Reference interest rates
Reference interest rates are a fundamental component of global financial markets, influencing the characteristics and value of financial and credit instruments for all market participants.
Interbank Offered Rates (IBORs) are the most common money market reference rates, used to represent the level at which banks exchange funds in the short-term unsecured money market. They are currently used to determine interest rates and remuneration for a variety of products.
Since the financial crisis of 2007, there has been a sharp decline in the volume of transactions in the unsecured money markets, resulting in IBORs being determined predominantly through professional judgments of the banks involved in setting these rates. The lack of actual transactions data on which calculate IBORs and the risk of manipulation of the IBOR assessment process have led supervisory authorities and central banks around the world to embark on a process of reforming money market reference rates, with the aim of strengthening their integrity and anchoring them to actual transactions. The reform action presented by the Financial Stability Board (FSB) in 2014, following the mandate received in 2013 from the G20, aims at:
- reform IBORs reference rates, in order to make existing rate calculation methodologies more reliable by linking them to a larger number of transactions and, when this is not possible,
- develop more robust alternative reference rates known as risk free rates or RFRs.
At present, an orderly replacement of existing rates with alternative rates, within the timeframe recommended by the supervisory authorities, is crucial to avoid market distortions and detrimental effects also for bank customers and counterparties. For this reason, it is important that bank customers and counterparties are adequately informed about the reform and the impact it may have on their current and future banking and investment products.
Rates affected by the reform
Euro Inter Bank Offered Rate (EURIBOR)
This is one of the most widely used variable rates in Europe. It is calculated by a group of selected banks and indicates the average interest rate of financial transactions in Euros between the main European banks. It is administered and published by the Europe Money Market Institute (EMMI) for different maturities (one week, one, three, six and twelve months).
In the future, EURIBOR may continue to be used as a reference rate, thanks to the reform implemented in the course of 2019 by which - in order to comply with the provisions of the BMR Regulation – the EMMI has developed a new calculation methodology (so-called "Hybrid Methodology"), according to which EURIBOR is calculated on the basis of the transactions that have actually took place, if these are available, then the interpolation of data on nearby maturities or on the surveys of previous days, finally - if this is still not sufficient - the combination of data observed on other markets and filtered through certain models created for this purpose.
Nevertheless, it is necessary to include fallback clauses in the contracts linked to EURIBOR that would apply, in the future, in the event that EURIBOR ceases to exist or is significantly modified. The purpose of such clauses is to identify the alternative rate that would be applied in the event of the termination or significant changes to EURIBOR, or the criteria to be followed to identify this rate. The ECB recently completed a public consultation aimed at identifying fallback clauses based on the €STR rate (see below for further details on the €STR rate).
EURO OverNight Index Average (EONIA)
This variable reference rate represents the rate for very short-term (overnight) transactions carried out on the European interbank market. In its original formulation, this rate, would not have complied with the European rules set out in the BMR Regulation, due to the scarcity of the underlying transactions and the high concentration of transactions, in terms of volume, in a small number of contributors.
Therefore - with the aim of maintaining EONIA for a transitional period - its calculation methodology was changed as of October 2nd, 2019, as the sum of a new, more robust rate called the euro short-term rate (€STR) and a spread of 8.5 basis points. The €STR is considered the RFR for the Eurozone, is administered by the European Central Bank, and reflects the cost - in euros - of unsecured wholesale funding in the Eurozone. Despite these changes, from January 3rd, 2022, EONIA will no longer be available and only €STR will be published in its place.
Contracts linked to EONIA still outstanding at that date shall contain a fallback clause governing the replacement of EONIA when it is no longer available.
London Interbank Offered Rate (LIBOR)
This is one of the most widely used variable rates at global level and is currently calculated in London by the ICE Benchmark Administrator, on the basis of the values provided by the banks that contribute to the calculation of LIBOR, taking into account their own cost of collecting money on the wholesale market. It is calculated for different maturities (from one day to 12 months) and for five currencies (USD, GBP, EUR, JPY and CHF).
In 2017, the U.K. Financial Conduct Authority ("FCA") stated that it had entered into a voluntary agreement with the panel banks to continue to contribute to the calculation of LIBOR until the end of 2021, after which date, they would no longer be required to provide values to be used in the calculation of that rate. On March 5th, 2021, the FCA announced to the market the dates on which the final termination and loss of representativeness of LIBOR will occur, whereby from December 31st, 2021, LIBOR publication will no longer be guaranteed for almost all currencies, while for certain maturities of USD LIBOR (O/N, 1M, 3M, 6M, 12M) publication will be supported until June 30th, 2023.
In addition, while LIBOR rates will continue to be published until the end of 2021, the Bank of England, the FCA and the Working Group on Sterling Risk-Free Reference Rates expect that all U.K.-based financial institutions will have ceased marketing, by the end of Q1 2021, new LIBOR-linked products whose maturities extend beyond 2021. Notwithstanding these expectations, the Regulators recognise that there are several LIBOR-linked contracts which are particularly difficult to change by the LIBOR end date (so-called tough legacy contracts). A public consultation on the FCA's exercise of powers to continue to publish, on a synthetic basis, GBP LIBOR and JPY LIBOR for a further year after December 31st, 2021, and certain USD LIBOR maturing at 1M, 3M, 6M after June 2023 is expected to be launched soon. In this regard, the FCA added that the methodology used for the purpose of publishing LIBOR on a synthetic basis should correspond to the forward-looking methodology of the corresponding risk-free rates to which a fixed spread adjustment should be added.
In any case, even if a synthetic LIBOR is published, it will not be representative for the purposes of the BMR regulations and cannot be used to sign new contracts.The supervisory authorities, which have worked together with the market to identify these alternative rates known as RFRs (e.g., the so-called SONIA rate, replacing LIBOR in sterling; SOFR rate to replace LIBOR in U.S. dollars) continue to encourage the transition from LIBOR to RFR rates and have also provided guidance to update the contractual models of market participants before the end of 2021. Therefore, to avoid disruptive effects on markets, it is necessary to ensure that LIBOR-linked contracts contain robust fallback clauses that allow for the identification of the applicable RFR at the time of LIBOR’s termination.
What are RFRs
In view of the necessary changes to be made to IBORs rate, various national working groups have been set up with the support of the central banks of the respective countries, with the aim of identifying alternative reference rates and ensuring a smooth transition of IBORs that avoids risks to financial stability.
The possible alternatives for IBORs are called RFRs. They are alternative reference rates that have an active and liquid market as their underlying. They are based exclusively on actual market transactions and are solid and reliable overnight rates that are almost entirely risk-free.
Main differences between IBORs and new RFRs
There are differences between IBORs reference rates, and the new rates designed by working groups that need to be considered.
- While IBORs-linked contracts are characterized by a forward-looking approach, whereby the amount of interest to be collected or paid to costumer is known in advance, RFRs- linked contracts are backward-looking in nature whereby the amount of interest to be paid will only be known at the end of the relevant period, as the calculation is characterized by the average of the relevant overnight rates during that period. This could be problematic for those products (syndicated and bilateral loans, floating rate bonds, swaps) that require the rate to be determined well in advance, for this reason market participants have requested the development of a forward-looking term structure on RFRs that ensures knowledge of the period rate well in advance of the contractual maturity. However, these rates are not currently available in all jurisdictions.
- IBOR benchmark rate levels, as opposed to RFRs, take into account credit and liquidity risk; as a result, interest rates referring to a given transaction may not be the same depending on whether IBORs or RFRs are considered, resulting in the risk of a transfer of economic value between counterparties to a contract due to the IBOR transition. This risk can be mitigated using appropriate mechanisms, such as the application of an adjustment spread to the RFRs to compensate for the difference between the RFRs and the IBOR rate to be replaced.
- The IBORs rates are unsecured, while the various RFRs are both secured and unsecured,
- IBORs rates are also based on expert judgments while RFRs are only based on actual transactions.
- IBOR rates have different maturities while RFRs are overnight only.
Fallback clauses in contracts
Fallback clauses are contractual provisions aimed at mitigating the risk of sudden termination of the contract in the event of permanent unavailability, significant changes, or declaration of non-representativity by a competent authority of one or more reference rates. Contracts with such clauses allow for (i) replacement of the rate that is no longer available with a new rate, when possible, or (ii) establish firm criteria for identifying the new rate.
Although such clauses represent an essential safety net, they are not, and should not be conceived as, the primary mechanism to be used to deal with the transition. As such, the process to be implemented for IBOR transition purposes is to (i) include robust fallback clauses in all new agreements linked to IBOR rates, and (ii) renegotiate existing IBOR agreements in advance, in order to transition to the alternative rates prior to the termination of an IBOR rate, and then without waiting for the activation of a fallback clause. The Mediobanca Group has launched an awareness campaign for the benefit of its clients and counterparties aimed, among other things, at urging, when necessary, the inclusion of such robust fallback clauses in contracts, with the aim of ensuring continuity in commercial relations while helping to mitigate the disruptive effects on the market.
Derivative financial instruments are generally governed worldwide by the rules set forth by the International Swaps and Derivatives Association (ISDA). On October 23rd, 2020, ISDA published the new IBOR Fallback Protocol for existing derivative contracts and the IBOR Fallback Supplement for new contracts, both became effective on January 25th, 2021. Adherence to the ISDA protocols allows participants to include a fallback clause, within new and legacy derivatives contracts, that will be triggered in the event an IBOR becomes permanently unavailable, or in the event of significant changes to that rate.
In addition, ISDA had already published the ISDA Benchmark Supplement Protocol in 2018, with the aim of allowing market participants to incorporate the ISDA Benchmarks Supplement within relevant transactions under existing master contracts. This protocol was published primarily in response to the requirements of the BMR Regulations for certain types of contracts, in order to outline the actions, the parties would take if a benchmark index underwent significant changes or was no longer provided. Mediobanca has adhered to both Protocols and has launched a campaign to urge its counterparties and clients to adhere to them.
What the IBOR transition means for clients
Mediobanca has launched an awareness campaign to help clients understand the effects of the reform. In this context, Mediobanca recommends that its clients:
- understand their risk exposure: conduct a review of existing contract documentation in order to be able to identify references to IBORs or other related benchmarks;
- assess the possible need for liquid instruments in the short term;
- seek external advice (banks, professional associations, external consultants...) to assess the most appropriate actions to take to prepare for the transition; and
- discontinue/decrease exposure to products linked to IBOR rates that are to be discontinued, evaluating as of now if and when to transact in products that refer exclusively to the new RFRs
- Keep abreast of industry developments.
If several products are IBOR-linked, there is a risk of desynchronization, whereby the same transition is not assured for all products. A recurring example is that of a client who has two linked products: a variable-rate loan and a corresponding hedging instrument. If the loan is not transitioned with an RFR in the same manner as the hedge (which tends to be governed by ISDA definitions), there is a risk of a mismatch between the loan and its hedge. In that case, the hedge may not be fully efficient.
The transition may be even more difficult if the investor has several products with different banking or financial institutions. In these cases, it is advisable to discuss with all of them as soon as possible, in order to plan a transition to the new rates.
Mediobanca Group's strategy with respect to the rate reform
The Mediobanca Group complies with the recommendations of the supervisory authorities and continuously updates the fallback clauses in contracts. The Mediobanca Group is also adapting its commercial offering to the progress of the rate reform project, to gradually reduce the offer of products linked to rates whose cessation is certain or highly probable in the coming months. Clients and counterparties of the Mediobanca Group for products linked to IBORs who have not already been contacted will be contacted shortly to assess the effects of the IBOR rate reform on their products.