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Libor transition

 

The London Inter-bank Offered Rate (LIBOR) is one of the most commonly used interest rate benchmarks in global financial markets. A major transition is currently underway across the financial industry to switch from LIBOR, to alternative reference rates (ARRs) as a priority. The publication of LIBOR is expected to cease by the end of 2021.

Interest rate benchmarks, such as LIBOR, are widely used reference rates which underpin interest rates for a range of financial instruments held within portfolios managed by Invesco. The rates are written into loans, bonds, derivatives and many other financial contracts and investments.

Certain Invesco funds and mandates use LIBOR in their investment objectives, performance fee calculations, asset allocation models and comparators. The LIBOR benchmark is also relied on by financial firms from an operational perspective, including in valuation curves, stress testing, pricing and asset allocation models.

Invesco is therefore taking steps to assess the impact of the LIBOR transition on its clients and to plan for the transition to ARRs. 

What is LIBOR?

LIBOR is a set of benchmark interest rates that provide an indication of the average rates at which panel banks could borrow wholesale, unsecured funds for set periods currencies. It is calculated and published daily by the Intercontinental Exchange (ICE) Benchmark Administrator (IBA) based on submissions from a panel of banks.

At the time of writing, each LIBOR calculation is based on interest rates (input data) received from a panel of between 11 and 16 Contributor Banks for each of the five LIBOR currencies.

IBA calculates LIBOR as an average from the interest rates submitted by the Contributor Banks, based on what they would be charged if they were to borrow from other banks.

LIBOR is calculated for five currencies (USD, GBP, EUR, CHF and JPY) and for seven tenors/terms for each currency (Overnight/Spot Next, One Week, One Month, Two Months, Three Months, Six Months and 12 Months).

35 individual rates (one for each currency and tenor/term combination) are published each London business day.

LIBOR is expected to cease after end-2021

The UK's Financial Conduct Authority (FCA) announced in 2017 that it would no longer seek to compel or persuade panel banks to submit the rates required to calculate LIBOR after the end of 2021. Beyond this date, the future of LIBOR is not guaranteed.

Financial products will, where possible, need to remove dependence on LIBOR by the time the rate ceases to be published in order to avoid disruption.

In some cases, particularly in the cash markets, introducing robust fallbacks to LIBOR is likely to be challenging where high levels of investor consent is required - although there has been some progress to date.

Why is it being replaced?

The integrity of LIBOR was called into question during the height of the financial crisis when several banks contributing to its calculation were accused of manipulation of the rate. There followed a contraction in the unsecured interbank lending market and the future of LIBOR was placed in doubt.

In 2014, the Financial Stability Board published a report explaining that benchmarks, such as LIBOR, should be based on actual transactions to the greatest extent possible. Since then global financial regulatory authorities have expressed concerns about the reliability and robustness of existing interbank benchmark rates.

In 2017, both the FCA and the Bank of England noted that it had become increasingly apparent that the absence of active underlying markets and the scarcity of term unsecured deposit transactions raised serious questions about the future sustainability of the LIBOR benchmarks.

In an example used by the FCA, in one currency–tenor combination for a daily benchmark rate, between them the Contributing Banks had executed just fifteen transactions of potentially qualifying size in that currency and tenor over a 12-month period. 

Without sufficient transaction data, LIBOR submissions made by banks to sustain the LIBOR rate are largely based on major banks’ judgements concerning their cost of borrowing, rather than market transactions representing their actual cost of borrowing. This heightens the risk of benchmark manipulation. In the FCA’s view, not only was it potentially unsustainable, but also undesirable, for market participants to rely indefinitely on LIBOR, which increasingly uses reference rates that do not have active underlying markets to support them.

By contrast, Risk Free Rates are based on overnight lending markets figures - which are generally considered to be more liquid. 

The FCA received a voluntary agreement from the LIBOR panel banks to continue to submit to LIBOR until end-2021, to enable time for the market to transition away from LIBOR.

What is replacing LIBOR?

Public-private sector working groups established in the jurisdictions of the five LIBOR currencies have identified overnight ARRs to replace LIBOR, as follows:

Country Working Group / Transition Committee Existing Rate New ARR Administrator Type Description
USA Alternative Reference Rates Committee USD
LIBOR
SOFR (Secured Overnight Financing Rate Federal Reserve Bank of New York Secured Secured rate that covers multiple overnight repo market segments
UK Working Group on Sterling Risk-Free Reference Rates GBP
LIBOR
SONIA (Sterling Overnight indexed Average) Bank of England Unsecured Unsecured rate that covers overnight wholesale deposit transactions
Switzerland The National Working Group on Swiss Franc Reference Rates CHF
LIBOR
SARON (Swiss Average Rate Overnight) SIX Exchange Unsecured Secured rate that reflects interest paid on interbank overnight repo rate
Japan Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks JPY
LIBOR TIBOR
TONAR (Tokyo Overnight Average Rate) Bank of Japan Unsecured Unsecured rate that captures overnight call rate markets
EUR European Money Markets Institute (EMMI) and Euro RFR Working Group EONIA €STR (Euro Short-Term Rate) European Central Bank Unsecured Unsecured rate that captures overnight wholesale deposit transactions

 

 

 

Are the ARRs the same as LIBOR?

While the singular term ‘ARR’ suggests something fairly generic, it can be seen from the table above that in fact each ARR is different from the other.

While ICE Benchmark Administration is the sole administrator for LIBOR, the ARRs are mainly administered by central banks in the jurisdiction in question.

While LIBOR is calculated based on a consistent basis, the ARRs are a mix of secured and unsecured rates, some for example based on the overnight repo market and others based on overnight wholesale deposits.

ARRs are calculated on a different basis and are not like-for-like replacements for LIBOR. ARRs are overnight rates which are backward-looking, i.e. are published after the period to which they relate.

LIBOR, on the other hand, is set at or prior to the commencement of the period (or term) to which they relate, allowing certainty during such a period over amounts which will be due at the end of that period.

LIBOR and most other IBORs are intended to measure unsecured interbank lending rates and, as a result, include or imply a credit spread.

The proposed ARRs are based on short-term wholesale transactions for unsecured ARRs (i.e. SONIA, TONA and €STR) and repurchase or “repo” transactions for secured ARRs (i.e. SOFR and SARON which does not form part of the ARRs. The ARRs are therefore nearly risk free and so do not include or imply a credit spread of the type seen in LIBOR.

To transition existing contracts and agreements that reference IBORs to the ARRs, adjustments for credit and term differences may need to be incorporated and applied to the alternate rate to avoid, to the extent possible, a value transfer.

Any spread adjustment applied to an ARR will only serve as a rough proxy for the historic delta between a LIBOR currency/tenor and the relevant ARR.

In some instances, it may not be appropriate to amend a LIBOR reference to the relevant ARR. Alternative solutions may need to be used depending on the product or instrument in question.

It is worth noting that several of the ARRs are relatively new rates which do not have extensive historical performance data.

A high-level summary of the key differences between LIBOR and ARRs is set out below.

What are the key differences between LIBOR and ARRs?

There are a number of differences between the alternative ARRs and LIBOR:

LIBOR ARRs
Is a forward-looking term rate (a rate fixed for its period to maturity), published at the beginning of the borrowing period. Are backward looking, published at the end of the overnight borrowing period, looking back over the night’s transactions.
Is calculated by looking at daily submissions from panel banks. Are calculated by looking at real, historic transactions.
Reflects bank credit risk and term risk. Do not reflect bank credit nor term risk. Adjustments are therefore likely to be needed when contracts are transitioned from LIBOR.

 

When will the transition take effect?

Our base case at Invesco is that LIBOR will cease by end-2021. This is when the FCA has said it will no longer persuade or compel panel banks to provide submissions to LIBOR. At any time following this date it is possible that ICE Benchmark Administration may cease to publish the rate.

The EU Benchmark Regulation (BMR) also has a “representative test”, which in the context of LIBOR requires the FCA to make an assessment of LIBOR’s representativeness in certain circumstances, such as the departure of one or more Contributing Banks, or in any event, every two years.

However, due to the agreement it has with LIBOR Contributing Banks to remain on the LIBOR panels until end-2021, the FCA has said that it does not expect LIBOR to cease or become non-representative before end-2021.

New contracts will also increasingly refer to the new ARRs. The timing for this will vary depending on the type of contract, any laws relating to it, and when robust systems and procedures required to support the ARR in respect of such contracts become available.

Invesco currently expects the stock of LIBOR-referencing contracts to significantly reduce from Q1 2021. Likewise, we expect the stock of ARR-referencing contracts across the rates to increase throughout the period and for liquidity to continue to develop.

What is Invesco doing to understand the potential impact on clients?

We are working closely with regulators, market participants and industry bodies as well as participating in industry discussions and following developments in this evolving area so that we can adopt approaches and strategies that are consistent with industry best practice.

In order to assess the impact of LIBOR transition on fund and client portfolios and to prepare for transition, we are undertaking a review exercise across all investment teams that manage portfolios with LIBOR exposure. This exercise aims to determine the scope of that exposure and to assess the applicable LIBOR transition options.

What will Invesco be doing to mitigate the potential impact on clients?

We support the market transition away from LIBOR and are committed to working closely with our clients to ensure they are aware of and understand the potential impacts.

We have established a comprehensive global LIBOR transition program with a dedicated team of subject matter experts to manage the impact of the transition.

While Invesco’s internal planning and due diligence on these changes has already started, it is not yet possible to accurately determine the precise impact on our clients and our business. We are monitoring this situation and, where required, will update this website with further information.

What is Invesco’s approach to LIBOR transition in light of COVID-19?

We are continuing to work towards the transition away from LIBOR for all our clients by the end of 2021 at the latest, in line with the statements by our global regulators.

Our aim is to ensure a seamless LIBOR transition for our clients and our firm by the end of 2021. We are continually assessing how the transition may impact LIBOR-referencing investments, while closely monitoring regulatory and market developments.

Do clients need to do anything now?

We are pro-actively preparing for LIBOR transition and we encourage our clients to do so as well.

Although the full impact of the reforms is still unclear, there are a number of potential steps that you may wish to take now:

  • Consider the latest industry information available on LIBOR and other legacy benchmark transition;
  • Identify any investments you have which reference LIBOR and engage with us to the extent that you are unclear as to the potential impact on those investments; and/or
  • Consider seeking advice from your professional advisers on the possible implications of the changes from a financial, legal, accountancy or tax perspective.

Where to obtain more information?

We will seek to update this page periodically as market developments occur and industry announcements are made. In addition, should you seek general information on LIBOR transition, please consider reviewing published information from regulators, working groups and other industry bodies.

Important information

The information and any opinions expressed on this website are derived from proprietary and non-proprietary sources deemed by Invesco to be reliable, but are not necessarily all-inclusive and may be subject to change. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions or actions taken in reliance thereon is accepted by Invesco, its officers, employees or agents.