Overview of IBOR Transition RFR list Fallback and spread adjustment

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End of LIBOR and IBOR's REFORM

Background of LIBOR abolition

What is LIBOR?

LIBOR (London Interbank Offer Rate) is currently calculated every business day for 35 types in 5 currencies and 7 tenors. Rates are calculated based on offered Rate by `Reference Banks` every London business day. As shown in the figure below, LIBOR is used for huge financial transactions such as bonds, loans and derivatives, so the abolition of LIBOR will have a great impact on economic activities.

Currencies Contract Amount
JPY $30 Trillion
USD $150 Trillion
EUR + EURIBOR $152 Trillion
GBP $30 Trillion
JPY Interest Rate Swap ￥2,453Trillion
JPY Currency Swap ￥305Trillion
Source : Review Committee on Japanese Yen Interest Rate Index "Discussion on Appropriate Selection and Use of Japanese Yen Interest Index" Summary Report July 2019

LIBOR Scandal

As mentioned previously, LIBOR is not based upon actual deal. Furthermore, Reference Banks doesn’t have any obilgation of dea l on the referencerate that the bank estimated. In 2005 2009, several traders at Reference Banks had manipulated the reference rate for the purpos e of their profit andthis scandal came to light in 2012. As LIBOR is based upon the reference rates, LIBOR was raised doubts as to whether LIBOR has reliability,robustness, and fairness.

Following the discovery of LIBOR scandal, the International Organization of Securities Commissions (IOSCO) published the "Report on the Collection of Principles on Financial Indicators" in July 2013. The content is mainly related to the indicator calculator, but it also has an indirect effect on the data provider, such as the indicator calculator supervising the data provider and requesting the data provider to formulate the Code of Conduct. .. Then, in July 2014, the Financial Stability Board (FSB) published "Reforms of Major Interest Rate Indicators."

Reformimg Major Interest Rate Benchmarks

  1. The reliability and robustness of IBORs, such as LIBOR and TIBIOR, be improved and identify the Risk Free Rate(RFR) that is n ot include risk premium in addtion to IBORs. premium in addition to IBORs.
  2. Realize the appropriate use of reference rate according to financial products and contracts (Multiple Rate Approach ).


Emerged possibility of LIBOR ceasing

In July 2017 amid LIBOR reforming, Andrew Bailey, former head of Financial conduct Authority (Current Governor of BoE), announced FSA will not force reference banks to submit Reference Rate of LIBOR after 2021. This announcement triggered off increasing probability of LI BOR ceasing and each country started to prepare for LIBOR transition.


Major CurrenciesRFR (Risk Free Rate）

Risk Free Rate of Major Currencies
Currency USD CHF GBP EUR JPY
Indentified Risk-Free Rate (RFR) SOFR Secured Overnight Financing Rate SAON Swiss Average Rate Overnight SONIA Sterling Overnight Index Average ESTR Euro Short-Term Rate TONA Tokyo Overnight Average Rate
Collateralized / Uncollateralized collateralized Non-collateralized
Alternative Term Structured Rate of LIBOR Term Rate based upon SOFR Term Rate compound in arrears fixing based upon SARON Term Rate based upon SONIA Term Rate based upon ESTR / EURIBOR TORF = Term Rate based upon TONA / TIBOR
Multiple Rate Approach or NOT Only RFR (NOT) RFR and IBORs
Japanese yen, Euro, Australian dollar, Hong Kong dollar and other currencies will adopt Multiple rate approach, and US dollar, British pound and Swiss franc are unified into RFR because there are no other IBORs.


Preparing to LIBOR cessation

There are two ways to deal LIBOR ceasing :Transition and Fallbacks

In chronological order, transition and fallback will be done as folllows


Fallbacks Concept

As mentioned above, if LIBOR ceased while LIBOR referencing contract continues, Fallbacks process will be required. We explain here fallbacks triggers, fallbacks implementation procedures, and spread adjustment.

Triggers

Given that Fallbacks are in case of LIBOR ceasing, it is necessary to set a Fallbacks triggers that initiate the transition from LIBOR to a new reference rate. Currently, ISDA expects the following examples of triggers

  1. Cessation Trigger : When LIBOR's regulator or publisher announces LIBOR ceasing
  2. Pre cessation trigger : When LIBOR’s regulator finds LIBOR no longer to be capable of being representative
  3. Regulation trigger : When law or regulator proclaims by official document or statement that the use of LIBOR as an interest r ate indicator is prohibited
  4. It is also possible to set your own triggers between counterparty.
  5. On 5 March 2021, FCA issued the announcements and the trigger was activated.

    6. ・The final publishing date for all JPY, CHF, EUR, GBP LIBOR and 1week / 2M USD LIBOR is 31st December 2021.

    ・The final publishing date for O/N, 3M, 6M, and 12M USD LIBOR is 30th June 2023.

    ・All LIBOR except USD LIBOR will become unrepresentative from 1s January 2022, and USD LIBOR will become unrepresentative from 1st July 2023 (Index Cessation Effective Date).

    ・Spread adjustment rates for all LIBOR fallbacks were fixed on 5th March 2021 (Spread Adjustment Date).

  6. These announcements are the "Cessation Trigger" that LIBOR's regulator announces LIBOR ceasing. From these announcements, it can be said that LIBOR will be representative until 31st Dec 2021, also it can be said that FCA stated a clear message that LIBOR will cease.


Fallbacks implementation procedures

Fallbacks implementation procedures are different between transactions or contracts. However, ISDA will introduce a standardi zed fallbacks articles for existing contracts. The following methods are proposed for determining the Successor Rate

Hard wire approach・・Determine the Successor Rate (Fallbacks Rate + spread) when counterparty agree to the fallbacks article.

  1. Since all matters are determined when the Fallbacks article is introduced, there is an advantage that the burden on the parties is small. It is probable that Hardwired approach will be adopted on interest rate swaps.

Corrective approach・・Determine the successor interest rate and how to activate the trigger. There are also measures such as entrusting the decision t o an independent advisor.

  1. The advantage is that the successor interest rate can be determined by the situation at the time of fallback, but there is still a lot of disputed risk.

Spread adjustment

In order to do Fallbacks smoothly, it is necessary to develop the Fallbacks rates that based upon the term RFR.However, as mentioned before, there is a spread between LIBOR and RFR because RFR doesn’t include credit and liquidity risk premium.Therefore, if the Fallbacks rate is set to the Successor rate without adjustment, transfer of value (profit / loss) will occur. It is necessary to adjust the spread to minimize the transfer of value. (Note that it is not possible to completely prevent transfer of value by ad justing the spread.) The following is the formula of Successor rate

Successor rate = Fallbacks rate(RFR) + Spread Adjustment≒LIBOR LIBOR

Fallbacks rate is selected from some options. Regarding spread adjustment method, there are several options: Forward approach   Average and median approach of actual values, and Spot approach.

  Method calculated based on the interest rate difference between the forward rate of LIBOR and the Fallbacks rate at the time of Fallbacks

  Method of calculating based on the mean or median of the difference between LIBOR and Fallbacks rate over the past period

  Method of calculating based on the difference between LIBOR and Fallbacks rate at Fallbacks


For ISDA derivatives, Bloomberg was elected as the fallback calculator, and the medium spread data forpast five years isused for calculation.　Refer to　FBAK & ISDA on Bloomberg. The fallback spread adjustment rates ​​for ISDA derivatives fixed by the trigger activation on 5th March 2021. Following are the spread adjustment rates.

Currency Tenor Spread Adjustment % Ticker
JPY S/N -0.01839% SJY00SN Index
JPY 1Week -0.01981% SJY0001W Index
JPY 1Month -0.02923% SJY0001M Index
JPY 2Months -0.00449% SJY0002M Index
JPY 3Months 0.00835% SJY0003M Index
JPY 6Months 0.05809% SJY0006M Index
JPY 12Months 0.16600% SJY0012M Index
CHF S/N -0.05510% SSF00SN Index
CHF 1Week -0.07050% SSF0001W Index
CHF 1Month -0.05710% SSF0001M Index
CHF 2Months -0.02310% SSF0002M Index
CHF 3Months 0.00310% SSF0003M Index
CHF 6Months 0.07410% SSF0006M Index
CHF 12Months 0.20480% SSF0012M Index
EUR O/N 0.00170% SEE00ON Index
EUR 1Week 0.02430% SEE0001W Index
EUR 1Month 0.04560% SEE0001M Index
EUR 2Months 0.07530% SEE0002M Index
EUR 3Months 0.09620% SEE0003M Index
EUR 6Months 0.15370% SEE0006M Index
EUR 12Months 0.29930% SEE0012M Index
GBP O/N -0.00240% SBP00ON Index
GBP 1Week 0.01680% SBP0001W Index
GBP 1Month 0.03260% SBP0001M Index
GBP 2Months 0.06330% SBP0002M Index
GBP 3Months 0.11930% SBP0003M Index
GBP 6Months 0.27660% SBP0006M Index
GBP 12Months 0.46440% SBP0012M Index
USD O/N 0.00644% SUS00ON Index
USD 1Week 0.03839% SUS0001W Index
USD 1Month 0.11448% SUS0001M Index
USD 2Months 0.18456% SUS0002M Index
USD 3Months 0.26161% SUS0003M Index
USD 6Months 0.42826% SUS0006M Index
USD 12Months 0.71513% SUS0012M Index