Benchmark rate reform and transition to risk free rates IBOR discontinuation and reform
Interbank Offered Rates (IBORs) are a series of benchmark interest rates, used globally for pricing loans, debt securities and derivatives. Following recommendations made by the Financial Stability Board in 2014, global initiatives have been undertaken to reform such benchmarks and to commence the transition to alternative benchmark or reference rates.
Developments in the three major IBORs, as at 6th September 2021, are summarised below:
Benchmark Discontinuation / Reform measures
LIBOR The London Interbank Offered Rate (LIBOR) is a global interest rate benchmark which is currently published across five currencies (Sterling, US Dollar, Euro, Swiss Franc and Japanese Yen) and seven terms (ranging from overnight to 12 months). On a number of occasions the Financial Conduct Authority (FCA) has stated that markets should be prepared for announcements that some or all LIBOR rates will cease after the end of 2021, or for the FCA to find that such rates are no longer representative after the end of 2021. On 5th March 2021, the FCA announced:
(1) immediately after December 31, 2021, publication of all seven euro LIBOR settings, all seven Swiss franc LIBOR settings, the Spot Next, 1-week, 2-month and 12-month Japanese yen LIBOR settings, the overnight, 1-week, 2-month and 12-month sterling LIBOR settings, and the 1-week and 2-month US dollar LIBOR settings will permanently cease;
(2) immediately after June 30, 2023, publication of the overnight and 12-month US dollar LIBOR settings will permanently cease;
(3) immediately after December 31, 2021, the 1-month, 3-month and 6-month sterling LIBOR settings will no longer be representative of the underlying market and economic reality they are intended to measure and that representativeness will not be restored and the FCA will consult on requiring IBA to continue to publish these settings on a changed methodology (or ‘synthetic’) basis;
(4) immediately after December 31, 2021, the 1-month, 3-month and 6-month Japanese yen LIBOR settings will no longer be representative of the underlying market and economic reality they are intended to measure and that representativeness will not be restored and the FCA will consult on requiring IBA to continue to publish these settings on a synthetic basis for one additional year; and
(5) immediately after June 30, 2023, the 1-month, 3-month and 6-month US dollar LIBOR settings will cease to be provided or, subject to the FCA’s consideration of the case, be provided on a synthetic basis and no longer be representative of the underlying market and economic reality they are intended to measure and that representativeness will not be restored.
EURIBOR The Euro Interbank Offered Rate (EURIBOR) and the Euro Overnight Index Average (EONIA) are the most important interest rate benchmarks within the Eurozone. EONIA European interest rates are subject to the EU Benchmarks Regulation (BMR) which was introduced in January 2018 to improve the integrity of, and set a common framework for regulation of, benchmarks across the EU. The BMR set a deadline for critical benchmarks to meet certain regulatory standards. The BMR transition period, after which critical benchmarks failing to meet the standards cannot be used for new contracts, has been extended to 31 December 2023. In July 2019, European Money Markets Institute (EMMI) was authorised as administrator of EURIBOR under the BMR and implementation of a new hybrid methodology for EURIBOR was completed in November 2019. EONIA will not be reformed and has been published in parallel with the Euro Short- Term Rate (€STR) since publication of €STR began on 2 October 2019. EONIA will be permanently discontinued on 3 January 2022.
TIBOR Reform measures were introduced in 2017 in respect of The Tokyo Interbank Offered Rate (TIBOR), which is widely used as an interest rate benchmark for bank loans in Japan. It is not proposed that TIBOR be discontinued. Further reform may be undertaken, including the potential integration of Japanese Yen TIBOR and Euroyen TIBOR (Japanese offshore markets).
Replacing certain IBORs with Risk Free Rates
Risk free rates ("RFRs") are generally proposed by the applicable working groups as replacements or alternatives to IBORs, due to their transparency and limited exposure to manipulation. RFRs are calculated on a different basis and are not like-for-like replacements for IBORs. RFRs are overnight rates which traditionally are retrospective, i.e. they are published after the period to which they relate, as opposed to IBORs, which are set at, or prior to, the commencement of the period to which they relate. The differences between the two types of rate are discussed further below.
In preparation for the transition away from certain IBORs, authorities and industry working groups have identified various RFRs as possible replacements for LIBOR and EONIA for each of the currencies across which LIBORs are currently published: • The Bank of England’s working group has recommended reformed Sterling Overnight Index Average (SONIA) as the preferred RFR alternative to Sterling LIBOR; • The Federal Reserve Bank of New York, the European Central Bank, the SIX Swiss Exchange and the Bank of Japan have also established working groups to develop risk free rates to support the transition away from their respective currency LIBOR rates, and these rates have now also been selected (as set out in the table below); and • In October 2019, the European Central Bank began publishing the Euro Short-Term Rate (€STR), a new unsecured overnight interest rate as an alternative to EONIA.
As at 6th September 2021, the development of each RFR is at a different stage and they vary in a number of ways as highlighted in the table below.
Differences between IBORs and RFRs
As set out above, RFRs are described as ‘near risk free’ and are derived from actual transactions that have taken place in the liquid underlying markets. There are a number of differences between IBORs and RFRs which will need to be addressed in the transition process away from certain IBORs, including:
• Credit and Liquidity Premiums: IBORs include the cost of bank credit risk and term liquidity risk, as they are based on the submissions of panel banks indicating where they can borrow unsecured funds in the relevant interbank market, whereas RFRs are based on overnight transactions. Transitioning existing contracts from IBORs to RFRs may involve incorporating a spread into the RFR to cover the lender’s funding costs and the credit risk premium of the borrower.
• Calculation direction: RFRs are backward looking overnight rates whereas IBORs are forward looking term rates, meaning that for IBORs the rate of interest is fixed and publicly available at the beginning of each interest period. Industry working groups have extensively analysed compounding RFRs in arrears and the Working Group on Sterling Risk-Free Reference Rates ("£RFR WG") has issued recommendations in this regard, which are discussed further below.
Points for you to consider in relation to IBOR transition
The FCA has clarified the timing of the cessation and non-representativeness of certain benchmarks in its announcements on 5th March 2021, as described above. The £RFR WG has set an end-Q3 2021 recommended milestone to complete active conversion of all legacy GBP LIBOR contracts expiring after end 2021 where viable and, if not viable, ensure robust fallbacks are adopted where possible. The changes brought about by such events may have an impact on references to IBORs in existing products and may necessitate use of an alternative benchmark rate, such as an RFR or an IBOR which is not being discontinued, or require fallback to a financial institution's cost of funds.
Any such changes may impact the loans, debt securities and derivatives you currently hold (and those you enter into in future), including:
• requiring the application of fallback provisions in the contract which provide for an alternative mechanism for calculating the relevant payment amount, such as when IBOR rates are not available, or the amendment of contracts to (i) replace existing fallback provisions with more robust fallback provisions, or (ii) to include fallback provisions;
• potential changes to the interest and other provisions of existing contracts, to provide for the transition to an alternative reference rate;
• the potential for a material mismatch between products in your portfolio (such as loans and corresponding hedges), which currently refer to the same benchmark rate;
• an impact on the value or pricing or cost to you of the product;
• potential accounting and tax issues, as many businesses use IBORs for derivative and other valuation purposes; and
• potential operational implications, such as changes to systems or processes (such as the impact on cashflow forecasting, when moving from forward looking to backward looking rates).
We recommend you keep up to date with the latest industry developments and consider whether you require independent professional advice (whether legal, accountancy, tax or other advice) in relation to IBOR transition and keep your position under review.
Next steps
Loans
The FCA announcement on 5th March 2021 confirmed that the following 26 LIBOR settings will cease to be published from 31 December 2021.
LIBOR Tenor EUR LIBOR all tenors CHF LIBOR all tenors JPY LIBOR spot next, 1 week, 2 month and 12 month GBP LIBOR overnight, 1 week, 2 month and 12 month USD LIBOR 1 week and 2 month
The FCA announcement also confirmed that even if the remaining 9 LIBOR settings were to continue to be published on a synthetic basis, they will no longer be representative of the underlying market or economic reality that they are intended to measure.
LIBOR Tenor JPY LIBOR 1, 3 and 6 months GBP LIBOR 1, 3 and 6 months USD LIBOR 1, 3 and 6 months
Parties to facility agreements which contain any version of the LMA’s “Replacement of Screen Rate” clause should consider whether the FCA announcement constitutes a “Screen Rate Replacement Event” and whether they wish to begin the optional amendment process this clause offers in such circumstances. Parties to facility agreements containing the LMA’s rate switch provisions in the form of those in the LMA Recommended Forms (defined below) should consider whether the FCA announcement constitutes a “Rate Switch Trigger Event” in their agreements. The £RFR WG published a paper in August 2020 outlining how, by the end of Q3 2020, lenders should be in a position to offer non-LIBOR linked products to borrowers and must include clear contractual arrangements (through pre-agreed conversion terms or an agreed process for re-negotiation) in new and re-financed sterling LIBOR loans to convert to alternative rates by year end-2021. In compliance with these requirements Mizuho is able to offer non-LIBOR linked products and, where relevant, will include clear contractual arrangements for conversion in in-scope agreements.
Also, in light of the recommended milestones set by the £RFR WG, from 1st April 2021 all new or refinanced GBP lending entered into by Mizuho which expires after end 2021 has been and will continue to be based on SONIA or other non-LIBOR alternatives.
In September 2020, the £RFR WG also recommended the use of a Five Banking Days Lookback without Observation Shift as the standard approach for SONIA. A "Lookback" period allows for payment certainty for borrowers when using an 'in arrears' rate such as SONIA, as the actual rate is known to the borrower five days before interest is payable (rather than at the beginning of the interest period, as with LIBOR). Although the £RFR WG has recommended a standard Lookback period of five Business Days, the length of the Lookback period can be varied based on borrower/lender needs.
In relation to syndicated loans, the Loan Market Association (LMA) has now published recommended versions of its forms of facility agreement for loans referencing RFRs as part of its library of recommended forms (the LMA Recommended Forms). The LMA Recommended Forms (which were previously in circulation as exposure drafts) reflect the recommendations of the £RFR
WG and are being widely adopted by the loan market. The LMA Recommended Forms are being used for both term and revolving loans (in sterling and other currencies) and are also being adapted for use in bilateral transactions. In the majority of cases, the LMA Recommended Forms are being adopted with minimal amendments, which indicates that lenders are becoming broadly comfortable with the LMA’s approach. The publication of the LMA Recommended Forms occurred on 30 March 2021, just prior to the £RFR WG milestone for the cessation of new sterling LIBOR products on 1 April 2021.
The syndicated loan market does not have a protocol system (i.e. a multi-lateral method) for amendments (such as that which is operated by ISDA) given the multilateral nature of syndicated loans and so loan agreements referencing LIBOR may need to be individually amended to refer to a replacement rate. On 25th October 2019 the LMA, to help streamline the amendment process, published an exposure draft reference rate selection agreement for use in relation to legacy transactions transitioning from LIBOR to an RFR. The LMA published this draft reference rate selections agreement as a recommended form on 4 June 2021.
The Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have issued supervisory guidance encouraging banks to “cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021”, noting that new USD LIBOR issuance after 2021 would create safety and soundness risks. Foreign regulators have stated that they are considering similar steps. The Loan Syndication and Trading Association has published a concept credit agreement describing a term loan referencing daily simple SOFR or daily compounded SOFR (using a "compound the balance" approach). Consistent with the ARRC's recommended conventions, the concept document includes a lookback with no observation shift. On 29 July 2021, the ARRC announced that it was formally recommending the CME Group’s SOFR forward looking Term Rates. On 9 August 2021, the LSTA published a Draft Term SOFR Concept Document which reflects the ARRC’s recommended conventions, but also includes some additional convention options.
Derivatives and other trading products
The International Swaps and Derivatives Association (ISDA) launched the IBOR Fallbacks Protocol (the Protocol) on 23rd October 2020 for adhering parties, which is a multilateral method to amend legacy derivatives (and certain other trading contracts), and the IBOR Fallbacks Supplement (Supplement 70) to the 2006 ISDA Definitions (the Definitions) to implement robust fallbacks to IBORs into transactions. The Protocol and Supplement 70 took effect on 25th January 2021. Mizuho Bank, Ltd. and Mizuho International plc have both signed up to the Protocol.
The announcement made by the FCA on 5th March 2021 constitutes an “Index Cessation Event” for all LIBOR settings under the Supplement and the Protocol, and as a result the fallback spread adjustment will be fixed as of 5 March 2021 for all euro, sterling, Swiss franc, US dollar and yen LIBOR tenors.
In respect of the ISDA Benchmarks Supplement, at the time of the Index Cessation Event the LIBOR Floating Rate Options, as referenced in transactions incorporating the terms of the IBOR Fallbacks or the Protocol, include a reference to a concept defined or otherwise described as an
“index cessation event” which in effect means that a “Priority Fallback” of the ISDA Benchmarks Supplement will apply to the relevant transactions.
“Consequences of a Benchmark Trigger Event” of the ISDA Benchmarks Supplement will apply only to the extent the “Priority Fallback” fails to provide a means of determining the index level.
Timely adherence to the Protocol is being encouraged by national working groups, including the ARRC, as well as international bodies such as the Financial Stability Board. Please note that the £RFR WG has recommended the following best practice milestones: i) from 1 April 2021, cease initiation of new GBP LIBOR linked derivatives, bonds and securitisations that expire after the end of 2021; ii) from 1 July 2021, cease initiation of new GBP LIBOR-linked non-linear derivatives that expire after the end of 2021; and iii) by end Q3 2021, complete active conversion where viable.
However, the £RFR WG recognises that there will be limited circumstances when it may be appropriate to enter into new GBP LIBOR-linked derivative contracts that expire after the end of 2021, for risk management of existing positions (or exposure resulting from existing contracts, and to support active conversion). More details are available here.
Further best practice cessation milestones have also been published by regulatory bodies and industry working groups in advance of LIBOR discontinuation: • JPY LIBOR – A sub-committee of the Bank of Japan has issued a milestone to ‘cease initiation of JPY LIBOR referencing interest rate swaps expiring after 2021’ by September end. • USD LIBOR – The Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have issued supervisory guidance encouraging banks to “cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021”.
Mizuho expects clients to take these milestones into account when requesting to transact in new LIBOR-linked linear derivatives with us.
In May 2021 ISDA published Supplement 74 to the 2006 ISDA Definitions for stand-alone overnight RFR Rate Options for SONIA, SOFR, €STR, TONA, SARON, AONIA, CORRA, HONIA, SORA, THOR, NZOIA and NOWA and Supplement 75 approaches to compounding/averaging to provide for new RFR definitions and adopt conventions that more closely match the conventions adopted by the loan market.
The FCA and £RFR WG are encouraging a broad-based transition to SONIA by the end of 2021 as the primary method to ensure contractual certainty and retain economic control. You can find further information here and here.
Further information and resources
If you would like any further information, please contact your relationship manager or in relation to Mizuho Bank, Ltd. email [email protected] and in relation to Mizuho International plc email [email protected].
For further information on the impact of the FCA recent announcement on the cessation of LIBOR benchmarks, please see the Future Cessation and Non-Representativeness Guidance published by ISDA.
You can find further information from the USD Alternative Reference Rates Committee (ARCC) here, the Working Group on Sterling Risk-Free Reference Rates here, the Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks here and the EURRFR Working Group here. You can also find publications from the LMA here and from ISDA here.
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