The London Interbank Offered Rate (LIBOR) reform has been an ongoing project for the past several years, proceeding in fits and starts. It seems, however, that the global regulatory community has now finally begun in earnest to plan for a future without LIBOR. Reforming LIBOR is a complicated undertaking, since LIBOR acts as a reference rate to several hundred trillion dollars in both notional value of derivatives and in bonds, loans and securitizations and thus plays a very important role in the global financial market. LIBOR has attained such a unique role because it is calculated for five currencies (USD, GBP, EUR, CHF and JPY) which come in seven maturities (from overnight to 12 months).
By Thomas Werlen / Jascha Trubowitz (Reference: CapLaw-2018-17)
1) Background of reforming LIBOR
The LIBOR manipulation scandal revealed widespread problems with the reliability of LIBOR (See CapLaw-2014-14). The scandal involved several large banks, such as Deutsche Bank, UBS and Barclays, that manipulated LIBOR to benefit themselves. In the aftermath of this, the global regulatory community introduced reform efforts to rebuild the public’s trust in the reliability and robustness of reference rates, including LIBOR. The reform was essentially launched in February 2013 when the G20 tasked the Financial Stability Board (FSB) with reviewing and reforming major reference rates. To take the work forward, the FSB commissioned an Official Sector Steering Group (OSSG) of regulators and central banks to monitor and oversee the efforts to implement the benchmark reforms. While the FSB has taken the lead in many of the global efforts to reform major interest rates, working groups have been established in several jurisdictions to have public and non-public market participants together study their respective financial markets and decide which alternative interest rates would be the most appropriate for the replacement of LIBOR.
In July 2014, the OSSG published a report on Reforming Major Interest Rate Benchmarks which laid out recommendations to reform major interest rate benchmarks. This report recommended initiatives to strengthen LIBOR but also focused on identifying alternative risk-free or nearly risk-free rates (here collectively referred to as RFR) that could replace LIBOR. Alternative RFRs are described as being risk-free or nearly risk-free because they are based on secured borrowing markets or on unsecured borrowing by sovereigns with little default risk, and therefore do not contain a credit risk premium. These rates would thus be credit risk-free or nearly so.
RFRs have been proposed because they could remedy significant shortcomings of LIBOR. The sustainability of LIBOR is in serious doubt, as LIBOR lacks active underlying markets. There is also a far greater risk of manipulation when rates are based on judgments rather than on actual quotes and transactions. Furthermore, alternative RFRs have also been deemed more appropriate benchmarks for products and transactions, since they can ignore the credit risk premium embedded in LIBOR.
2) LIBOR reform is given a boost
Absent any urgency to implement the LIBOR reform, reform efforts undertaken by regulators languished. Yet, in a speech delivered on 27 July 2017, Andrew Bailey, the Chief Executive of Britain’s Financial Conduct Authority (FCA), delivered a boost to the reform efforts. He suggested that “[…] work on a LIBOR transition is unlikely to begin in earnest, if market participants continue to assume LIBOR will last indefinitely. […] In Switzerland, for instance, it has been clear for some time that the TOIS [Tom-Next Overnight Indexed Swap] reference would not survive”. […] only once a date was agreed for [its] discontinuation did serious work on transition to the new reference rate, Swiss Average Rate Overnight (SARON), begin.” It is therefore envisioned that all the current panel banks would voluntarily agree to sustaining LIBOR for a four to five year period, i.e. until end-2021. “[…] at the end of this period, it would no longer be necessary for the FCA to persuade, or compel, banks to submit to LIBOR” (Speech by Andrew Bailey, The Future of LIBOR, https://www.fca.org.uk/news/speeches/the-future-of-libor).
By providing a type of expiration date for LIBOR, Bailey effectively revitalized the LIBOR reform. Jurisdictions that had basically put their reform efforts on hold were now forced into action.
3) Implementation of the LIBOR reform
In the aftermath of the LIBOR manipulation scandals, the relevant jurisdictions covering LIBOR currencies set up working groups to study benchmark replacements for LIBOR. LIBOR will remain intact for now, but It appears that all of these jurisdictions will move towards implementing an alternative RFR.
a) United States
With the establishment of the Alternative Reference Rates Committee (ARRC) in November 2014 the foundation for benchmark reform was laid in the US. In June 2017, the ARRC chose the Secured Overnight Financing Rate (SOFR) as its preferred alternative to USD LIBOR. SOFR was selected because of its depth of the underlying market and usefulness to market participants.
b) Europe
The European Union regulatory bodies, the Financial Services Market Authority, European Securities and Markets Authority, the European Central Bank and the European Commission, only recently, in September 2017, set up a working group to identify an alternative RFR to be used in financial instruments and contracts in the Euro area. The EURO overnight index average, a new repo benchmark and a new unsecured overnight rate, is considered to be in pole position to replace EURO LIBOR.
c) United Kingdom
In March 2015, the Working Group on Sterling Risk-Free Reference Rates (UK Group) was first convened. It selected the Sterling Overnight Index Average (SONIA) as the preferred alternative RFR in April 2017, because there is an existing market for SONIA-linked swaps and because SONIA is based on actual transactions. The first publication is slated for 23 April 2018. The UK Group is tasked with setting this broad based transition to SONIA into motion, so that SONIA may be established as the primary sterling interest rate benchmark by end-2021.
d) Switzerland
Switzerland’s National Working Group on Swiss franc reference rates (NWG), established as the key forum for considering proposals to reform reference interest rates in Switzerland, sprang into action on 24 October 2017. That day, in its first meeting after Bailey’s speech, NWG’s members recommended SARON as the alternative for CHF LIBOR. The Swiss Average Rate Overnight (SARON) is a secured overnight interest rates average referencing the CHF interbank repo market. It was launched in 2009 by the Swiss National Bank in cooperation with SIX Swiss Exchange. The NWG selected SARON due to it being IOSCO-compliant and having a broad base of contributors. SARON is also based on actual transactions and tradable quotes and on data from the CHF repo market. In addition, SARON has a low probability of being manipulated and a low potential for conflicts of interest thanks to the high level of transparency (most CHF market activity is concentrated on the EUREX Repo platform). For the ongoing work, NWG members decided to form two sub-working groups, “Loan and deposit market” and “Derivatives and capital market” group, to examine CHF Libor-based product types and dependencies group.
e) Japan
In Japan, a number of steps have been taken by market participants toward identifying and establishing a Japanese alternative RFR. The “Study Group” was convened in April 2015 by the Bank of Japan to lead financial benchmark reform efforts in Japan. In December 2016, the Study Group selected the Tokyo Overnight Average Rate (TONA) as its preferred alternative RFR benchmark. The rationale for choosing TONA was the depth of the underlying market and the limited credit risk component thanks to TONA being an overnight average.
4) Transitioning to risk-free rates is not without risk
Among the challenges that RFRs face are the low trading volume for longer maturities (i.e. 3-month / 6-month) given that all the alternative RFRs are an overnight average rate, different risk premia of collateralized rates (repo) and uncollateralized rates (LIBOR), substantial transition cost when switching from LIBOR to the alternative RFR, hedging risks from trading legacy LIBOR positions against new alternative RFR hedges, economic risk of potential renegotiation of contracts and, lastly, significant legal risks.
Among the most challenging aspects of the transition away from LIBOR are the potential legal risks involved. Additional transition costs and operational risks will result from contract amendments. The same also holds true for legacy contracts that will convert to alternative RFRs. Legal disputes may also arise in connection with the transition to the alternative RFRs, because many contracts use LIBOR as an interest rate.
Thomas Werlen (thomaswerlen@quinnemanuel.swiss)
Jascha Trubowitz (jaschatrubowitz@quinnemanuel.swiss)