Global IBOR Reforms

It was almost exactly three years ago this month when the CEO of the British markets regulator, the Financial Conduct Authority, took markets by surprise and announced an official target date for the demise of LIBOR. After the announcement that LIBOR would be phased out by the end of 2021, LGIM established a working group composed of members of our Legal, Portfolio Management and Client Strategy teams globally who are leading our efforts around the transition. This group is focused on managing the transition process as well as monitoring the developments in the replacement rate markets.

Here in the US, the Alternative Reference Rates Committee (ARRC) chose SOFR (Secured Overnight Financing Rate), a volume-weighted median of borrowing rates from the US Treasury repo market, as the replacement rate. In May 2018, the market began construction of SOFR derivatives, a necessary infrastructure to establish comfort in the pricing and liquidity of the reference rate for end users. Ultimately, market participants hope to see the SOFR derivatives market liquidity continue to be bolstered such that a smooth and cost-efficient transition can occur.

To our clients, perhaps the most relevant LIBOR use is through derivatives instruments, mainly fixed-floating interest rate swaps and related options. LIBOR is also the reference rate for total return swaps (e.g. on Treasuries, equity indices, and high yield indices), Eurodollars and various corporate floating-rate loans. For clients who trade over-the-counter total return swaps, we continue efforts to reference alternative non-LIBOR funding rates, such as Fed Funds, where practical. We continue to evaluate the risk and reward of the evolving opportunity set to ensure the existing positions affected by the change continue to age gracefully.

For clients with cleared interest rate swaps based on LIBOR floating legs, there will be some housekeeping election items over the next several months as the standard terms shift. We will proactively setup discussions with you and manage these elections on your behalf. As our Working Group monitors and assesses all aspects of the transition process, we aim to keep you updated with important information. To that end, below is a Q&A around various relevant questions.

 

Update for all investors

An international initiative has been launched to reform interbank offered rates (“IBORs”) and to develop more robust alternatives. This move was prompted by the widely publicized cases of attempted manipulation by traders from prominent investment banks of various IBORs. IBORs are important because they are frequently used as a benchmark or target return for many funds, as well as underpinning various financial instruments and products. IBORs may also be present in other non-financial contractual arrangements.

Regulators around the world have been engaging with market participants, including banks and asset managers, to consider how best to transition to new alternative risk-free rates (“RFRs”). Legal & General has participated in various market work streams led by the Bank of England to help all aspects of the market transition.

The transition away from IBORs represents a significant challenge, particularly for banks, asset managers and financial services firms across the industry. Estimates of the amount of IBOR-related activity in the banking and financial sector vary, but all point to global exposures in the hundreds of trillions. A significant amount of work across all market participants is therefore required to ensure a smooth transition.

When will this happen?

From December 2021 banks will no longer be compelled to submit a LIBOR rate, effectively discontinuing the rate. The transition should therefore be completed across the industry by the end of December 2021. As a consequence, substantial shifts in global trading and transition activity to alternative RFRs are expected throughout 2020 and 2021.

This is a market-led transition that depends heavily on the developments of market participants, which are being enabled by numerous industry groups. We are monitoring these developments closely and taking action where appropriate in the interest of our clients.

How will it affect your investments with us?

We have made significant progress in identifying and addressing our clients’ investment exposure to IBORs and have established a governance structure around our transition activity. We are working in partnership with our parent company Legal & General Group PLC, who have established thorough and strong governance with a central co-ordination oversight, supported by divisional delivery.

This allows us to share project management and legal expertise to ensure an effective and controlled transition pipeline ahead of the December 2021 deadline.

What are the risks?

The FCA has reiterated that market participants should not depend on LIBOR beyond 2021. The transition involves a two-way path: (i) establishing multiple new products, and (ii) changing existing IBOR-referenced products. It also affects products across different jurisdictions which are transitioning to different alternative rates at different times.

Risks are therefore associated with:

  • Transfer of economic value when moving IBORs to RFRs
  • Operational process changes
  • Amending legal agreements
  • Liquidity risks of terminating IBOR instruments and replacing these with alternative RFR instruments

All these risks are being monitored closely at LGIMA.

Do you need to do anything?

Currently, you do not need to take any action with respect to your investments with LGIMA. We will be in touch regarding your investments as appropriate, so please do look out for communications from us on this matter. However, if you are potentially impacted by the transition in other ways, please seek appropriate legal advice and guidance. You can also contact your usual LGIMA representative if you would like to discuss this regulatory change and potential impact on your investments in more detail.

Further information can be found here:

What are IBORs?

IBORs (Inter Bank Offer Rates) are financial benchmarks showing the average rates at which major banks can borrow in the interbank market. They are forward-looking, unsecured rates and range from overnight to 12 months.

IBORs also act as reference rates to hundreds of trillions of dollars in notional derivative exposure, for example interest rate swaps, and trillions of dollars in bonds, loans, mortgages, securitizations and deposits across institutional, corporate and retail market participants.

IBORs exist in different currencies. For example, GBP LIBOR is the rate at which UK banks can borrow from one another in sterling, and USD LIBOR is the rate at which banks can borrow from each other in US dollars.

What are the alternatives to IBORs?

Alternative Risk-Free Rates (“RFRs”) are being established across the different IBOR jurisdictions. In the US, the Federal Reserve convened a group of private market participants known as the Alternative Reference Rates Committee (ARRC) to manage the transition from LIBOR. The ARRC has recommended that SOFR (Secured Overnight Financing Rate) be used as the dollar near risk-free reference rate and has promoted its adoption as an alternative to USD LIBOR.

Alternative RFRs are intended to be more representative and robust. In addition to the manipulation scandals, the number of transactions underpinning the rates set by IBORs has been declining; as a result of post-financial crisis reforms, banks often now favor secured lending through deposits, repos and bonds. This means that IBORs are no longer a true reflection of the markets they are designed to represent.

How will the move from IBORs to RFRs happen?

The widely accepted LIBOR fallback has been the UK alternative RFR, SONIA, which is already well developed in the derivatives market, with early transition activity within the cash and loans markets.

With respect to derivatives, the International Swaps and Derivatives Association have also been working to establish common ‘fallback’ terms and a new Protocol listing fallback options for all available IBORs is expected to be published at some point in 2020. This will assist derivatives market participants in their transition to RFRs.

What role is LGIM playing in the transition?

LGIMA, along with LGIM UK and our parent company Legal & General, have been engaged in the market transition at various levels with the Bank of England and other leading industry organizations, including the Securities Industry and Financial Markets Association (SIFMA), since 2017. Through these forums and our engagement with our counterparties and clients, we have been able to plan our transition away from IBORs ahead of the December 2021 deadline.

The global impact

Global impact of IBOR
Working Group Alternative Ref
Rate Name
Administrator Collateralizations Description
Alternative Reference Rates Committee (link is external) Secured Overnight Financing Rate (SOFR)(link is external) Federal Reserve Bank of New York Secured Secured rate that covers multiple overnight repo market segments
Working Group on Sterling Risk-Free Reference Rates (link is external) Sterling Overnight Index Average (SONIA) (link is external) Bank of England Unsecured Unsecured rate that covers overnight wholesale deposit transactions
The National Working Group on CHF Reference Rates (link is external) Swiss Average Rate Overnight (SARON) (link is external) SIX Exchange Secured Secured rate that reflects interest paid on interbank overnight repo rate
Study Group on Risk-Free Reference Rates(link is external) Tokyo Overnight Average Rate (TONAR)(link is external) Bank of Japan Unsecured Unsecured rate that captures overnight call rate market
Working Group on Risk-Free Reference Rates for the Euro Area (link is external) Euro short-term rate (€STR) (link is external) European Central Bank Unsecured Unsecured rate that captures overnight wholesale deposit transactions

Source: Financial Conduct Authority

 

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