Benchmark reform is the impending transition from one type of interest rate used to reference some $350 trillion of corporate loans, debt and derivative product from the end of 2021-mid 2023 to other alternative rates. It is likely to affect interest payments and product valuation.
The most popular benchmark reference interest rate is the London Interbank Offered Rate (LIBOR. It is supposed to be representative of wholesale, unsecured transactions in a variety of hard currencies (presently USD, GBP, EUR, GHF and JPY) for several maturities between overnight and 12 months. Every business day, a benchmark administrator collates submissions from contributor banks based on their actual transactions or by using the contributor’s expert judgment when few or no transactions have taken place, and publishes LIBOR fixings. Global lending markets reference these fixings for customer and client borrowings, usually adding a credit spread to reflect the relative creditworthiness between borrower and lender. These fixings are also an integral component for huge amounts of derivative and capital markets product.
The early 2000’s saw advances in credit risk management practices that made bankers increasingly reluctant to lend wholesale funds on an unsecured basis on anything but an overnight term – the premise being that fewer bad things might happen to monies lent overnight compared to a term loan. Consequently, most of the approximately $500m daily LIBOR transactions are overnight only meaning that term LIBOR fixings are largely subjective, not being based on any substantial amount of trade. In the past, this has made term LIBOR susceptible to manipulation, resulting in fines for banks and prison sentences for traders. The early response was the Wheatley Review in 2012, initial reform of LIBOR, greater regulatory oversight and a recommendation by the Financial Stability Board in July 2014 to develop nearly Risk Free Rates (RFR) as alternatives to LIBOR. This is benchmark reform.
Working Groups on alternative reference rates in various jurisdictions have proposed different risk free rates to replace LIBOR; some using secured financing data sources whilst others reference unsecured money market data. They have varying publication times, different administrators and all are overnight rates only.
In the United States, the Secured Overnight Financing Rate (SOFR) is the preferred risk-free rate for USD markets. SOFR derives from secured financing transactions, otherwise known as repo. Over $1trillion of SOFR linked transactions transact each day. Repo markets have their own challenges though, demonstrated by recent ructions in US markets due to liquidity issues. Perversely, this can result in a replacement risk free benchmark rate that is potentially more volatile than the rate it is replacing.
Term LIBOR fixings give cash flow certainty. A borrower borrowing money today for 12 months will know exactly how much they will have to repay in a year’s time if the loan references a 12-month LIBOR rate fixed today. This is an in advance borrowing. Replace this with an alternative rate referencing an overnight rate instead and the borrower will have to wait until the loan matures before they know exactly how much is due. This is an in arrears borrowing. The lack of a term structure for many proposed replacement rates creates uncertainty of future cash flows.
Additionally, most borrowers, lenders and derivative markets participants will have legal documentation detailing their obligations. Within these documents is fallback language that sets out the legal steps to be taken in case LIBOR becomes temporarily unavailable. These contracts will need amending for a permanent discontinuation, involving a trigger protocol, details of the replacement rate and a replacement spread applied to the new rate to make it economically equivalent to the old rate, replicating existing credit spreads with no financial advantage or disadvantage to borrower, lender or derivative counterparty.
Benchmark reform in various jurisdictions is currently at different stages of transition, and is moving at different speeds towards, in all likelihood, different outcomes. The results could potentially have an unpredictable and adverse impact on the valuation and obligations of financial instruments like loans, bonds and derivative product. Financial organisations will need to adapt to new or amended operational processes and changes to contractual documentation will require communication, education and treating customers and clients fairly.