The biggest capital market change since the introduction of the European currency is taking place: Interest rate benchmarks including the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), the Euro Overnight Index Average (EONIA) and certain other Interbank Offered Rates (IBOR), are being reformed.
What are IBORs?
For more than 40 years, IBORs set the benchmark rate for a wide range of financial products such as derivatives, bonds, loans, structured products, and mortgages to determine interest rates and payment obligations. IBOR reflect the average price as a benchmark for which selected international banks with a good credit standing can get loans on the interbank market without securities. On the European market the LIBOR, the EURIBOR and EONIA are among the most important reference values. The calculation and publication of the LIBOR is currently carried out by the ICE Benchmark Administration (IBA) and for the EURIBOR by the European Money Markets Institute (EMMI) that record entry data on a daily basis of selected panel banks and publish it for different terms.
The function as reference is extremely relevant, since IBORs have a direct influence on the development of financial instruments’ value. Furthermore, the reference interest rates have a special meaning in respect to the economy and money policies, due to their high market volume. Overall, the market volume of financial products sums up to hundreds of billions of EURO and further billions in currencies such as US-Dollar, British Pound, and Japanese Yen.
Why are IBORs being reformed?
A series of scandals has brought the IBOR benchmarks down. In 2012, a group of banks were accused of manipulating their IBOR submissions during the financial crisis. In addition, the market and trading liquidity in the interbank markets has decreased since the financial crisis, as transactions have become significantly smaller.
Accordingly, regulatory authorities and working groups all over the world have been discussing alternatives. The Financial Stability Board (FSB) in 2014 recommended to use near risk-free rates (RFRs) that are based on more active and liquid overnight lending markets, instead of IBORs where appropriate. Important benchmarks such as LIBOR, EURIBOR and EONIE must now be fully replaced with new risk-free interest rates by December 31st, 2021.
What are risk-free rates (RFRs)?
In contrast to IBORs, that are date rates (forward looking rates), RFRs are past-oriented rates (backward looking rates) in which the interest calculation is carried out in retrospect. Additionally, the IBORs are afflicted with a credit risk and therefore contain a credit risk bonus, whereas RFRs are pure overnight interest rates that are almost completely risk-free. Since the purely transaction-based calculation of the IBORs was criticized heavily in the past, the future calculation of the reference interest rates will be carried out by a three-tiered waterfall model. This process, consisting of transaction-based detection, near-transaction derivation, and expertise, is supposed to eliminate manipulation and make a daily publication possible with little or no transactions.
The transition won’t be easy
The RFRs are distinctly different in amount and volatility to the previous IBOR interest rates. Accordingly, risk management systems must be adapted, to deal with hedging and/or market evaluation problems. However, as companies move away from IBORs, trillions of dollars in debt and derivatives will likely continue to point to the index after the 2021 deadline. Nevertheless, in accordance with legal requirements, RFRs must be implemented in old and new contracts that extend beyond 2021.
This transition will require considerable transformation efforts from both financial services companies and market participants. This will pose a number of challenges to re-arrange the required institutional infrastructures (trade, data clearing), in order to manage a seamless transition to the RFRs.