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LIBOR Transition

LIBOR Transition

The London Interbank Offered Rate (LIBOR) is likely to be permanently discontinued by the end of 2021. LIBOR is currently one of the most important benchmarks in the financial markets and is linked to contracts worth trillions of US dollars. The UK Financial Conduct Authority (FCA) has stated that after 2021 it will no longer compel panel banks to submit rates used for the calculation of LIBOR. Regulators in major jurisdictions have emphasized that it is the time for market participants to start transitioning from the use of LIBOR to alternative benchmarks.

release 2020.6.26

Q & A

What is LIBOR?

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).”

Although LIBOR has been recognized as an infrastructure of global financial market, it is very likely that it may no longer be available after the end of 2021.

Why is LIBOR being replaced?

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.

What impact will the permanent discontinuation of LIBOR have?

Given that LIBOR is widely used in various products and the volume of transactions referencing LIBOR is considerably large, the discontinuation 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 discontinuation 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 of the end of 2021.

What kind of adjustments should be made prior to LIBOR discontinuation for contracts referencing JPY LIBOR?

The Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks (hereafter the “Committee”) presents “transition” or “fallbacks” for moving from JPY LIBOR to alternative benchmarks, defined 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,” the Japanese Bankers Association (JBA) released “sample fallback provisions for bilateral loans” (supervised by a full service law firm Mori Hamada & Matsumoto, available in Japanese only) in March 2020 to facilitate the introduction of fallback language in the contracts for the loan market.

What should we keep in mind when selecting “Fallbacks”?

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. Therefore, one party may enjoy a gain while the other may suffer losses. In order to minimize the value transfer, a spread adjustment between JPY LIBOR and the replacement benchmark will be made. The spread adjustment will be calculated when the relevant announcement is made regarding either ‘non-representativeness’ or ‘permanent discontinuation’, but the replacement rate will not apply until the date on which LIBOR is ‘non-representative’ (based on the statement by the FCA) or is discontinued (if such a date is different from the announcement date).

What are the alternative benchmarks?

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:

Option Overnight RFR Compounding
(Fixing in Arrears)
Term Reference Rates
(Swap)
Term Reference Rates
(Futures)
TIBOR
Underlying rate Uncollateralized overnight call rate (TONA) JPY overnight indexed swap (OIS) Overnight call rate futures TIBOR
Reference Period Fixing in Arrears Fixing in Advance Fixing in Advance Fixing in Advance
Availability Available
* Some challenges remain in systems, operations, and accounting.
Not available
(but expected to be developed by around mid-2021(QUICK has been selected as the calculating and publishing entity))*
Not available
(but the Tokyo Financial Exchange is considering to resume trading of Overnight call rate futures in around 2020)
Available
(but IBORs are not available in some currencies such as US dollar and Pound Sterling)
  • QUICK began publishing the prototype rates of JPY term risk free rates on May 26, 2020. For the time being, QUICK will publish a summary of the previous week's daily rates at approximately 17:00 JST on every Tuesday (the second business day of the week). QUICK plans to switch to daily publication around autumn 2020.

Term Reference Rates(Swap and Futures)are now being developed as they are supported the most by market participants as noted in the “Final Report on the Results of the Public Consultation” by the Committee. 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.

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

Country IBOR New Risk Free Rate Transition Committee
Europe EURIBOR and EUR LIBOR €STR (Euro Short-Term Rate) European Money Markets Institute (EMMI) and Euro RFR Working Group
Japan JPY LIBOR and TIBOR TONA (Tokyo Overnight Average Rate) Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks
Switzerland CHF LIBOR SARON (Swiss Average Rate Overnight) The National Working Group on Swiss Franc Reference Rates
United Kingdom GBP LIBOR SONIA (Sterling Overnight Index Average) * Working Group on Sterling Risk-Free Reference Rates
United States USD LIBOR SOFR (Secured Overnight Financing Rate) * Alternative Reference Rates Committee
  • As with the case of Japan, RFR-based term rates are also being developed in the U.K. and U.S. markets. However, to prepare for the permanent discontinuation of LIBOR, financial authorities in U.K. and U.S. have urged the financial institutions to accelerate LIBOR transition to the compounded average of the RFR calculated on an in-arrears-basis, rather than waiting for the development of term RFR.

What are the differences between IBORs and RFRs?

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 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.

What is the timing of the transition?

The permanent discontinuation of LIBOR is set for the end of 2021—but the timeline is not absolute. Various rates based on LIBOR could potentially continue to be published after that point. However, according to the FCA’s statement, markets need to prepare for potential announcements that some or all LIBOR settings will cease after end-2021, or the FCA will find that they are no longer going to be representative after end-2021. Announcements could be made before end-2021, even if the discontinuation or loss of representative status would not occur until the panel banks had left at the end-2021 or another applicable date of panel bank departure thereafter.

In the U.S. market, the transition has already begun, albeit slowly, with some U.S. institutions issuing securities and writing contracts that reference SOFR. A tipping point for SOFR could happen when central clearing houses begin using SOFR, discounting all dollar-denominated interest rate swaps. As more derivatives reference SOFR, they will likely to spur the broader use of SOFR. Meanwhile, a key priority of the UK RFR working group is to discontinue GBP LIBOR lending by the end - Q1 2021, which could accelerate the transition to RFR.

What you need to prepare for the transition?

You need to remove dependence on LIBOR by end-2021 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 discontinuation. 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.

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