We are approaching a watershed moment for the world’s financial markets. The basis on which we calculate a vast range of financial instruments is changing. This is likely to affect all participants in financial markets: private individuals, businesses, governments, other institutions, and investors of all kinds. An orderly transition is vital for the financial system and the wider global economy. As a large, global bank, Deutsche Bank is determined to play its part.
Authorities around the world are now driving initiatives to reduce the financial system’s dependence in Interbank Offered Rates or ‘IBORs’ and to transition to alternative Risk Free Rates. IBORs are average rates at which some banks can borrow in the interbank market for periods of time, or ‘tenors’, ranging from overnight to 12 months. For decades, financial markets worldwide have relied on Interbank Offered Rates – the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR) and Tokyo Interbank Offered Rate (TIBOR). IBORs play a central role as reference rates to a wide variety of transactions – loans, deposits, bonds and securitizations – worth trillions of euros. The notional value of derivative contracts which rely on IBORs runs into hundreds of trillions of euros.
The drive for reform reflects several concerns around reliance on IBOR. One is potential systemic risk. This arises from the shrinking of underlying markets on which IBORs are based relative to the huge volume of transactions which rely on them. Transaction volumes in unsecured interbank markets are very low, so banks are making IBOR submissions based partly on ‘expert judgement’ rather than actual transactions. Banks which are members of panels which set IBORs are becoming reluctant to make submissions due to concerns over potential liability when rates are submitted using ‘expert judgement’. For some currencies, some panel banks have stopped making LIBOR submissions altogether.
Alternative Risk Free Rates have several important benefits. They‘re based on robust, highly liquid underlying markets. They’re based on actual transactions rather than ‘expert judgement’. They are seen as a more appropriate benchmark rate because they don’t require the credit risk premium which is embedded in interbank offered rates.
The aim of the transition is to introduce Risk Free Rates which are transparent, objective because based on real transactions, and difficult to manipulate. These form a reliable basis for all types of financial contracts which rely on a reference rate.
The transition to alternative Risk Free Rates will affect individuals, companies and institutions who use a huge variety of financial services which rely on IBORs as a reference rate. A few examples: family businesses funding their expansion with credit based on an IBOR; students coming out of university with long-term loans whose interest rate relies on an IBOR, or international companies seeking to protect themselves against fluctuations in interest rate or currency rates with derivatives which reference IBORs. Transition will also affect pension funds, and the pensioners they serve, who are seeking regular income from investments with interest rates based on an IBOR.
Regulatory authorities in major jurisdictions around the world have signalled their aim to substantially complete the transition process by the end of 2021. Andrew Bailey, Chairman of the UK Financial Conduct Authority (FCA), has announced that the FCA would no longer compel banks to make LIBOR submissions from the end of 2021, adding that from that point on, ‘the survival of LIBOR could not and would not be guaranteed.’
A major transition like this involves challenges. Wide adoption of alternative Risk Free Rates right across the world’s financial markets will require significant awareness-raising and resources. Building liquidity is vital, notably in derivatives which rely on the new rates. Market infrastructure, including trading, clearing and settlement mechanisms, needs to be adapted to handle instruments which reference the new rates. Existing contracts need to be amended, involving cost and effort. Replacement of legacy contracts has implications for market valuation and the effectiveness of existing hedges. Tax and accounting changes also need to be dealt with.
Deutsche Bank serves clients all over the world with a unique global network and presence on the world’s major financial markets. It is committed to helping its clients, trading counterparties and other stakeholders to navigate this transition in a safe and orderly fashion. This includes supporting clients with documentation which enables a smooth transition; providing liquidity, execution and risk management; and helping develop instruments which comply with the requirements of regulators across the globe.
Risks and benefits
A number of leading international benchmark rates are subject to reform initiatives, and are vulnerable to material change or discontinuation. Affected rates include, but are not limited to, the London InterBank Offered Rate (“LIBOR”), the Euro Interbank Offered Rate (“EURIBOR”) and the Euro OverNight Index Average rate (“EONIA”).
In July 2017, the UK’s Financial Conduct Authority (FCA) announced that panel banks would no longer be compelled to contribute rates for the determination of LIBOR after 2021. If panel banks cease to contribute the data required to compile LIBOR, LIBOR may become more volatile and less liquid and ultimately may be discontinued.
In January 2018, most elements of the EU Benchmark Regulation (EU BMR) came into force, requiring benchmarks administered or used in the EU to meet certain standards by the end of 2019. There is a risk that if a benchmark’s methodology is changed in order to comply with regulation, it may perform differently. There is also a risk that certain benchmarks do not meet the requirements of the EU BMR and are either discontinued, or become ineligible for use in the EEA. In early 2018, the administrator of EONIA announced that EONIA would be unable to attain compliance with the standards set by the EU BMR.
Central banks, such as the European Central Bank, the Bank of England and the Federal Reserve, have encouraged initiatives to develop ‘Risk Free Rates’, to serve as alternative interest rate benchmarks. The Secured Overnight Financing Rate (SOFR) is one such alternative to USD LIBOR, and other ‘Risk Free Rates’ are being developed. It is likely that at some time, liquidity will transition to new ‘Risk Free Rates’. This poses a risk that the precursor rate becomes less liquid.
If a financial product references an affected benchmark, changes to or the discontinuation of such a benchmark may adversely affect the payments under and value of such product. Terms and conditions of financial products typically contain fallback provisions, which identify how a successor or substitute rate will be selected if LIBOR, EURIBOR, EONIA or a similar benchmark is not published. There is a risk that fallback terms do not adequately cater for the circumstances in which they need to be used. For example, fallbacks which rely on a poll of banks are dependent on the co-operation of third parties, which may not be provided.
Other fallbacks may fix payments at the last known benchmark level, which may be commercially undesirable, or allow a specified party to determine a successor or substitute rate. If a financial product uses a successor or substitute rate, such a rate may result in less favourable payments under the product when compared to the original rate. The terms of a financial product may call for such a product to be terminated or redeemed early if a suitable successor or substitute rate cannot be identified, and the cost associated with a termination or redemption may be sizable and may result in a loss for the client.
When entering into transactions with Deutsche Bank, clients should consider the risks and benefits of using a particular benchmark and understand the consequences if such a benchmark is changed or discontinued. Clients should consider whether they have suitable contingency plans in place should any of the events described above happen.
Further considerations about benchmark usage are set out in IOSCO’s “Statement on Matters to Consider in the Use of Financial Benchmarks” dated 5 January 2018, and available here.