the financial services industry.

    On 5 March 2021, the Financial Conduct Authority (FCA) announced2 the cessation and non-representativeness dates for all LIBOR settings:

    • Immediately after 31 December 2021, for Sterling, Euro, Swiss Franc and Japanese Yen LIBOR settings in all tenors, and US Dollar LIBOR 1-week and 2-month settings; and
    • Immediately after 30 June 2023, for US Dollar Overnight, 1-month, 3-month, 6-month and 12-month settings.

    Immediately following the FCA announcement, the International Swaps and Derivatives Association (ISDA) stated3 that this constituted an index cessation event under the IBOR Fallbacks Supplement and the ISDA 2020 IBOR Fallbacks Protocol for all 35 LIBOR settings. Therefore, the five-year historical median spread adjustments for LIBOR in its five currencies and all settings were fixed as of Friday 5 March 2021. The final spread adjustments for each combination of currency and tenor have been published by Bloomberg4. The use of fallback (or default) rates is discussed briefly below, and further detail is readily available5.

    In addition, the Working Group on Sterling Risk-free Reference Rates’ paper6 (issued by the Bank of England and updated April 2021) titled “Priorities and roadmap for transition by end-2021”, sets out many milestones and deadlines.

    In 2020, given the reduced availability of resourcing during the Covid pandemic, questions were being raised across the financial services industry as to whether the end-2021 deadline should be extended. Such pressure seems to have abated as working practices adapt and vaccines are delivered. Moreover, the move away from IBORs is primarily market-driven, albeit regulator-supervised.

    Investment firms and banks appear to be making good progress now with reviewing their contractual and procedural dependence upon IBORs, using the results for planning and executing their transition programme to replacement rates. RFRs are commonly used as alternatives to IBORs, but usage is not universal or always consistent, so terminology and method must be checked by market participants.

    The need for consent could create some operational challenges

    One key challenge that has been highlighted in the market is contractual consent, such as for mortgage backed securities (MBSs) and floating rate notes (FRNs). Using FRNs as an example, new FRNs are now being created using replacement rates. However, many current FRNs scheduled to run beyond the 31 December 2021 deadline will contractually need consent by issuer and investor in order to change their benchmark rates.

    If such consent is needed, then changing the rate of the FRN will require the issuer, its investment bank and its issuing and paying agent to initiate a corporate action, which will make its way (possibly via a Central Securities Depository) to the custodian banks holding the assets on behalf of investors. Such conversions may happen in a variety of ways depending on the issuer and the terms of the bond.

    The issuer could potentially ask via a bond meeting for consent as a voluntary corporate action event in its own right, paving the way for a mandatory change event in due course. Operational difficulty could arise however if corporate actions (especially voluntary ones) are bunched into the last 5 or 6 weeks of 2021, creating a high volume of corporate actions being managed by the industry before and around the Christmas holiday.

    This operational risk can possibly be mitigated by:

    • Scenario 1: changing an FRN’s benchmark rate ahead of end-2021, if the FRN’s conditions so permit and the parties consent. Some issuers and investors may not want to move early however, for various reasons including operations, tax, or merely not changing the locked-in revenue or cost; or
    • Scenario 2: it may be possible in some cases to obtain the consent earlier in 2021, whilst changing the coupon rate from a specific future date, such as coupon reset date or 31 December 2021. In this scenario, the matter of future buyers being bound by the consent vote and agreement of previous owners has been raised. Future buyers would however normally be buying on the basis of the amended terms whether those are undertaken immediately, as in scenario 1, or deferred to 31 December 2021. The results of such a consent vote would be published or made available on corporate websites. Sophisticated investors would accordingly (or through other means) be aware of the move away from IBORs, so it wouldn’t be a surprise when investing. Nevertheless, each issuer could follow an individual path rather than there being a standard, so the particular approach needs checking in each case;
    • Scenario 3: do nothing, and let the rate be left in limbo, benchmarked to a rate that no longer exists. In this case the FRN’s terms may provide for a fallback or default rate, but the intention for such a rate is usually only a contingency or to be used short-term. In the case of fallback or no specified rate, a long-term solution will need to be agreed between the parties.

    Navigating more known unknowns

    In addition to the matters set out in our previous article, there are a number of issues to be addressed in moving away from an IBOR to a replacement rate.

    New derivatives are now being issued using replacement rates as a benchmark. Where a change of rate is needed, valuation of the position before and after the change will generally be determined by the valuation agent, taking account of any interest accrual. Complex pricing models will be used in many cases, particularly where contingencies and their timing are involved, such as for options, warrants and convertibles. A pricing model (including market conventions and liquidity factors where relevant) must be created that is sophisticated enough to create a valid price, whilst being simple enough to be used; this task could take extra time.

    In setting interest rates, it is important to note for LIBOR that the UK’s HM Treasury (HMT) issued a consultation in February 2021 concerning “safe harbour” rates7. HMT’s document explains that “stakeholders envisage that a legal safe harbour would act as a helpful contingency in reducing the potential risk of contractual uncertainty and disputes in respect of certain legacy contracts referencing or relying upon a benchmark […] that the FCA has designated to be unrepresentative or to be at risk of becoming unrepresentative”. If enacted, such a provision could be useful where a LIBOR setting becomes unrepresentative before an alternative has been specified.

    The transition away from IBORs will be a long journey

    In conclusion, much progress towards IBOR transition has been made by both regulators and market participants, but the effort and uncertainty involved is still considerable. The move is a market trend as well as a regulatory mandate, so regulators can supervise but not fully control it. The paper (updated April 2021) published by the Bank of England on sterling rate deadlines8 referred to earlier is particularly helpful. Market participants will need to keep engaged on the topic to understand fully the detailed scope of their necessary changes, and to ensure that they are resourced to make the changes very soon.

    1 RFRs are typically backward-looking overnight rates based on actual transactions and reflect the average of the interest rates that certain financial institutions pay to borrow overnight either on an unsecured basis from wholesale market participants (for unsecured RFRs, such as SONIA) or the average rate paid on secured overnight repurchase or “repo” transactions (for secured RFRs, such as SOFR). RFRs do not include or imply any credit or term premium of the type seen in LIBOR or EURIBOR. However, RFRs are not truly free of risk. RFRs can rise or fall as a result of changing economic conditions and central bank policy decisions.
    2 https://www.fca.org.uk/publication/documents/future-cessation-loss-representativeness-libor-benchmarks.pdf
    3 https://www.isda.org/2021/03/05/isda-statement-on-uk-fca-libor-announcement/
    4https://assets.bbhub.io/professional/sites/10/IBOR-Fallbacks-LIBOR-Cessation_Announcement_20210305.pdf
    5 For example https://www.pwc.com/us/en/industries/financial-services/regulatory-services/libor-reference-rate-reform/isda-fallback-protocol.html
    6 https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/rfr-working-group-roadmap.pdf
    7 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/961317/HMT_Safe_harbour_Consultation.pdf
    8 https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/rfr-working-group-roadmap.pdf

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