The Inter Bank Offered Rate (IBOR) has been a hot topic since the fraudulent activities were discovered back in 2013. Supervisors are pushing the market to move to new reference rates but when, how, and at what risk and at what Cost?
What is IBOR?
IBOR is the hypothetical rate banks will lend to one another in the interbank market and covers a variety of tenors (3 and 6 month being the most popular) and currencies. It is used for nearly every interest related activity in the bank such as a reference rate in derivative contracts e.g. Forward Rate Notes. It directly effects retail consumers too. For example, the mortgage interest rate consumers pay is based on models using an IBOR as an input.
Way forward
Two issues prompted regulatory action on IBOR:
- Fraud by the in IBOR setting participating banks, discovered in 2013
- Declining volumes in the interbank lending market, partly driven by regulatory actions post 2008 making it more of a hypothetical judgement by the rate setters in banks (vs. based on real transaction data).
As a result, the regulators have established working groups (consisting of regulators and market participants) to identify an alternative for IBOR, the so-called: Risk Free Rates (RFR).
Implications
Switching to a new reference rate (e.g. USD LIBOR to SOFR) is like changing tires on a car when driving on the highway. It is not only difficult, it is very risky, as in this case the new tires have a different shape and size. The new risk-free reference rates have less liquid markets based on them, have limited formally published forward curves (i.e. Term Rates although these are starting to arrive in late 2019/2020), ignore credit spread, and react differently on market circumstances than the IBORs do.
Then, why not stick to IBOR?
The second issue, described above, is that IBOR no longer represents reality and therefore becomes less meaningful. As the adoption of RFRs rises and IBOR liquidity dries up, banks submitting reference rates are getting more exposed to increased conduct risk and face increased regulatory scrutiny. So, given a choice, rate setters will decline to voluntarily participate and dwindle in number. Consequently, IBORs will probably not survive (at least in their current form). The Financial Conduct Authority has indicated to continue publishing GBP LIBOR as long as at least four panel banks submit rates but will not force them to do so. In other words, its future is not certain and whilst it may remain beyond 2021, it might be in an un-referenceable “zombie” state.
So, what to do and when?
Even though IBORs will not officially (probably) cease until end 2021, new markets (e.g. Vanilla Interest Rate Swaps on SOFR) referencing the RFRs will grow in liquidity and banks should look to be trading in them as their clients’ demand. During transition, systems and models must cope with IBORs and multiple overnight RFRs and the term RFRs as they become available. Therefor, serious consideration must be given to legacy trades (as and when the market reaches consensus on consistent triggers / fallbacks). But also to the scenario planning (e.g. cliff edge cessation at end 2021) around determining how and when the business shifts its portfolio from one reference rate to another. Even though an alternative risk-free rate is not or only partially available today.
Clear transition policy
In the treasury function, where interest rate risk and liquidity risk are managed on a daily basis for bank funding, a clear transition policy must be determined. Overall, a tightly governed transition programme co-ordinating efforts in the Corporate, Retail and Investment bank across regions should be initiated. To give focus, we suggest formal workstreams:
- Industry Participation (attending / influencing the RFR and other working groups);
- Systems and Models (understanding the impact of any changes);
- Legal Impact and Client Outreach (leveraging learnings from programmes like Brexit);
- Portfolio Analysis & Strategy (understanding current and future LIBOR exposure).
A lot needs to be done, better start today.
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