LIBOR Transition

LIBOR is a widely-used benchmark for short-term interest rates, providing an indication of the average rates at which certain banks (referred to as LIBOR “panel banks”) could borrow from other banks on an unsecured basis for certain tenors and in particular currencies.

LIBOR is published in five currencies (US dollar, Pound Sterling, Swiss franc, Euro, and Japanese yen) and for seven interest tenors (ranging from overnight to 12 months). Of these, LIBOR for Japanese Yen is known as “JPY LIBOR”.

LIBOR has an important role in global markets. It is widely used as a reference rate for loans, bonds, derivatives and other various financial contracts. It is also used as a benchmark to gauge funding costs and investment returns for a broad range of financial products, including floating-rate bank loans, interest rate swaps, etc.

Besides LIBOR, there are similar interbank offered rates available for certain currencies, such as TIBOR (Tokyo Interbank Offered Rate) for Japanese yen or EURIBOR (Euro Interbank Offered Rate) for the Euro. These rates are known collectively as “IBOR(s).”

While LIBOR has been recognized as part of the infrastructure of global financial markets, the FCA has announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative after the end of 2021 (except for some USD LIBOR tenors. Please also refer to Q4).

Following the financial crisis, the number of transactions in the interbank market significantly decreased. This raised questions about the sustainability of the LIBOR framework.

In 2017, the FCA announced it would not compel panel banks to provide LIBOR submissions beyond the end of 2021, and therefore LIBOR is expected to be phased out of use by financial market participants by the end of 2021.

Thereafter, discussions on the transition of LIBOR rapidly advanced and market participants started preparing for the transition to alternative benchmarks. Transition to alternative benchmarks is underway, but much work lies ahead in order to make transition to alternative benchmarks successfully by the end of 2021 (except for some USD LIBOR tenors. Please also refer to Q4).

Given that LIBOR is widely used in various products and the volume of transactions referencing LIBOR is considerably large, the cessation may have a significant impact on both existing and future transactions, particularly in loans, bonds and derivatives.

According to a joint survey made in 2019 by the Japanese Financial Services Agency and the Bank of Japan which covered 278 financial institutions, LIBOR-related contracts in Japan is about 1.4 million in terms of number of contracts and 6,500 trillion yen (or about 60 trillion US dollars) in terms of total outstanding amount, respectively. About 50 to 60 percent of which, in terms of outstanding amount, will mature beyond the end of 2021.

Besides the impact on financial products and contracts referencing LIBOR, the permanent cessation of LIBOR may also impact various rules and business practices. This includes tax and accounting treatment, administrative procedures, IT systems, infrastructure and internal governance of corporations. As these rules and business practices are interdependent and underpinned by LIBOR, the impacts will not only affect financial institutions, but also non-financial corporates. They will need to take initiatives with strong commitments by senior management including top executives while bearing in mind the target deadline.

On 5 March 2021, the FCA announced that all LIBOR settings currently published by the IBA will either cease to be provided by any administrator or will no longer be representative according to the following timeline:

For derivatives, the International Swaps and Derivatives Association, Inc. (“ISDA”) stated that the FCA’s announcement constitutes an “Index Cessation Event” under the IBOR Fallbacks Supplement and related protocol for all LIBOR settings. The ISDA spread adjustments published by Bloomberg Index Services Limited (Bloomberg) will serve as a fallback.

The FCA will consult on whether it should require the IBA to publish certain LIBOR settings on a “synthetic” basis (i.e., a forward-looking term rate version of the designated alternative risk free rate for the relevant LIBOR currency plus an adjustment spread) for “tough legacy” contracts as specified below:

The Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks (the “Committee”) defines “transition” or “fallbacks” for moving from JPY LIBOR to alternative benchmarks as follows.

Transition
the methodology to replace LIBOR with an alternative benchmark for financial products and transactions at the time of expiration of current contracts. This includes amending current contracts before the expiration.

Fallbacks
the methodology to agree on a replacement rate to be used after the permanent discontinuation of LIBOR between contracting parties in advance, for existing contracts referencing LIBOR.

“Transition” is recommended as it can minimize the impact of permanent discontinuation of LIBOR by replacing LIBOR with an alternative benchmark.

For “Fallbacks,” sample fallback provisions have been published to facilitate the introduction of fallback language in the contracts for the loan market as follows:

• The Japanese Bankers Association (JBA) released “updated sample fallback provisions for bilateral loans” (applicable after the announcement on ‘non-representativeness’ or ‘permanent discontinuation’, supervised by a full service law firm Mori Hamada & Matsumoto, available in Japanese only) in January 2021.
• The Japan Syndication and Loan-trading Association (JSLA) also released “updated sample fallback provisions for syndicated loans” (applicable after the announcement on ‘non-representativeness’ or ‘permanent discontinuation’,　supervised by a full service law firm Mori Hamada & Matsumoto, available in Japanese only) in February 2021.

Additionally, the ISDA’s IBOR Fallbacks Supplement amending the 2006 ISDA Definitions and IBOR Fallbacks Protocol for legacy non-cleared derivative contracts referencing LIBOR and other interbank offered rates (IBORs) took effect on 25 January 2021. The Committee strongly encourages early adherence to the Protocol by both financial and non-financial firms in order to promote the smooth transition away from LIBOR.

LIBOR and the replacement benchmark have different economics (although the degree of difference will vary by transaction and be based on several factors), resulting in an interest rate spread. As a result of this spread, “value transfer” may occur. In order to minimize the value transfer, a spread adjustment between LIBOR and the replacement benchmark will be made. The spread adjustment was fixed on 5 March 2021 in response to announcements made on that date by the FCA. However, the actual fallback to the replacement rate will not occur until the date on which LIBOR is ‘non-representative’ or is discontinued.

■JPY

In the JPY market, the Committee discussed the alternative benchmarks to replace JPY LIBOR and in its discussions, several benchmarks were raised, which are those based on the risk free rate (RFR) and TIBOR, as options.

The decision on which alternative benchmark to be used should be made among contracting parties when they choose either “transition” or “fallbacks”.

The following table summarizes the options of alternative benchmarks presented by the Committee:

1. QUICK Corp. has calculated and published the “TONA Averages” and the “TONA Index” by compounding TONA since March 2021.
2. “TORF” is the abbreviation of "Tokyo Term Risk Free Rate" calculated based on the Japanese overnight index swap (OIS) rate.
3. The production rate of TORF for actual trading has been published by “QUICK Benchmarks Inc.” which was established by QUICK Corp. in January 2021 to ensure the transparency of TORF calculation and operational soundness.

Term Reference Rates (TORF) are supported the most by market participants. TIBOR, for loan products, and Overnight RFR compounding in arrears, for bond transactions, are supported to some extent respectively, although some challenges (e.g. operations, systems, accounting) are raised.

■USD and GBP

The following table summarizes the options of alternative benchmarks presented by the transition committee for the U.S. and U.K. markets:

1. According to the Alternative Reference Rates Committee (ARRC), the ARRC’s recommendation of an administrator that can produce a robust forward-looking term rate may be delayed until after the end of 2021 because of insufficient liquidity in SOFR derivatives markets, and development of an appropriately limited scope of use for the term rate.
2. There have been efforts to identify selected use cases where there may be robust rationales for using Term SONIA.
3. ICE Benchmark Administration launched the “ICE Term SONIA Reference Rates” in January 2021.
4. Refinitiv launched the “Refinitiv Term SONIA benchmark” in January 2021.

The relevant national working groups have identified RFRs for respective currency and they introduce their own local-currency-denominated alternative reference rates for short-term lending

RFRs are described as ‘nearly risk-free’ and are derived from actual transactions that have taken place in the liquid underlying markets.

There are some fundamental differences between IBORs and RFRs which will need to be addressed in the process of transition from certain IBORs, including

1. Credit and Liquidity Premiums - IBORs include the cost of bank credit risk and term liquidity risk as they are calculated based on the submissions of panel banks at which rate they can borrow unsecured funds in the relevant interbank market, whereas RFRs are based on overnight transactions and do not have term structure. Transitioning existing contracts from IBORs to RFRs may involve process incorporating a spread into RFR to cover the lender’s funding costs, etc.
2. Calculation direction - RFRs are backward looking overnight rates based on actual transactions whereas IBORs are forward looking term rates. This means that for IBORs the interest rate is fixed and publicly available at the beginning of each interest period. The Committee is exploring compounding RFRs in arrears as one potential option to meet the demand for term rates.

In the Final Report on the Results of the Second Public Consultation, the Committee recommends the waterfall structure shown below as the replacement benchmarks for fallback in loans and bonds which are supported by a majority of respondents, taking into account the consistency with global discussions and market participants' preference for alternative benchmarks based on RFRs.

In addition, the Committee considers that the most preferable replacement benchmarks are those proposed by the Committee, assuming they are applied mainly to standard loan contracts or straight bonds. The Committee, however, would not preclude contracting parties from concluding a contract with different priorities from the recommended waterfall structure. It is necessary for the parties to take into consideration the characteristics of products and the feasibility of applying the structure from operational perspectives.

In the Final Report on the Results of the Second Public Consultation, the Committee recommends the spread adjustment methodology as shown below for fallbacks in loans and bonds which is supported by almost all respondents, in order to ensure consistency with other currencies and ISDA derivatives and avoid operations from becoming complicated. 

The Committee deems it appropriate to adopt the same methodology as that for O/N RFR Compounding (Fixing in Arrears) even in a case where Term Reference Rates are adopted as the replacement benchmark.

Note that the official spreads published by Bloomberg are fixed, as a result of FCA’s LIBOR announcement for all euro, sterling, Swiss franc, US dollar and Japanese yen LIBOR settings on 5 March 2021.

Spread adjustment methodology

If a compounded RFR (Fixing in Arrears) is used, the rate for the entire interest period would not be known until the end of that period. Under the "lookback" approach, the interest payable over an interest period is determined by the RFR over an "observation period" instead of the interest period. The observation period starts and ends on a specified number of business days before the relevant interest period. This allows the parties to know the interest that will be payable at the end of that interest period a few days in advance of the payment date.

The Working Group on Sterling Risk-Free Reference Rates in the United Kingdom (UK RFRWG) and the Alternative Reference Rates Committee (ARRC) in the United States recommended the "Lookback without Observation Shift" approach for O/N RFR (Fixing in Arrears) conventions to use in loans. Here, the O/N RFR (Fixing in Arrears) is derived from the observation period but weighted according to the days in the interest period. In addition, the UK RFRWG recommended five business days as the lookback period while the ARRC illustrated five business days as an example.

Accordingly, the Sub-Group on Loans of the Committee discussed mainly the "Lookback without Observation Shift" approach for TONA and consulted with its members. As a result of the consultation in the Sub-Group, it is noted that a large majority of respondents agreed with illustrating a lookback period of five business days as an example, with a view to maintaining consistency with the discussions in the UK RFRWG and the ARRC, taking into consideration interest payment operations. It was also noted that almost all respondents agreed that contracting parties shall not be precluded from adopting "Observation Period Shift approach" as it was a viable and robust approach. Under this Observation Period Shift approach, each O/N RFR (Fixing in Arrears) is weighted according to the days in the observation period rather than the interest period.

Note that QUICK has calculated and published two types of benchmarks derived by compounding TONA from 15 March 2021. 

[Overview of TONA compounded benchmarks]

(1) TONA Averages

Interest rates derived from the daily compounded TONA for the period starting exactly 30 days, 90 days, and 180 days prior to the reference date of the benchmark (each business day) until the reference date.

(2) TONA Index

The TONA index is the assessed value of the asset as of the reference date, assuming the asset, which was valued as 100 on 14 June 2017, (the date on which the Bank of Japan established “Uncollateralized Overnight Call Rate Code of Conduct”), was managed using TONA. By using the TONA Index, interest rates based on compounded TONA for any given period may be calculated relatively easily.

The timing on permanent cessation of LIBOR has already been determined. Therefore, contracting parties should be fully prepared as soon as possible based on the transition plan.

Regarding new LIBOR referencing products, the developments of each National Working Group are as follows:

●The Committee has included "Roadmap to Prepare for the Discontinuation of LIBOR" in the Final Report on the Results of the Second Public Consultation. Following this, the Sub-Group for the Development of Term Reference Rates reported a target deadline for ceasing the initiation of new interest rate swaps referencing JPY LIBOR.

●The 2021 milestones include, but are not limited to, the following:

• End of Q1 2021: Develop systems and operations for O/N RFR Compounding (Fixing in Arrears) in loans and bonds.
• End of Q2 2021: Cease the issuance of new Japanese Yen LIBOR linked loans and bonds that expire after the end of 2021.
• End of Q3 2021: Cease the issuance of new Japanese Yen LIBOR linked interest swaps that expire after the end of 2021
• End of Q3 2021: Significantly reduce the amount of loans and bonds referencing LIBOR.

●The UK RFR WG has published milestones encouraging active conversion of legacy contracts. The 2021 milestones include, but are not limited to, the following:

• End of Q3 2020: Lenders include contractual arrangements in new and re-financed LIBOR-referencing loan products to facilitate conversion to SONIA or other alternatives.
• End of Q1 2021: Cease initiation of new GBP LIBOR linked loans, bonds, securitizations and linear derivatives that expire after the end of 2021. Complete identification of all legacy GBP LIBOR contracts expiring after the end of 2021 that can be actively converted and accelerate active conversion where viable. Widespread sign-up to the ISDA protocol ahead of effective date except for risk management of existing positions.
• End of Q2 2021: Progress 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. Cease initiation of new GBP LIBOR nonlinear derivatives that expire after the end of 2021, except for risk management of existing positions.
• End of Q3 2021: 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.
• End of Q4 2021: Be fully prepared for the end of GBP LIBOR.

●The ARRC has published the Best Practices for Completing Transition from LIBOR as follows:

• End of Q4 2020: no new USD LIBOR floating rate notes should be issued where the maturity is after 2021.
• End of Q2 2021: no new USD LIBOR business loans, floating-rate securitizations (except for CLOs), or derivative trades that increase LIBOR risk should be issued where maturity is after 2021. CLOs are targeted for the end of Q3 2021.

In addition, the Federal Reserve Board (FRB), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (“OCC”) 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 31 December, 2021. New contracts entered into before 31 December, 2021 should either utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s cessation.

You need to remove dependence on LIBOR by the end of 2021 (except for some USD LIBOR tenors. Please also refer to Q4)through:

1. Identification of LIBOR-linked contracts
   As a first step, you need to identify where your LIBOR exposures are. You also need to examine whether the contracts mature beyond the end of 2021. It is important to note that LIBOR may be used in not only loans, bonds and derivatives, but also other areas such as intra-group accounts.
2. Review your contract terms and conditions
   Your contracts may not include fallback language related to permanent LIBOR cessation. You therefore need to review and amend terms and conditions as necessary.
3. Operational readiness
   You may need to update systems and infrastructure for the changes.
4. Communication with banks
   You should communicate with banks regarding preparation and impacts on your businesses. You can seek further advice from financial service professionals, such as accountants.