LIBOR Transition: Private Sector

On 5 March 2021, the UK Financial Conduct Authority (FCA) announced that the publication of LIBOR on a representative basis will cease for LIBOR settings as follows:

• For overnight, 1-month, 3-months, 6-months and 12 months US dollar LIBOR settings, immediately after June 30, 2023; and
• For all euro, sterling, Swiss franc and yen LIBOR settings, immediately after December 31, 2021.¹

Euribor is not affected by this announcement.

The International Swaps and Derivatives Association confirmed that the announcement by the FCA will result in the fallback spread adjustment under the IBOR Fallbacks Supplement and the ISDA 2020 IBOR Fallbacks Protocol being fixed at the date of the announcement for all LIBOR settings. When the panels for all US dollar LIBOR settings cease after the end of June 2023, fallbacks for all outstanding derivatives of adhering counterparties will automatically shift to near risk-free rates plus the spread adjustment that has now been fixed.²

On 23 March 2021, the Alternative Reference Rates Committee (ARRC) announced that it will not be in a position to recommend a robust forward-looking Secured Overnight Financing Rate term rate by mid-2021, and that it cannot guarantee that it will be able to do so by the end of 2021. The ARRC encourages all market participants to continue to transition from LIBOR using the tools available now. Read more.

ADB is monitoring market developments and the building of market consensus and is closely coordinating with other multilateral development banks on the reference rate transition.

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In July 2017, the United Kingdom’s Financial Conduct Authority (FCA) announced it will no longer compel banks to submit rates for the London interbank offered rate (LIBOR) beyond 2021, signaling that the survival of LIBOR in its current form “could not and would not be guaranteed”. As a result of this announcement, financial regulators worldwide have been strongly encouraging financial institutions exposed to the LIBOR reference rate to prepare for its replacement before the end of 2021. Across jurisdictions, regulators are promoting national currency-specific alternative reference rates. For United States dollar-denominated loans and securities, the recommended new benchmark is the Secured Overnight Financing Rate.

1 . What is LIBOR?

LIBOR is the most widely used benchmark for short-term interest rates. LIBOR is currently available for five currencies (US dollar, pound sterling, euro, Swiss franc, and yen) and for seven tenors in respect of each currency (overnight or spot next, 1 week, 1 month, 2 months, 3 months, 6 months, and 12 months). Although its origins date back to 1969, it was not formalized until the British Bankers' Association began overseeing the collection and governance of the data nearly 2 decades later. LIBOR has played a critical role in global markets; it has been widely used as a reference rate for financial contracts and as a benchmark to gauge funding costs and investment returns for a broad range of financial products, including adjustable-rate mortgages, credit cards, floating-rate bank loans, and interest rate or cross-currency swaps. It is estimated that globally, more than $300 trillion financial contracts are currently benchmarked on LIBOR.¹

2. What are the issues with LIBOR?

The methodology for calculating LIBOR has remained largely unchanged since it was introduced. Each day, a group of large banks, known as “panel banks”, report their funding rates to the Intercontinental Exchange Benchmark Administration, which took over administering LIBOR in 2014. Those numbers are averaged, adjusted, and released at about 11:55 a.m. London time each business day.

There are two main concerns with this process: first, there has been a significant decline in the sample size for calculating LIBOR since the 2008 financial crisis. In its aftermath, fewer panel banks have been reporting, and those that do, report fewer quotes based on market transactions. Instead, LIBOR has increasingly relied on what the Intercontinental Exchange Benchmark Administration calls "market and transaction data-based expert judgment." Therefore, concerns were raised about how well LIBOR reflects market realities since it is not based on actual market transactions. Second, LIBOR’s reliance on inputs from panel banks opened it to manipulation, and there have been a range of irregularities uncovered by regulators, which have led to large fines for those involved. As a result, global regulatory initiatives have sought to develop alternative reference rates (ARRs). In the United States (US) dollar market, for example, the US Federal Reserve commissioned the Alternative Reference Rates Committee (ARRC) in 2014 to recommend a benchmark interest rate to replace US dollar LIBOR.

3. What is the timeline for phasing out LIBOR?

In July 2017, the FCA, which regulates the administrator of LIBOR, announced that it will no longer compel panel banks to participate in the LIBOR setting process after 2021. On 18 November 2020, the administrator of LIBOR announced consultations on its intention to cease the publication of all settings of GBP, EUR, CHF and JPY LIBOR on 31 December 2021. On 30 November 2020, the administrator announced consultations on its intention to cease the publication of 1 week and 2 months USD LIBOR at the same time, and to cease the publication of overnight and 1 3, 6 and 12 months USD LIBOR on 30 June 2023.

The FCA has indicated that even if LIBOR were to continue beyond 2021, it would have fundamentally changed; and markets for LIBOR-related contracts are likely to be illiquid, and the ability to hedge outstanding LIBOR obligations is likely to be impaired. Therefore, global market participants with LIBOR-linked financial products must prepare to shift to ARRs by 31 December 2021.

4. How is ADB’s private sector operation exposed to LIBOR?

The main private sector lending product is the LIBOR-based loan product. ADB offers its borrowers LIBOR-based loans with a floating rate that has as the cost base rate of 3-month or 6-month LIBOR for US dollar and yen, and 3-month or 6-month Euribor for euro-denominated loans.

5. What benchmarks are available after LIBOR phases out?

For US dollar-denominated loans and securities, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as the new benchmark. It is calculated based on transactions in the US Treasury repurchase market, where banks and investors borrow or lend US Treasury securities overnight. The US Federal Reserve began publishing SOFR in 2018.

SOFR is a broad measure of the cost of borrowing cash overnight collateralized by United States Treasury securities. SOFR is published by the Federal Reserve Bank of New York and is a good representation of general funding conditions in the overnight Treasury repo market. As such, it reflects an economic cost of lending and borrowing relevant to the wide array of market participants active in the market. In terms of the transactions underpinning SOFR, it has the widest coverage of any Treasury repo rate available. The transaction volumes underlying SOFR are far larger than the transactions in any other United States money market and dwarf the volumes underlying London interbank offered rate.

The reference rate used ADB’s loans in euro, the Euro Interbank Offered Rate (Euribor), has been reformed. In July 2019, the reformed Euribor was found to be compliant with the European Union Benchmark Regulations and continues to be used, but the euro LIBOR may cease to be published after 2021. The Euro Short-Term Rate is the new benchmark recommended to replace the Euribor and the euro LIBOR should either reference rate cease. In addition to Europe, Australia and Japan are also pursuing a multiple-rate approach to benchmarks, where reformed reference rates will continue for the foreseeable future alongside the development of recommended ARRs. Notably, across currencies and jurisdictions, regulators promote their own currency-denominated ARRs based on short-term lending, and these vary in composition. Table 1 provides an overview of selected major currencies for which ARRs have been identified and recommended by public and private sector working groups in those jurisdictions.

Table 1: Alternative Reference Rates for Private Sector Loans

Country	LIBOR–IBOR	Alternative Reference Rates	Public or Private Sector Working Groups	Description
United States	US Dollar LIBOR	SOFR	Alternative Reference Rates Committee	Secured rate that covers multiple overnight repurchase market
Japan	JPY LIBOR, TIBOR, and Euroyen TIBOR	TONAR	Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks	Unsecured rate that covers overnight call rate market
Europe	EUR LIBOR and Euribor*	ESTR	Euro RFR Working Group and European Money Markets Institute	Unsecured rate that covers the overnight wholesale deposit transactions

ESTR = euro short-term rate, EUR = euro, Euribor = Euro Interbank Offered Rate, JPY = Japanese yen, LIBOR = London interbank offered rate, SOFR = Secured Overnight Financing Rate, TIBOR = Tokyo Interbank Offered Rate, TONAR = Tokyo Overnight Average Rate, US = United States.

Note: A secured rate is collateralized by funding transactions which serve as security. For example, SOFR is collateralized by funding transactions secured by US Treasury securities. An unsecured rate is not collateralized.

6. What are the key differences between LIBOR and the Secured Overnight Financing Rate?

Although SOFR and LIBOR both reflect short-term borrowing costs, there are key differences. First, SOFR relies entirely on transaction data, whereas LIBOR is based partially on market-data “expert judgment." Second, SOFR is so far only available as a daily rate (i.e., an overnight rate), whereas LIBOR is quoted with varying rates on forward terms of 1 day to 1 year. Finally, LIBOR incorporates a built-in credit-risk component because it represents an uncollateralized cost of borrowing by a bank. In contrast, SOFR represents a risk-free rate because it is based on interbank trades and collateralized by funding transactions secured by US Treasury securities.

Table 2: Key Differences

SOFR	LIBOR
Relies entirely on transaction data from over $700 billion daily repurchase transactions.	Is based partially on market-data and partially on expert judgment.
Measures the cost of collateralized borrowing overnight based on interbank trades and secured by US Treasury securities.	Measures the cost of unsecured borrowing in the interbank market and incorporates a built in credit-risk and liquidity component.
A backward-looking rate, published daily.	A forward-looking rate, published daily, with term rates from 1 day to 1 year.

7. Where can information on SOFR be found?

ARRC publishes materials to explain SOFR and the transition. Below are ARRC best practices and a SOFR starter kit.

SOFR Starter Kit

History and Background

• Background on USD LIBOR
• History of the ARRC and the selection of SOFR

Key Facts About SOFR

• How SOFR works
• SOFR by the numbers
• Common misconceptions of SOFR

SOFR Next Steps

• SOFR best practices
• Recommended fallback language
• The user’s guide to SOFR
• Helpful tools from the ARRC

8. How was Euribor reformed and why was LIBOR not reformed in the same way?

The Euribor is the reference rate that ADB’s uses for its loans in euro. Euribor underwent a reform process over the past few years to reduce the risk of market manipulation and to align with European Union Benchmark Regulation requirements. The governance framework was strengthened, and a hybrid calculation methodology was developed based on a quantitative assessment and panel bank’s judgement. Two public consultations related to the hybrid calculation methodology took place between March 2018 and February 2019, which concluded that the methodology was adequate in terms of market representativeness. In July 2019, the reformed Euribor was found to be compliant with the European Union Benchmark Regulations and will remain to be used.

While LIBOR has undergone several reforms, including moving from a quote-based methodology to a transaction-based methodology, a lack of adequate interbank market activity means it remains at risk of no longer being representative of the market it seeks to measure.

9. What will be the benchmark that will replace JPY LIBOR?

On 18 November 2020, the administrator of LIBOR announced consultations on its intention to cease the publication of all settings of JPY LIBOR on 31 December 2021.The Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks has recommended TONAR replace JPY LIBOR. Japan is pursuing a multi-rate approach to interest rate benchmarks, where reformed TIBOR will continue for the foreseeable future alongside the development of recommended ARRs.

10. How will a suitable ARR for ADB be determined?

The official sector and public and sector working groups in each of the five currencies for which LIBOR is produced have identified and recommended ARRs and are now actively supporting the transition towards their use. The working groups in each of the five currencies for which LIBOR is produced have identified ARRs to replace LIBOR as follows: SOFR for US dollar, SONIA for pound sterling, €STR for euro, SARON (Swiss Average Rate Overnight) for Swiss franc, and TONAR for yen.

The working groups’ support of the transition towards the use of ARRs assists the development of markets and is expected to build liquidity in ARRs. Market consensus on the use of ARRs is still emerging in the loan markets. ADB follows market developments to better understand the building of market consensus, particularly around conventions in the use of SOFR in loans.

There is no certainty that a forward-looking term SOFR will emerge. Communication from the ARRC notes² that: “While it is true that a forward-looking SOFR term rate may be appropriate for a limited set of contracts, the growth in SOFR-linked futures, swaps, and floating-rate debt demonstrates the current viability of using SOFR itself in a wide range of financial contracts. A robust forward-looking term rate requires a deep, active SOFR derivatives market, which requires most financial contracts to reference SOFR itself. It is essential that most financial contracts reference SOFR itself as soon as possible, to develop a forward-looking SOFR term rate, and in turn facilitate a smooth transition. Since March 2020, the New York Fed has been publishing SOFR Averages for several tenors and an index to calculate SOFR rates over custom time periods. These provide a transparent and reliable source that market participants can use to start building new SOFR-linked contracts now. There is currently not sufficient underlying futures activity to support a robust term rate and no assurance that one will be produced ahead of LIBOR becoming unusable.” The ARRC recommends that market participants that can use SOFR should not wait for forward-looking rates to transition away from LIBOR.

Once there is more certainty to the transition path in the loans market, ADB will act in a timely manner and prudently review how best to adopt the new dominant market paradigm.

11. How will ADB cooperate with other multilateral development banks in this area?

ADB and other MDBs have agreed to collaborate and share knowledge and best practices on the reference rate transition. MDBs are committed to working together and sharing information throughout the transition period. While there may be differences in approaches because of the unique characteristics of each organization's loan portfolio, the structure of loan products, and the terms and conditions for reference rate replacements, MDBs will coordinate as much as possible to make the transition process easier and smoother for their borrowers.

¹ For example, A. Bailey in his most recent speech related to Libor referenced that “These are rates which directly impact the cash flows and values of an estimated $400 trillion of financial products globally”. A. Bailey. 2020. Libor: Entering the Endgame. Speech delivered by the Governor of the Bank of England, London and New York. 13 July, 2020
² Common Misconceptions of SOFR – ARRC’s SOFR Starter Kit Part II