Launch of risk-free rates from 1 January 2022 – the end of the Interbank Offered Rates
For several decades, so-called Interbank Offered Rates (IBORs) have been used as a benchmarking base rate for interest in global financial markets. IBORs indicate the interest rate at which a selection of banks with first-class credit ratings are prepared to lend to one another the leading trading currencies (USD, EUR, GBP, CHF and JPY) on an unsecured basis and for various maturities of up to one year. The terms of a large number of loans, derivatives, security and bank deposits with a nominal amount equivalent to several hundred trillion USD are tied to these IBORs.
However, the time of IBORs is coming to an end. The most commonly used IBORs worldwide will be converted to risk-free rates (RFRs) at the end of 2021. The pressure on financial institutions to implement these RFRs is high as the changeover is complex and requires considerable time.
Criticism of IBORs
IBORs were widely criticised following the financial crisis. IBORs are calculated by reference to the values provided by participating panel banks, such values are based on expert assessment. So-called benchmark administrators, while eliminating the lowest and highest values, determine and publish mean values of the reported estimates.
The IBORs are published on the basis of estimates and are not the result of actual transaction data. In the past, attempts have been made to manipulate these interest rates by way of collusive quotations. Furthermore, liquidity in the unsecured interbank money market has declined considerably since the financial crisis, so that the solid underpinning of the benchmarks with market activity is questionable.
Replacement by risk-free rates
Most of the IBORs will be switched to risk-free rates at the end of 2021. These rates are “risk-free” because they do not contain any maturity-related risk spreads but are based on actual overnight transaction data. The RFRs were developed by working groups with market participants and supervisory authorities or central banks, respectively, and are called differently depending on the currency: for example SARON for Swiss francs, SONIA for British pounds, SOFR for US dollars and TONA for Japanese yen. Most IBOR reference rates will no longer be published after 31 December 2021. The only exception is the USD Libor which will continue to be determined and published for the most important maturities until 30 June 2023.
EURIBOR, on the other hand, can continue to be used as a reference interest rate. After the European Money Market Institute as administrator of the previous EURIBOR revised the calculation method of the EURIBOR, the Financial Services and Markets Authority granted its authorisation in July 2019, so that the use of the EURIBOR is also ensured after 2021.
Mechanism of the RFRs
As set out above, the risk-free rates are based on daily published transaction data. As opposed to IBORs, RFRs do not include a maturity-related risk spread. In order to create equivalence between IBORs and interest determined on the basis of RFRs for existing loans, derivatives and other transactions, a risk spread corresponding to the maturity and the currency is therefore added or agreed (so-called compounding or adjustment spread). For newly concluded transactions, such spread is calculated into the interest margin from the beginning. The adjustment spreads for the respective IBOR maturities were determined on the basis of the historical median deviation over a 5-year period and published by Bloomberg on 5 March 2021.
Another difference to the IBORs is that the RFRs are not fixed in advance for the respective interest period. The interest rate determined on the basis of an RFR is only available at the end of the respective calculation period. A borrower’s interest payment obligation can only be calculated at the end of the respective interest period. A look-back mechanism applies. In order to determine the interest payment obligation before the end of the interest period an observation period applies. An observation period corresponding to the term of the interest period is recommended which however commences 5 business days before. For each day of the respective interest period, the value of the interest rate of the preceding days of the observation period is therefore used.
In the context of interest rate weighting, a distinction is also made between the so-called shift method (lookback with observation shift) and the so-called lag method (lookback without observation shift). In case of the shift method the interest rate is being assessed according to the number of days in the observation period. The decisive factor is then whether a day in the observation period is a business day or not. In contrast, the lag method determines the applicable interest rate in the observation period - however, the actual interest period is relevant for the question of whether a business day or a bank holiday applies, i.e. whether the determined daily interest rate applies more than once. In the lag method, the interest rates are weighted on the basis of the business days and bank holidays in the actual interest period.
Effects of the changeover to RFRs
The transition from IBORs to RFRs affects current and future transactions in the relevant currencies and, in addition to loans and bonds, also affects all other financial products for which interest rates are relevant. Numerous loan agreements are affected by the change in reference interest rates. All processes, systems, models and the loan agreements themselves - existing and new - must be adapted. The Loan Market Association has provided draft templates to assist with the transition to RFRs, but these require individual adaptation and negotiation.
Providers of financial products must also negotiate amendments to the terms of their agreements (including derivatives, securities and bank deposits) to the extent that these continue beyond 2021 and use the discontinued IBOR reference interest rates. Almost all floating rate currency products will have to be recalculated. ISDA provides support in the area of derivatives with corresponding protocols. Also some fixed-interest products refer to the IBOR reference rates so that revision of the underlying conditions is required. Last but not least, adjustments are necessary along the value chain, for example in financial processing, risk controlling and accounting.
The new calculation methods are also challenging for the banks’ internal systems. Not all banks are duly prepared for the change in reference interest rates.