Over the last 30 years or so, Libor benchmarks have become deeply embedded in all corners of the financial markets. But the benchmarks are about to change, as the market switches towards risk-free rates. Now, in reality, the groundwork for these changes has been under development for many years. For customers, it becomes reality in early 2022.
London Stock Exchange Group’s affiliates, have been supporting customers through the transition process by providing, amongst other things, risk management, reporting, and data calculation tools. But what’s happening? Why is it happening? And what do customers need to do, in order to be ready for this transition?
Each Libor is a measure of wholesale market borrowing costs. I think a really important point to make is that there’s actually a family of Libors. There are Libors in five difference currencies.
Libor, the London Inter-Bank Offered Rate, basically measures five currencies, US dollar, GBP, euro, Swiss franc and Japanese yen, across seven tenors, covering anything from overnight all the way through to one year.
And this is actually the most widely used rates benchmark in the financial industry, with more than 400 trillion notional. And those notional, they are on a wide range of financial products. Including corporates, and even personal loans, mortgages, bonds, securitised products and derivatives.
Why is it changing? Well essentially, the information that went into the determination of that market reference point, and the process by which that information was captured, that’s not really fit for purpose. It’s vulnerable. It’s a little frail.
The benchmark has run its course. It’s got two key weaknesses, and that’s why it’s being ended. The first of those is the reputation, the credibility of the benchmark was damaged due to the broking scandal. And the second issue is the fact that the number of transactions that underlie the benchmark is relatively small. And during periods of stress, it can dry up to almost no transactions. And so essentially Libor becomes a hypothetical number, than a really robust rate, based on transactions that people can trust.
The countdown to the end of Libor is ticking. Especially the countdown to end 2021. GBP, JPY, CHF Libor will stop being published on 31st December 2021. For US, the cessation date has been pushed, back in March, to 30th June 2023, so the date is a bit different for USD. Given those dates, transition is more advanced in sterling, Swiss franc and Japanese yen, than on USD. The new risk-free rates, so called SONIA for sterling, SOFR for USD, SARON for CHF, TONA for JPY, or ESTR for EUR, for euro, are very different from Libor.
It’s difficult to overestimate the implications of this change. Libor, Libors have been described as the world’s most important number. Hundreds of trillions of dollars worth of contract are affected by these changes. LCH is a clearing business. We have around 350 trillion dollars worth of contracts under management, interest rate swaps under management. And, again, around 40% of those contracts are linked to one of the Libors that’s going to be discontinued, so huge ramifications.
The replacement rates fundamentally different from Libor, in the sense that they don’t have that term structure. By having an overnight rate, it means the cash flows aren’t known until the end of the period, assuming they’re compounded in arrears. And not having a risk component to it means, ultimately, the rate is likely to be lower, and not necessarily capture that credit element during periods of stress.
And in addition, Libor and risk-free rates reflect very different element of credit risk. Libor is an inter-bank rate, unsecure borrowing rate, and it includes the implied credit risk of the panel of banks, and the liquidity premium related to the length of the interest rate period. Whereas RFRs have neither, as they are overnight rates.
A risk-free rate is a rate, for example, like SONIA. It’s overnight. It’s typically used, or can be used in compounded arrears. And that means the cash flows are known only at the end of the period. And it’s fundamentally different from Libor, where the cash flows are known at the beginning of the period.
In terms of practical implications, of course, it’s always important to look at that reference point. What were Libors being used for? And how were they being used? People were taking them in as this daily reference point for a borrowing cost, forward-looking over a period that’s to come. In terms of the practical implications, we’re replacing a lot of these forward-looking rates with overnight rates. They don’t tend to give you that certainty of borrowing cost over the horizons you’re used to.
In relation to existing exposures, the rate, the industry will adopt fallback rates. These fallback rates are designed to be broadly economically comparable to Libor. But they’re fundamentally going to be different in the sense of the way they’re calculated. They’re composed for a risk-free component, plus a spread adjustment. When it comes to new contracts, ultimately, we’ve got a slightly different approach. You don’t need to compensate for the difference that you’ve got between Libor and the replacement rates.
LCH is a really big organisation. And we offer a number of different services across, in support of all the market participants across many different marketplaces. I’m part of a clearing business, which is called LCH, which is one of the affiliates within the group. And even within that affiliate, we support a number of different markets. And the one I’m going to talk about is, really, SwapClear, which operates in support of the interest rate swap market. That particular service clears hundreds of different interest rate products across nearly 30 different currencies.
I think of probably four key steps in that market, which we’ve helped our market participants on the transition journey. Step one, really, you’ve got to identify the alternative. If you’re going to stop using something, you need to identify what you’re going to start using instead. Second step was, really, getting adoption, driving adoption of products linked to those new benchmarks. In our case, that’s creating a clearing capability. We’ve done that across all of the main alternatives that have been identified.
The third is probably the most technical. And that’s to do with rewiring the way that interest rate swaps were valued. That’s something called discounting. And we had a couple of really transformational discounting switches in 2020, in dollars and in euros. And they, if you like, lay the foundation for what is then the fourth step. And that’s really been the cornerstone of all the work in the SwapClear service over the course of 2021. We are, at the end of the year, delivering contractual conversions of the outstanding trade populations of Libors. So, if you like, removing the contractual reliance of these contracts on Libors, and moving them to reliance on something more robust.
At Refinitiv, we’ve been working closely with the rest of the industry, with our clients, and with the regulators, in order to work out how to respond to these substantial material changes. Refinitiv acts as a benchmark administrator. We have experience in producing rates, such as CDOR and WMR. And we’re introducing a new series of rates as part of the Libor transition.
New market data available from Refinitiv on alternative risk-free rates is very wide. It goes from benchmark rates, because you simply need to change your fixing from GBP Libor 1 month, 3 months, 6 months, for instance, to SONIA term rates. Refinitiv is administrating GBP, SONIA term rates, for instance. But we are also sourcing term rates administrated by other providers.
To take this one by one, if we take a look at the US market, in the US market, US dollar Libor is used in counter products such as bonds and securitisations, loans, etc., that reference US dollar Libor. And some of these can be refinanced, but many of the contracts cannot. In order to ensure that there’s a suitable replacement, Refinitiv was selected by the ARRC, in order to publish the ARRC’s recommended fallback language.
These new benchmarks, that we’re currently publishing a prototype, measure SOFR, the overnight risk-free rates. And this has been adjusted into various forms. And then on top of that, we then add a spread adjustment, in order to compensate for the typical difference between SOFR and Libor. This is designed to try and capture the key elements of the way that Libor is composed, but in a different way. And this means that, post the end of Libor, any contracts that still need to reference US dollar Libor can continue to do so, and use these rates as a replacement.
The other things that we are discussing with our customers, and the financial market community, is that we’ve seen an increased usage in zero curves, and growing demand for term rates and fallback. Currently, what you have to understand is that we live in a dual-rate market environment, where Libor and alternative risk-free rate coexist. And market participants need to have two sets of data for Libor and risk-free rates for their banking systems, front, middle and back offices. That’s why we’ve built an OIS derived zero curve for the alternative risk-free rates. We use OIS as constituents.
I think the good news is very many market participants have been working on this for a number of years now. Those who are most affected, I think, are really already pretty well prepared.
For users of the most, more advanced SONIA or SARON or TONA, it’s about implementing the changes now and making sure you comprise those instruments. I would advise to make sure you feed your IT systems with zero curves, and you switch your discount quote or forward curve to alternative risk-free rates. And same for the fixings. The other thing which is important is to ensure that you have the analytics capabilities to price those instruments, especially the rates derivatives. Backward-looking compounding is very different from forward-looking and pricing from a term structure.
Really engage with your service providers, those who provide you either the products that you buy or the technologies and systems that you use. And really just get them to set out for you what they’re doing to support customers like yourselves in transition. And make sure that you’ve identified the ways in which you might be affected. But as I say, for the most part, those who are directly affected, we certainly feel confident that all the hard work that’s gone in over recent years is bearing fruit.
And the most important thing to make sure you’re prepared for is to ensure that you’ve thought through all of your exposures, you’ve got access to the data, and you’ve upgraded your systems. Without those hygiene factors, you won’t be prepared for Libor transition. And come the end of the year, you’ll be in an incredibly uncomfortable position.
I think the one big takeaway, really, is just to make sure that you’re aware of where your expenditures lie. And, of course, get yourselves ready for 1st January 2022, when these rates are not going to be available anymore.
A number of benchmarks will be making the switch in early 2022. LSEG has developed a full suite of facilities to help report and reconcile positions, and to manage risk in support of these new risk-free rates. Most customers are already prepared. But just the sheer size of this market, the length of time that Libor has been used, and the long date of maturity of some contracts, means that a few positions will inevitably fall through the cracks. The good news is there’s still plenty of time to check positions, and ensure that IT systems are prepared for the change. And, of course, LSEG and its affiliates have provided a wide-ranging toolkit to help all clients manage the transition, and then move into the new benchmark regime.
