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Benchmark reforms: Bigger than Brexit?

Economic Comment


To the dossier 'Benchmark reforms: Bigger than Brexit?'

LIBOR and other interbank offered rates (IBORs) have served as the benchmark interest rates for decades, and are still being referenced in a plethora of contracts. However, IBOR rates are no longer as representative for the entire market as they once were. Therefore, regulators around the globe are in the process of phasing out IBORs and replacing them with better alternatives.

Due to the widespread reliance on the current IBORs, the potential impact of benchmark reform has often been described as “bigger than Brexit”. Introducing new benchmark rates and discontinuing the existing IBORs comes with potential legal, financial, and operational risks. To mitigate these risks, it is important to ensure that contracts, systems and processes are able to deal with the new reference rates.

What is happening?

LIBOR and other interbank offered rates (IBORs) have served as the key interest rates for decades, and have become engrained into the financial system. But this is changing rapidly, with regulators around the globe looking to replace these IBOR benchmarks with better alternatives. So one of the foundations of global financial markets will change dramatically over the coming years.

Figure 1: Share of unsecured transactions has been declining
Figure 1: Share of unsecured transactions has been decliningSource: ECB Money Market Survey

Traditionally, these interbank offered rates are meant to represent the cost of unsecured interbank borrowing. But this market has shrunk dramatically over the past decade. To some extent this is due to temporary factors, such as liquidity provision and increased intermediation by central banks. But more importantly, since the Global Financial Crisis, unsecured interbank lending has become mostly a relic of the past. Instead, a large majority of transactions is now executed on a collateralised basis through repurchase agreements[1].

This has put into question the availability, robustness and representativeness of IBORs as the de facto benchmark rates. In most cases alternative reference rates are now being developed and launched with the aim of replacing the existing IBORs, which are currently still used in a wide range of financial products and contracts.

Bigger impact than Brexit?

Although the number of market transactions underpinning the benchmark fixings has declined over time, the footprint of these benchmarks remains extremely large. IBORs are at the base of many financial contracts, including, but not limited to, interest rate derivatives, floating rate notes, bank loans, and deposits. Additionally, these interest benchmarks may even be found in unexpected places, such as the agreed penalty for the late delivery of a product or service.

Due to this widespread reliance on the current IBORs, the potential impact of benchmark reform has often been described as “bigger than Brexit”. While it would be too much to discuss all transition risks in detail, we do want to highlight some of the most important considerations.

Figure 2: Business risks stemming from benchmark reforms
Figure 2: Business risks stemming from benchmark reformsSource: ISDA, Rabobank

First of all, contracts may need to be amended or even renegotiated if the original benchmark ceases to exist. While some contracts may already include specific fall-back options, these may be designed only for occasions where the benchmark is unavailable for a short period due to unforeseen circumstances. Such a fall-back clause may not have the desired effect when a benchmark is discontinued. Moreover, different contract-specific clauses, as well as the various jurisdictions that govern the broad scope of products, may render a coordinated switch to new benchmarks very difficult to pull off.

As a result, hedging strategies could be affected by benchmark switches. For instance, although the original exposure and the hedge currently reference the same IBOR, their replacement benchmarks are not necessarily the same. That would open up basis risk[2] between the original contract and the hedge. And even if both contracts do switch to the same new benchmark rate, temporary basis risk could arise if the benchmark change is not executed on the same date.

This same issue may also affect the use of hedge accounting. After the benchmark switch, it could prove difficult to demonstrate the effectiveness of the hedge, which could force discontinuation of hedge accounting and may ultimately result in higher variability of profits on the income statement. Therefore, work may be needed to continue the use of hedge accounting.

Next to potential basis risk, financial risks can also arise from changes in valuations. The discounting curves based on new benchmarks differ from the current discounting curves, and may therefore either increase or decrease present value. This also includes swap contracts where the floating leg doesn’t change (e.g. Euribor swaps). After all, the dual discounting methodology means that such swaps are discounted against the OIS[3] curve, which is currently based on Eonia.

Moreover, such valuation issues are not limited to financial contracts. IBORs may currently be used in fair value calculations for, for instance, discounting provisions, impairments and leases[4]. Changes in the reference curve used for these calculations could affect their valuations as well.

Lastly, there are also operational risks that need to be tackled. With the market moving to new reference rates, systems, software and models must be made compatible with the new standards. This may involve discussions with external vendors and extensive testing to ensure correct implementation.

Different solutions for the same problem

The abovementioned risks are heightened by the decentralised nature of the transition process. Despite a more or less global strive for improved benchmarks, the different regulators have all sought their own solutions. Unsurprisingly, then, the benchmarks of the future as well as the transition plans vary substantially across the different markets. Therefore, it is important to keep track of the developments in each relevant market.

The shared principle across jurisdictions is that benchmarks should be based on observable, arms-length transactions, but the implementation varies. We identify two key differences across the jurisdictions: the choice between a secured or unsecured rate, and whether the new benchmark contains a term structure. When it comes to the former, the US and Swiss markets are the odd ones out: in these cases the selected replacement is a repo rate, whereas most other major benchmarks will remain based on unsecured transactions. Secondly, it currently looks as though the EUR market will be the only one with a term structure still available in the fixing. Because the FSMA has approved the use of (evolved) Euribor, the EUR market will still see 1 week and 1, 3, 6, and 12 month fixings on a daily basis. Regulators in the other jurisdictions are currently much more reluctant to offer such term fixings, because they are harder to observe than an overnight rate, and such term rates are therefore inevitably less firmly based on underlying transactions.

The chosen successors also create different transition paths. Most of the key benchmarks we know today may cease to exist in the not too distant future. The FCA only guarantees that the LIBOR benchmarks will be available until the end of 2021, and EMMI has announced that it intends to cease publishing Eonia rates on 2 January 2022. Since the FSMA has authorised the new Euribor methodology, these fixings will continue to remain available for the foreseeable future. However, even in this case action may be needed to ensure that contracts meet new European requirements and to limit risks of the possibility that Euribor may still be discontinued in the future.

Table 1: Different solutions
Table 1: Different solutions
Source: Rabobank, ISDA, FCA, EMMI, ECB

Read more about the developments on the specific benchmark rates:


[1] Repurchase agreement (‘repo’): a form of short-term borrowing. 
Party A sells an asset (usually of high credit quality) to Party B, and also agrees to buy it back after an agreed period at a predetermined price. This way Party A is effectively borrowing cash from Party B for the agreed period, with the difference between the sale and repurchase price being the implicit interest rate. The simultaneous exchange of the asset provides collateral for Party B if Party A fails to repay the loan.

[2] Basis risk: the risk that the price changes of a pair of positions in a hedging strategy do not exactly offset each other.
This could occur if, for instance, the main exposure and the instrument used to hedge the exposure do not reference exactly the same underlying.

[3] Overnight Indexed Swap (OIS): A swap where the floating leg is based on a daily compounded interest rate.

To the dossier 'Benchmark reforms: Bigger than Brexit?'

Bas van Geffen
Rabobank KEO

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