Reference Rate Reform: Are You Ready? A New Era Of Benchmark Rates

• Published date: 13 March 2023
• Subject Matter: Finance and Banking, Financial Services, Commodities/Derivatives/Stock Exchanges
• Law Firm: EY Law
• Author: Mr Philip Peerens

A major transformation is taking place in the financial markets as the London Interbank Offered Rate (LIBOR) and other IBORs (EURIBOR, EONIA, TIBOR, etc.), having dominated these markets for decades, will be replaced in 2021.

What changes are taking place?

IBORs are considered to reflect the general level of interest rates in the economy and have been at the core of the financial system. LIBOR for instance, the most widely used rate, accounts as the benchmark rate for over USD 400 trillion worth of financial contracts. IBORs have been used as reference interest rate in a large amount of financial contracts (i.e. loans, derivatives, securities, etc.), lease and purchase contracts (where it can be used as a variable component of the price mechanism), as well as in transfer pricing agreements.

The current IBORs are calculated on the basis of daily submissions by a group of panel banks. These submissions are often based upon estimates of such panel banks on future transactions.

Over the last years however, cases of misconduct and manipulation of the IBOR submissions by the panel banks have prompted the demand for transition to a new type of benchmark rates, referred to as alternate reference rates (ARRs). In 2013, the financial markets regulatory authorities had published recommendations to reform the IBOR benchmarks. Subsequently, the EU introduced its Benchmarks Regulation, which came into effect on 1 January 2018.

Against this background, working groups across all major currencies have lately been proposing ARRs for the following currencies: SONIA (Sterling Pound), SOFR (US Dollar), ESTER (Euro), TONA (Japanese Yen) and SARON (Swiss Franc).

Challenges

The transition from IBORs to ARRs will impose far-reaching challenges for the financial world, as the two types of rates are structurally different:

• IBORs are forward-looking term rates and are published for different tenors (e.g. 3 months, 6 months,.) at the beginning of the borrowing period. They reflect the credit risk that banks take into account for unsecured and uncollateralized debt.
• ARRs on the other hand are backward-looking overnight rates meaning that they are published at the end of the overnight borrowing period, and are only based upon actual 'historical' transactions. Furthermore, ARRs are secured rates that do not reflect the actual cost of (unsecured) interbank lending.

Particularly for...