FAQ: IBOR transition to risk-free rates in Europe
- June 19, 2020
Private Equity | London
Private Equity | London
Hedging and Capital Markets
Private Equity | London
Chatham’s experts on financial risk, hedge accounting, and regulatory matters answer questions our clients have asked to prepare for the transition from IBOR benchmark rate to risk-free rates in Europe.
The transition from the London InterBank Offered Rate (LIBOR) and similar rates like Euribor and Tibor (together IBORs) to risk-free rates (RFRs) looms over the capital markets as 2021 approaches, when IBORs may no longer function as benchmark rates. In this document, Chatham’s experts on financial risk, hedge accounting, and regulatory matters answer some of the questions our clients have asked to prepare themselves for the upcoming changes. As this transition is constantly evolving, we will continue to update this document to reflect these changes. Please note the publish date for reference as well as the fact that the terms “LIBOR” and “IBOR” will be used interchangeably in this publication. The focus of this FAQ is the impact of LIBOR replacement in Europe. USD LIBOR reform is discussed separately in the FAQ: USD LIBOR Transition to SOFR.
- Why is LIBOR so important?
- Why is LIBOR going away?
- When is LIBOR going away?
- What do we need to do to prepare for the transition? When will I need to act and how?
- What are RFRs?
- What is the RFR for the UK?
- What is the RFR for the Eurozone?
- How does LIBOR compare with RFRs?
- What is the different between compound and simple averaging methodology for RFRs?
- What are the key operational differences between LIBOR and RFRs?
- What fallback language does Chatham recommend be included in loan and cash documents?
- What are the common changes in ISDA documentation for clients to consider in relation to RFR for existing hedges? Is there a Chatham-standard language?
- Will the cash and derivatives markets match up?
- How will the derivatives market (specifically caps) be treated?
- How will the spread be determined and implemented when LIBOR goes away and RFRs come into place?
- Will there be term rates links to RFRs?
- Does Chatham recommend waiting until term rates are available before transitioning cash and derivative contracts from LIBOR to RFRs?
- What strategies are we seeing clients use currently to hedge through the LIBOR transition?
- Overall how will accounting be impacted during the period prior to transition to RFRs?
- How will accounting be impacted during transition to RFRs?
- What financial statement disclosures do I need to provide prior to transition?
Preparing for transition
IBORs are interest rate benchmarks that underlie trillions of dollars of financial products, including corporate borrowings and derivatives. It is estimated that $240 trillion of debt and derivative contracts rely on LIBOR benchmarks, three times global GDP. Meanwhile, LIBOR is set to be discontinued shortly after the end of 2021. Given IBORs are so deeply rooted in most market processes and systems, the transition away from LIBOR is likely to be one of the biggest transformation programmes that financial markets have undertaken. (Back to top)
Willem Buiter, a former member of the Bank of England’s Monetary Policy Committee, summarised the challenges facing LIBOR as early as 2008 with his pithy description of LIBOR as “the rate at which banks don’t lend to each other.” LIBOR is intended to measure the rate at which banks could borrow funds in the wholesale markets. However, the way banks fund themselves has changed and there are very few transactions in the markets that LIBOR purports to measure. This lack of transactions means that panel banks use their expert judgement when setting LIBOR to make hypothetical submissions of what interest rates would be if they were to borrow in the relevant wholesale unsecured markets. The inherent subjectivity and judgement at the heart of LIBOR has led to numerous manipulation scandals and potentially undermines the stability of the global financial system. For all the above reasons, in July 2017, the Financial Conduct Authority (FCA) Chief Executive, announced that the FCA would no longer compel or persuade panel banks to submit quotes for LIBOR beyond 2021, making transition away from LIBOR to RFR regimes seemingly inevitable. (Back to top)
In September 2018, the FCA and Prudential Regulation Authority (PRA) wrote to CEOs of major banks and insurers in the UK asking for details of the preparations and actions they are taking to manage transition from LIBOR to alternative interest rate benchmarks. Unless LIBOR continues as a private, and presumably less liquid initiative, there will be a cessation of LIBOR by the end of 2021. However, given the FCA’s insistence that LIBOR’s replacement should be determined by the market rather than through regulatory instructions, it remains unclear as to the cut-off point for transition given the lack of legislation underpinning the cessation of LIBOR for both entities and their counterparty banks. In January 2020, the FCA and the Bank of England issued a joint press release encouraging market makers to change the market convention for GBP interest rate swaps from LIBOR to the Sterling Overnight Index Average (SONIA) in Q1 of 2020 and ceasing GBP issuance of LIBOR-based loans by the third quarter of 2020. It remains to be seen how the market will react to this announcement during Q1 2020. (Back to top)
While the market continues to adopt a “wait and see” approach in terms of mass adoption of RFRs, we recommend that organisations should consider the following steps in preparing for the transition:
- Assess contracts and exposures to LIBOR to determine the scale of the change
- Take stock of existing fallback provisions in cash and derivative instruments (triggers, replacement index and spread adjustment)
- Identify operational and system capabilities to deal with compounded in arrears interest computations
- Closely track external developments in terms of LIBOR reform
- Educate staff and engage customers to ensure implications are understood and required responses are put in place (Back to top)
The Financial Stability Board’s 2014 recommendation was for each jurisdiction that relied on LIBOR to propose an alternative “near risk-free” benchmark. The idea was that RFRs should represent each currency’s baseline interest rate environment, rather than the rates available in the interbank lending market. This had several immediate advantages over LIBOR:
- RFRs could be calculated on the basis of overnight deposit transactions that were already reported to central banks. This meant that they would not need to rely on judgment-based submissions, making them less prone to manipulation.
- The market for overnight deposits is vastly more liquid than that for interbank lending, with hundreds of transactions every day.
- As LIBOR measures interbank lending, it includes an implicit premium for the banking sector’s credit risk. RFRs should not do this, making them more appropriate benchmarks for a variety of purposes (e.g. interest rate derivatives and discount factors).
RFR working groups in several jurisdictions identified replacement benchmarks and have begun developing strategies for transition. Select examples of benchmarks which are either being replaced or benchmarks where changes either have or will be made to their methodology are set out in the table below.
In July 2017, the Working Group on Sterling Risk-Free Reference rates (RFRs) selected SONIA as the replacement benchmark in sterling markets for GBP LIBOR. SONIA was first introduced in March 1997, reformed in April 2018, and is administered by the Bank of England and published on every London business day. SONIA is an unsecured overnight rate based on actual sterling deposit transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. (Back to top)
While LIBOR is the dominant interest rate benchmark for four of the five currencies it represents (GBP, USD, CHF and JPY), EUR LIBOR is rarely used in debt and derivatives contracts. Euro instruments instead rely on EURIBOR, which is calculated in a similar way to LIBOR but administered by the European Money Markets Institute (“EMMI”). On 2 July 2019, the Belgian Financial Services and Markets Authority (FSMA) authorised EURIBOR under the Benchmark Regulation (BMR) which means that EURIBOR is not set to be discontinued. However, the EURIBOR calculation methodology switched to a hybrid methodology whereby EURIBOR is now based on panel bank contributions anchored on transactions in the underlying unsecured money market.
The Euro Overnight Index Average (“EONIA”) rate is the 1-day interbank interest rate for the Euro zone. On 2 October 2019, the EONIA methodology was redefined as the euro short-term rate (€STR) plus a fixed spread of 8.5 bps. The €STR reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area based on money market transactions. It is expected that market participants will gradually replace the EONIA with the €STR for all products and contracts, making the €STR their standard reference rate. (Back to top)
Discontinuing LIBOR is not a simple process of taking all references to LIBOR in existing contracts and systems and replacing them with references to the appropriate RFR. Three fundamental differences exist between RFRs and LIBOR:
- Overnight Rates - RFRs only give the overnight (i.e. 1-day) borrowing cost for the previous day. Meanwhile, each LIBOR is a forward-looking term rate, meaning that it gives an annualised interest rate for the period starting on the day it is published. This may be 1 day, 1 week, 1 month, 2 months, 3 months, 6 months or 12 months.
- Backward-looking - Financial products referenced to RFRs use an average of the overnight rate (averaged RFR) over a period equal in length to the relevant interest period, not a single day’s reading of the rate, for establishing the amount of interest to be paid. LIBOR, a forward-looking term rate published on the first day of the month, cannot be directly replaced by the RFR rate published on the same day.
- Risk free rates - RFRs are nearly risk-free rates and tend to fix lower than their corresponding LIBOR, which incorporate an implicit premium for the banking sector’s credit risk. Consequently, transitioning from LIBOR to RFRs would mean lenders would be looking to adjust the existing borrower margin to reflect a spread over the RFRs. Borrowers would expect to see their margin over RFRs to be greater than the margin over LIBOR to compensate for the LIBOR-RFR spread. Importantly, borrowers would want to have a seat at the table when it comes to negotiating suitable margin adjustments on the transition date. This is to ensure that the transition to the RFR results in an economically neutral position on transition date for all parties concerned.
An averaged RFR can either be calculated by using a simple or a compound average. Simple interest is the arithmetic mean of the daily RFRs. A compounded RFR approach would be calculated by taking the daily fixings of an RFR over a set period (e.g. a 3-month interest period on a loan), and then compounding these into a single, aggregate rate for that period. The result is an interest rate that is close to being “risk-free,” but that also takes account of any changes to the interest rate environment that took place during the calculation period.
Simple interest is long-standing convention and is in some respects easier from an operational perspective. However, from an economic perspective, compound interest is the more correct convention and has generally been favoured by the markets as the preferred approach for averaging RFRs. The prevailing view of the Working Group on Sterling RFRs in its January 2020 Press Release was that overnight SONIA compounded in arrears, should be the market convention for most derivatives, bonds, and bilateral and syndicated loan markets. (Back to top)
While transiting from LIBOR to RFRs is expected to remove the conduct risk associated with setting LIBOR, overnight RFRs are generally viewed as being more challenging to deal with from an operational perspective. Whereas LIBOR fixes in advance (i.e., at the start of an interest period), a compounded RFR is backward-looking and can only be calculated once the period has ended, as its calculation requires each daily fixing of the RFR. This has significant implications for cash flow planning. Borrowers using a compound RFR will no longer be able to plan their interest cost cash flows at the start of each interest period, as they will only know the final interest rate on period’s end date. There are a variety of ways to deal with this, and the most popular to date has been to introduce a delay between each interest period’s end date and the date payment is due. Typically, this is five business days — not as much notice as borrowers using LIBOR are accustomed to, but significantly better than a same day cash flow. In January 2020, the Working Group on Sterling RFRs recommended all SONIA based issuance and loan transactions to have a 5-day lag period between calculating the SONIA rate, interest amounts and making the actual payment on the due date.
It is also worth noting that, while borrowers using compounded RFRs will not have complete certainty of their interest cost until the end of each period, they will have a reasonable estimate much earlier than this. Compounding daily RFR fixings is a similar process to averaging, meaning that by the midpoint of the calculation period each subsequent daily fixing only has a limited impact on the final figure. Even a significant change towards the end of the period (due to an interest rate hike or cut by the central bank, for instance) may only change the total interest cost by a few basis points. (Back to top)
“Fallback” language refers clauses in contracts that provide for the event that LIBOR is unavailable. For older loans, the provisions in different contracts can vary enormously and may not have received a great deal of attention when the contract was initially negotiated. One consequence of this is that older fallback arrangements will frequently contemplate a temporary unavailability of LIBOR rather than a permanent discontinuation. As such, they may not be either practical or desirable for long term use.
Meanwhile, loan contracts that have been negotiated in recent years will contemplate the permanent discontinuation of LIBOR. Nevertheless, even here there are unlikely to be references to RFRs. The most widely used provisions are those drafted by the Loan Market Association (LMA). The latest version of the syndicated loan agreement of the LMA provides a waterfall of fallbacks in the event a reference rate ceases to be available without specific reference to RFRs. However, these are at best temporary measures, and are not suitable for replacing a discontinued rate in the longer term. Under the current provisions, if the fallbacks fail, the lenders (as a whole) and the borrower will need to negotiate and agree on an alternative rate. In October 2019, the LMA published exposure drafts of Compounded SONIA/SOFR based Facility Agreements as well as a Reference Rate selection agreement for use in relation to legacy transactions and the transition to RFRs. The LMA mentioned that currently there is insufficient established market practice to enable the LMA to publish a recommended form of Reference Rate Selection Agreement.
Chatham does not have specific fallback language that it currently recommends for loans and cash products since there is still no market consensus regarding a standard substitute rate definition. We have seen some clients prefer to take a hardwired approach to fallback language in their loans by including a specific rate, index, or the future determination of a substitute rate by a specific committee or organisation (such as the Fed, the Bank of England or ISDA). Other clients, however, have preferred to retain flexibility in their loans and have included language incorporating whatever fallback rates are ultimately adopted by the marketplace. Whichever approach a client prefers though, Chatham recommends that clients and their advisors take a close look at the trigger and fallback language (or lack thereof) in their loans and their derivatives used to hedge those loans. (Back to top)
What are the common changes in ISDA documentation for clients to consider in relation to RFR for existing hedges? Is there a Chatham-standard language?
Under the 2006 ISDA Definitions, if LIBOR is not available, current fallbacks require the calculation agent to obtain quotations for what LIBOR should be from major dealers in the relevant interdealer market. These current fallbacks were not designed to cover permanent discontinuations of LIBOR.
In its July 2018 and May 2019 Consultations, ISDA has been working on amending the Definitions to include fallback language that would apply upon the actual discontinuation of the relevant IBOR (i.e. after the announcement date) whereby, for a given IBOR, the fallback rate would be the compounded in arrears overnight rate identified by the RFR working group as the alternative to that IBOR. These amended Definitions would include fallback rates that will apply to new derivatives and it will provide a protocol that will allow adhering parties to incorporate the fallback rates into existing derivatives trades.
We expect that many clients will likely incorporate ISDA’s amended Definitions into their new trades, but it is not yet clear whether most clients will address their existing trades through the protocol or through bilateral agreements. If an entity does not incorporate the revised ISDA Definitions into the terms of its derivative, it remains to be seen how this will play out in practice.
Regardless of the method by which clients incorporate fallback language, Chatham suggests that clients try to align the trigger and fallback language in their loans with the language in the derivatives used to hedge those loans to avoid a potential mismatch in timing or the fallback rate. (Back to top)
There are potential differences between the cash and derivatives markets at this stage and both markets are still developing. As an example, some cash markets could conceivably contemplate fallbacks to forward-looking term rates whereas ISDA is exclusively focused on RFR compounded in arrears for their protocol fallback. Even for cash products using RFRs compounded in arrears, early agreements have used conventions around the lag on the fixing dates and day count dates that are different from those seen in the derivatives market. This could create difficulties for those seeking to use derivatives to hedge their interest rate risk.
If the trigger and/or fallback language in a derivative document and the underlying loan agreement do not match, end users need to be aware of the potential for mismatch and what that could mean from a risk management and accounting perspective, advocating and pushing for change where necessary to minimise the gap. (Back to top)
Chatham expects the market to use SONIA compounded in arrears (with a 5-day lookback period) for the derivatives fallback rate. Unfortunately, the volatility market is still in the early stages of development, and trading in SONIA caps in particular is illiquid at best. Nearly all the regulators’ focus at this stage has been on determining rates and calculating payments with seemingly little concern for related issues like the option market. This presents problems not only for caps and floors, but also for calculating XVA (Credit Valuation Adjustments, Debit Value Adjustments, Funding Value Adjustments, etc.) on other products like swaps.
That said, with SONIA starting to become the norm for cash products, we expect to see liquidity in SONIA-linked options grow rapidly over the coming months. Chatham employees should continuously share information on different banks’ appetite and pricing for these products as the market develops. (Back to top)
RFRs are overnight rates whereas LIBORs are published for various tenors and incorporate a credit spread adjustment for interbank credit risk. To account for the move from a term rate to an overnight rate, a one-off spread adjustment is required to the applicable overnight RFR so that it is comparable to LIBOR. To avoid or reduce any value transfer arising solely from the transition from LIBOR to the RFR, Chatham recommends that clients try to negotiate a fair spread adjustment in their loans and derivatives. Many loan documents include a spot-spread methodology which is based on the spot spread between the LIBOR and the adjusted RFR on the day preceding the relevant fallback provision. Chatham would advise clients to carefully consider the potential results before agreeing to this methodology since variations in RFRs create the potential for significant value transfer as a result of the selection of an arbitrary calibration date.
On the derivatives side, ISDA released the preliminary results of their consultation for the spread adjustment on LIBORs in November 2019 and the majority of respondents preferred the historical median approach for the spread adjustment. This spread adjustment would be based broadly on the median spot spread between the relevant IBOR tenor and the adjusted RFR calculated over a static lookback period of 5 years prior to the relevant trigger event of the fallback (so the credit spread will differ across different tenors). (Back to top)
In theory, it is possible to derive forward looking term rates using the swap market for overnight RFRs. The swap rate for a given period would be a reasonable candidate, as it is equivalent to the market’s expectation of the compounded RFR fixing over that period. That said, the view of the Working Group on Sterling RFRs January 2020 guidance note is that overnight SONIA compounded in arrears is the default approach for transition to SONIA in most derivatives, bonds, and bilateral and syndicated loan markets and is expected to be the primary vehicle for GBP LIBOR transition. The use of a forward-looking SONIA term rate would be limited to products where the use of SONIA compounded in arrears would create operational difficulty regardless of the sophistication of the borrowers for example, certain trade and working capital and export finance and emerging markets clients. (Back to top)
Does Chatham recommend waiting until term rates are available before transitioning cash and derivative contracts from LIBOR to RFRs?
No, Chatham recommends being as proactive as possible with respect to the LIBOR transition. Many organisations are just beginning their LIBOR transition plans, however, 2021 (when LIBOR could no longer be a benchmark rate) doesn’t leave much time for the massive transition, especially with key details yet to be determined. At this point, Chatham recommends our clients assess/inventory their risk to LIBOR/fallbacks and staff teams as necessary to monitor and facilitate the transition. It is also highly unlikely that term rates for SONIA will be available for broad-based adoption given the view of the Working Group on Sterling RFRs is that term rates for SONIA are likely to be available for a small section of products in the market and SONIA compounded in arrears will be the primary vehicle for GBP LIBOR transition. (Back to top)
With the markets where they are today, LIBOR borrowing/hedging is by far still dominant in the real estate, private equity, and corporate client bases. Most of the focus is on ensuring flexibility for LIBOR fallbacks and cessation events in loan documentation.
Some clients have included trigger-event and cessation-event language in trade confirmations for longer-dated trades (again focused on flexibility and commercial reasonableness). A further key focus is ensuring that fallback provisions on loans and derivatives are aligned. (Back to top)
The IASB’s Phase 1 on IBOR reform deals with pre-replacement issues arising on IBOR reform and in September 2019 an amendment was issued to IFRS 9, IAS 39, and IFRS 7. The amendment provides a temporary exception from applying the highly probable requirement in determining whether a hedge forecast transaction is still expected to occur during the period in which uncertainties exist about the designated interest rate benchmark and/or the timing or the cash flows of the hedged item or hedging instrument. Consequently, during this period of uncertainty, the reliefs provided allow almost all entities to continue to apply hedge accounting without changing their existing processes. These reliefs apply for periods beginning on or after 1 January 2020, with earlier application permitted. Without this guidance hedge accounting for interest rate exposures would be lost by many market participants. (Back to top)
Current IFRS guidance requires extensive analysis of contract modifications, the results of which can lead to P&L impacts and loss of hedge accounting. In Q4 2019, the IASB issued a staff paper on Phase 2 of IBOR reform (Staff Paper) discussing the potential accounting issues related to the measurement of financial instruments, including simple loans, and hedge accounting arising as a result of IBOR reform. The objective of the proposal is to provide useful information about the effects of the transition to RFRs on financial statements and support preparers in applying the requirements of IFRS during IBOR reform. The Staff Paper though is not an exposure draft nor does it constitute accounting guidance that can be applied by preparers that transition before the final accounting standard is issued (expected later in 2020).
- Debt and loans: when a debt contract is modified as a direct consequence of IBOR reform and is done on an economically equivalent basis, the guidance in the Staff Paper provides a practical expedient in that the modification is accounted for prospectively as an adjustment to the effective interest rate (EIR) of the instrument with no day one P&L impact. Some examples of such modifications would be changes in the existing benchmark rate from IBOR to RFR, changes to incorporate a fixed spread to reflect the historical basis difference between IBOR and the RFR and changes to the reset periods and payment dates flowing from transition to the RFR form. However, the accounting implications from modifications to the terms of a loan contract that are not related to IBOR reform would need to be assessed in accordance with the current modification guidance in IFRS 9. Some examples of such modifications would be changes to the loan’s notional amount, maturity, counterparty credit spread or insertion of prepayment, conversion or interest rate cap or floor features.
- Hedge accounting: the Staff Paper extends practical expedients from loan modifications to allow hedging relationships to continue in situations where the modifications to either the hedging instrument and/or the hedged item are directly required by IBOR reform. One point to emphasise though is the importance of the timing of transition for both the hedged item (loans) and hedging instrument (derivative) to be aligned in terms of the date of transition and from an economic perspective. Failure to do so is likely to result in significant accounting complexity and potential P&L noise.
- Embedded derivative review: Upon issuance and modification, all contracts must be analysed for embedded derivatives. Both qualitative and quantitative factors are considered to determine whether the embedded derivative should be accounted for separate from the host contract. The IASB is expected to grant relief so that amendments related to reference rate reform will not trigger analysis of embedded derivatives.
- Leases: Most leases are carried on the balance sheet as a liability with an associated right-of-use asset, while certain leases are off balance sheet. A modification in the contract requires a reassessment of this classification. The IASB is expected to grant relief in this area.
- Revenue: Certain long-duration construction contracts are recognised in earnings based on a percentage of completion. Amendment of the contract requires a reassessment of the amount recognised in earnings and possibly a new pattern of recognition in the future. The IASB expects to provide relief for this analysis if the modification is solely due to replacement of a reference rate. (Back to top)
For entities that have early adopted the Phase 1 amendments to IFRS 9, IAS 39 and IFRS 7, they should be disclosing the following in their December 2019 financial statements:
- the significant interest rate benchmarks to which the entity’s hedging relationships are exposed
- the extent of the risk exposure the entity manages that is directly affected by IBOR reform
- how the entity is managing the process to transition to RFRs
- a description of significant assumptions or judgements made in applying the Phase 1 relief
- the nominal amount of the hedging instruments affected by Phase 1 relief.
Even for entities that have not early adopted Phase 1 relief, to the extent applicable, they should be disclosing under the existing requirements in IFRS 7, the impact of IBOR reform in the Financial Risk Management section as being an emerging and/or existing risk for the business. (Back to top)
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0068
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