[00:00:00] So the spectrum of the LIBOR based instruments is very, very, very wide, and a total notional of LIBOR instruments is around 300 trillion. So it's it's huge. It's massive.
[00:00:12] Welcome to The Big Explainer. Funding markets are essential to the financial plumbing of the global system. Businesses and consumers across all parts of the economy will probably have loans or mortgages that were referenced off LIBOR in its various forms. LIBOR is a benchmark of which an estimated 300 trillion dollars worth of products are referenced. That's the equivalent of over four times the size of the global economy. This is a huge market and a key, but also normally mundane component of the financial system. Funding markets were, however, brought into sharp focus during the financial crisis of 2008. LIBOR was then hit by a price fixing scandal that has influenced an overhaul of this massive market, with the changes to be implemented by the end of next year. So what is LIBOR? I asked Alex Hardouin, Head of Rates at Refinitiv for an overview.
[00:01:16] LIBOR just refers to London Interbank Offered Rate, so it's meaning of rates, it is representative of the rates at which large institutions, large banks could fund themselves in selected currencies for certain tenors. So it has been there for almost since the 80s, pretty much, it is across five currencies. It was, it is still based because it is still active, that's what you have to that people have to understand. It is based on submission's provided by 20 banks. So normaly these submissions are intended to reflect where the market is. The thing is that back in 2013, 2014, there has been some manipulations of those submissions, meaning that the banks that were submitting LIBORS were submitting a rate, which was not the rate effective on the market, but the rates delivered of the rate at which they want that rate to be. So that has caused a big issue in the market that everybody talked about at that time.
[00:02:29] LIBOR is a generic name in reality, there are a number of different IBORS for different currencies.
[00:02:35] I mentioned five currencies, so the L in LIBOR stands for London, but IBOR is used of course in the UK, in the US, in the Eurozone, there is an equivalent called Euribor, which is the euro version of the LIBOR. And then you have LIBOR in a lot of different geographies. So when we are talking about LIBOR transition is not only the LIBOR per-se, but it's all those IBOR type risk free rates. So you will very often hear about LIBOR transition, IBOR transition or transition to new risk free rates. And those risk free rates are very different from the LIBOR. I mentioned that there were various tenors which allowed to build term structure from overnight. Spot one week, one month, two months, three months, six months, one year. So pretty much the near end of the curve was there with LIBOR. Most of those ex-IBOR rates are now replaced by overnight index rates, which are daily rates, and those rates are very different in nature. So LIBOR was a risk free range, which is considered to be an asset risk free with with no premium on top of it. Overnight is the same, it's also considered to be risk free rates, is used as a benchmark by the market so that's why it's so important. And the new risk free rates are overnight based. So for US, it's now called SOFR, for Sterling, it is SONIA, for euro, it is ESTOR for Japan LIBOR, it is TONAR for Swiss, LIBOR it is SARON.
[00:04:27] This funding market is a key part of the plumbing because of the size of the market and the wide range of products that it influences.
[00:04:33] So it's important because you have derivatives like interest rate swaps, basis swaps OIS, cross-currency basis swaps, swaptions, caps and floors. So the spectrum of the LIBOR based instruments is very, very, very wide. And a total notional of LIBOR instruments is around 300 trillion. So it's it's huge. It's massive. So that's why it's a big, big challenge for all market participants. And it will be the number one topic in 2021 for anybody in the fixed income market.
[00:05:09] One of the key differences between the new reference rates and the old IBOR rates is that the new reference rates are based off actually traded overnight rates, which are far more liquid and therefore more accurate than the old IBOR rates where the regulators were concerned that these were no longer liquid enough for this key market. Alex focuses on OIS or overnight index swaps. This is an interest rate swap where the reference rate is an overnight rate, but the term of the swap is fixed over a specific period.
[00:05:37] So the first very important data that people need is the fixing itself. So which means the SOFR rates for US, for instance, or the SONIA rates or the SARON or the TIBOR or ESTOR for euro. You need that fixing. So what we have, we see liquidity in the overnight index swaps. So we will see a lot of SOFR OIS, SONIA OIS, ESTOR. We'll we see a bit of liquidity coming on TIBOR and SARON, but are less developed. I would say that SONIA is the most developed then SOFR then ESTOR. You find some short term interest rate features from the values exchanges and then you will find derivatives like the basis swaps SOFR against LIBOR, for instance, typically, which is something quite important to monitor because you see the difference between SOFR & LIBOR. Also to price existing LIBOR deal is the asset that, you know, there's a need to have a fallback rate. Or fallback language to to to transfer existing LIBOR deals into the new risk free rates. So we will display that rates very, very soon on our offering. There's also something very important and on top of those either broker data or fixing data or fall-back. We are also calculating curves and curves are really, really important in order to price those derivatives. So we have a SOFR base curve and that curve is very accurate because now that we see liquidity on the OIS SOFR market, we are getting trades executed on trade web, which is partially owned with by Refinitiv. So it means that we can have US SOFR OIS on our terminals. And out of that, we create a very, very accurate SOFR curve that then you can use to either discount cash flows of existing rates, derivatives, and that is very important, you know OIS discounting it's also been something very popular since few years, because the logic behind is that banks or anybody in a swap needs to discount using the most the most liquid funding source. And OIS is a very, very liquid funding source. And we have those curves OIS curves built for SOFR, ESTOR, SONIA and it's building up on SARON and TIBOR. And then what we can do with those curves is that you can price, meaning you can create any kind of swap. So we have tools in, for instance, in EIKON terminals such as a Swap Pricer or in Excel, we have Excel function where people can value swaps. If you want to enter into a new swap, being spot starting for starting or calculate the net present value of an existing swap, you can use those curves to project the future cash flows.
[00:08:42] Because the new rates are references of liquid overnight rates, they don't have forward looking prices. The old IBOR rates had a term structure or prices long different maturities such as one month to three months. New term structures, therefore, will now need to be calculated for the new reference rates from these overnight rates.
[00:09:00] I mentioned in the introduction that the new risk free rates are backward looking, whereas LIBOR was forward looking. So you don't have that element of term structure such as you had in the past with LIBOR, where you had an overnight, the next one month, three months, six months, and you could derive a curve directly from the LIBOR. You don't have it anymore with with SOFR. So that's why we use the OIS SOFR contributions that we are getting from either tradeweb or the interdealer brokers. But we are also calculating term rates for customers, even for somebody who would need to enter into a mortgage, for instance, which used to be against LIBOR three months. Now you don't have that three months point anymore. So what we are building now is the what we call the term rates. So Refinitiv has submitted SONIA term rates and we are working on SOFRt term rates ESTOR term rates to have that element also of tenors and calculate term rates forward looking based on compounded OIS rates. So that's also something very important for the marketplace, as well as providing calculation tools. So people need to be able to calculate their forward cash flows. So we are also working on an Excel spreadsheet and little app in EIKON that calculates compounded rates, which is very important on any on any dates, meaning that even if you have a nonstandard swaps, you will be you will be able to calculate your cash flows using the compounded rate calculator. So that's the things we are working on, and the thing with the element we think are needed by the market for the numerous conversations we are having with market participants.
[00:11:01] Many regulators are focusing on a transition to take place over the next 12 months, which doesn't leave much time for both financial firms and their customers to adapt to the new reference rates.
[00:11:10] From the discussion we've had with all sorts of customers from buyside corporates, large sell side, everybody now gets ready for the transition, meaning that everybody needs the data. I've just mentioned the valuations, the tools are all there. And and as as I said, introduction that will be the number one priority in 2021 for a lot of people because LIBOR is meant to stop in 2021. So then you will need to use the alternatives, risk free rates and the new risk free rates and the associated data and and the tools that we are providing.
[00:11:57] This is a very large market that is about to change. Some have argued that these funding numbers are the world's most important numbers because so much of our financial system is based upon them. But the transition will involve considerable cost for financial firms. Some products may reference obsolete numbers after the transition has been made. Communicating these changes will be a significant challenge. The old IBOR is embedded in companies operating models, and transition may lead to unexpected windfall losses and gains. The whole financial framework will be grappling with these significant changes over the coming 12 months.
