Dying Libor gives rise to risk-free rate benchmarks

The London Interbank Offer Rate, commonly known as Libor, is the most widely used benchmark in many financial products ranging from loans to derivatives. Libor has suffered from manipulations and a lack of underlying transactions available to determine the benchmark. Regulators are pushing for Libor to be replaced with risk-free rates (RFR). RFRs are based on a deep and liquid pool of underlying transactions instead of panel-based submissions, that was subject to misuse and identified as the root cause requiring reforms.

The end of Libor is near
Libor is published in 5 currencies - Japanese Yen (JPY), Euro (EUR), Swiss Franc (CHF), UK Pound Sterling (GBP) and US Dollar (USD). Working groups were set up in each of these jurisdictions to recommend and select the RFR.


Based on the characteristics of the national markets, the respective working group selected the Secured Overnight Financing Rate (SOFR) for USD Libor, the Tokyo Overnight Average Rate (TONA) for JPY Libor, Euro Short-term Rate (ESTR) for EUR Libor, the Swiss Average Rate Overnight (SARON) for CHF Libor and the Sterling Overnight Index Average (SONIA) for GBP Libor.

Transition challenges
The RFRs are completely new benchmarks, except for SONIA. They started with little liquidity but we have seen the increase in liquidity this year with the cessation of new contracts for GBP Libor and CHF Libor and the push for the interdealer market to trade RFR benchmarks over Libor (what the market commonly refers to as SOFR First and TONA First). A liquid RFR is essential to avoid any market dislocation or wide bid and offer spreads that may impact funding and collateral postings.

Documentation
Legacy contracts referencing Libor will need to be amended to include fallback language. Fallback language refers to the legal terms in a contract that define the steps to move to a new reference benchmark if the benchmark permanently ceases or is no longer representative of the underlying market. The current fallback language was designed for a temporary cessation.

The International Swaps and Derivatives Association (ISDA) published the IBOR Fallbacks Protocol, allowing adhering parties to incorporate Libor fallback language into certain types of documents. If a firm does not adhere or if the documents are not covered in the IBOR Fallbacks Protocol such as loan documents, firms will need to bilaterally negotiate and amend their documents to incorporate the fallback language. It is absolutely critical for firms to incorporate fallback language into all their contracts to ensure these contracts can continue using alternative benchmarks once Libor ceases.

Transition challenges for derivative and loan markets
Unlike Libor, RFRs are overnight rates and not term rates, they are not forward-looking and they do not contain an embedded credit spread. To recreate the term structure and credit spread, the RFR is daily compounded and a credit spread adjustment is added.

This fundamentally changes when cash flows are determined - cash flows are known a few days before the payment date instead of way in advance. However, for certain financial products such as loans, clients may want cash flows to be known way in advance by using a forward-looking term rate. This may lead to basis risks, hedging mismatches and valuation differences between different financial products.

There has been slow uptake and acceptance of RFR-related financial products due to the "newness" of the RFRs and the fundamental change of determining rates. Banks, together with regulators, can address this by providing education to their clients.

India's Libor transition from MIFOR to Modified MIFOR
The Mumbai Interbank Forward Rate (MIFOR) is based on USD Libor and the forward premium derived from the Indian forex markets. The Indian Banks Association (IBA) has selected Modified Mifor. The Financial Benchmarks India Pvt Ltd (FBIL) started publishing Adjusted Mifor from 15 June 2021 and Modified Mifor from 30 Jun 2021. Adjusted Mifor is for use in legacy contracts while Modified Mifor is for use in new contracts. In addition, the Reserve Bank of India (RBI) issued an advisory to banks to cease using Mifor and Libor (except under certain situations) for new contracts by the end of 2021.

Road ahead
The era of Libor is coming to an end. Market participants need to ensure they are prepared and ready to adopt these new RFR benchmarks by the end of 2021 or risk being left out of the market. Market participants should not underestimate the resources, work and IT changes required. Libor and Mifor will cease, embracing the RFRs is the only path forward.

(The author is managing director, Deutsche Bank India)