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The Cessation of LIBOR

Getting Ready for the Day After

 

Suresh Kunnoth, Product Manager, TCS BaNCS

The expected cessation in the publication of LIBOR by the end of 2021 is expected to be a significant financial market event since the conversion of legacy currencies into the Euro. For years, LIBOR (as well as similar benchmark rates in other markets, collectively called IBOR) had been the most commonly used financial benchmark rate, and it had almost become a synonym to identify interest rates in day-to-day conversational English. An estimated 400 trillion USD worth contracts in the market is linked to LIBOR and this includes both cash and derivative instruments such as floating rate notes, FRAs, swaps, loans, mortgages, caps, floors and collars.

The inadequacy of LIBOR as a benchmark in representing the true interest rate risk in a currency was exposed initially by the 2008 credit crisis, revealing several manipulations in the polling system, subsequently raising questions about its credibility and transparency. The 2013 IOSCO publication, Principles of Financial Benchmarks defined the guiding principles for choosing a benchmark. One of the fundamental principles of being a benchmark was that it should have been developed from actual trades of a market with sufficient depth. The Financial Stability Board and leaders of G-20 have accepted these proposals, thus setting the stage for an Alternative Reference Rate (ARR).

The ARR that is emerging as a suitable alternative benchmark are the Risk-Free Rates (RFRs) in various currencies. All these RFRs such as SOFR is US Dollars, SONIA in Sterling, €STR in Euro, SARON in Swiss Franc and TONA in Yen are overnight interest rates published from actual trades and are not as forward-looking as the LIBOR. This has posed a unique problem in finding a proper fallback arrangement to replace a forward-looking rate like the six month LIBOR with a daily rate such as SOFR. There have been various options under consideration (Table 1) and currently the consensus is emerging towards using the RFR compounded for business days and set in arrears for the calculation period, plus an appropriate spread between the IBOR and RFR compounded rates set in arrears, observed over five years prior to the date of eventual transition. The ISDA has assigned Bloomberg as the third-party vendor to collate the data and publish the rates and the spread.

Below stated are a few “Alternative Reference Rates” (ARR), currently in consideration for an alternative fallback rate.

The COVID-19 pandemic leading to the lockdown has slowed down the decision making process slightly. The ISDA published the fallback arrangement in May 2020, and are expected to come out with the revised derivative definitions of the 2006 version soon, which will provide a legal framework for the IBOR fallback arrangement. Similar efforts are in progress by most other regulators such as the Fed New York’s ARRC and the likelihood of it following the ISDA-Bloomberg arrangement as the IBOR fallback is great.

Market developments in this regard, are evolving and financial institutions need to leverage on agility in monitoring and adapting to changes quickly. Today’s treasury providers need to offer solutions with features such as simple or compounded for business day RFRs set in advance or arrears, projections and discounting using daily compounding RFR curves and swap curves for all supported/ new instruments defined by users and contracts with RFR definitions. Eventually, we believe that the financial market will identify the depth of forward-looking products such as SOFR futures and others. Keeping this in mind, it would bse prudent to enable all financial contracts with adequate fallback clauses for the future.

Disclaimer: Views or opinions represented in this blog is based on author’s own research and does not represent TCS BaNCS.