Reference interest rates
Reference interest rates (“reference rates” or “benchmarks”) are a fundamental component of global financial markets, influencing the characteristics and value of financial and credit instruments for all market participants. They are currently used to determine interest rates and remuneration for a variety of products, including derivatives contracts, floating rate bonds, deposits, loans and securitised products.
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, with different tenors.
Since the financial crisis of 2007, there has been an evolution in the way banks have financed their market operations, leading to a decline in the volume of (unsecured) money market transactions.
The lack of effective transactions data, on which calculate IBORs, and the risk of manipulation of the IBORs assessment process led, starting from 2013, supranational and sector authorities, such as the Financial Stability Board (“FSB”) and the International Organization of Securities Commissions (“IOSCO”), to embark on a process of reforming money market reference rates, with the aim of making them more robust and reliable.
In 2014, the FSB issued recommendations, based on the principles published by IOSCO in the previous year, to strengthen IBORs by anchoring them to effective transactions and, where not possible, to develop more robust alternative reference rates, known as risk free rates or RFRs.
Alternative Reference Rates or Risk -free rates (RFRs)
What are RFRs
RFRs are overnight rates that are almost entirely risk-free as they are based exclusively on actual market transactions in an active and liquid market. They are considered highly resilient to stress periods and market developments and difficult to manipulate.
The RFRs have been determined by national and international working groups, with the cooperation of the central banks of the relevant countries:
- European Central Bank (Working Group on Euro Risk-Free Rates) https://www.ecb.europa.eu/paym/interest_rate_benchmarks/WG_euro_risk-free_rates/html/index.en.html
- Bank of England (Working Group on Sterling Risk-Rree Rates)
- Federal Reserve (Alternative Reference Rate Committee)
- Swiss National Bank (The National Working Group on Swiss Franc Reference Rates)
- Bank of Japan (The Study Group on Risk-Free Reference Rates)
Competent authorities recommend the replacement of some IBORs (LIBOR, EONIA) with RFRs. An orderly transition within the timeframe recommended by the competent authorities is crucial to avoid market distortions and detrimental effects also for bank customers and counterparties. For this reason, it is important that these entities are adequately informed about the reform of IBORs, the nature of RFRs and the impacts that transition may have on their current and future banking and investment products.
Main differences between IBORs and new RFRs
There are differences between IBORs and RFRs 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 characteristic could be complex 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;
- IBORs 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 IBORS transition. This risk can be mitigated using appropriate mechanisms, such as the application of an adjustment spread to the RFRs to compensate the difference between the RFRs and the IBORs rates to be replaced;
- IBORs rates are unsecured, while the various RFRs are both secured and unsecured;
- IBORs rates are based on expert judgments while RFRs are only based on actual transactions;
- IBORs rates have different maturities while RFRs are overnight only.
Rates affected by the reform
EURO Inter Bank Offered Rate (EURIBOR)
What is EURIBOR?
EURIBOR 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 euro - between the main European banks. It is administered and published by the Europe Money Market Institute (“EMMI”) for different maturities (1w, 1M, 3M, 6M and 12M).
In 2019, the EMMI implemented a reform of EURIBOR - in order to comply with the provisions of the Benchmarks Regulation (EU) 2016/1011 ("Benchmarks Regulation") - by developing a new calculation methodology defined hybrid, according to which EURIBOR is calculated on the basis of:
- the transactions that have actually taken place, if these are available and sufficient; or
- the interpolation of data on nearby maturities or on the surveys of previous days, if these are available and sufficient; or, finally
- the combination of data observed on other markets and filtered through certain models created for this purpose.
Thanks to these adjustments, EURIBOR can continue to be used as a reference rate in the future and, for the time being, no date is given for EURIBOR cessation.
Notwithstanding the reform implemented, it is necessary to include fallback clauses in 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 European Central Bank (“ECB”) recommends, as an alternative rate to EURIBOR to be reflected in fallback clauses, a new, more robust, rate called the euro short-term rate ("€STR"), calculated and published by the ECB as of October 2nd, 2019. The €STR is considered the RFR for the Eurozone, is administered by the ECB, and reflects the cost - in euros - of unsecured wholesale funding in the Eurozone.
Euro OverNight Index Average (EONIA)
What is EONIA?
EONIA is the variable reference rate used in 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 Benchmark 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 €STR and an adjustment spread of 8.5 basis points. 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)
What is LIBOR
LIBOR 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 1d to 12M) 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 of LIBOR will occur. Therefore, 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.
Furthermore, 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 are continuously encouraging market participants to cease using these rates for new contracts whose maturities extend beyond the end of 2021. Notwithstanding these expectations, the Regulators recognise that there are several LIBOR-linked contracts, so-called tough legacy contracts, which are particularly difficult to switch by the LIBOR end date. On June 23rd, 2021, the FCA launched a public consultation on the exercise of its 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. 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 Benchmarks Regulation and cannot be used to sign new contracts.
The competent 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 RFRs and have also provided guidance to update the contractual models of market participants before the end of 2021.
In order 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 cessation.
Fallback clauses in contracts
What are fallback clauses
Fallback clauses are contractual provisions aimed at mitigating the risk of sudden termination of the contract in the event of permanent cessation, significant changes by a competent authority of one or more reference rates. Contracts with such clauses:
- allow for replacement of the rate that is no longer available with a new rate, when possible; or
- establish firm criteria for identifying the new rate.
The content of the fallback clauses
The fallback clauses included in contracts take into account robust written plans ("Contingency Plans") that European Banks are required to have pursuant to Article 28(2) of the Benchmarks Regulation; a summary of these plans adopted by Mediobanca is available here.
IBORs replacement and fallback clauses
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 IBORs transition purposes is to (i) include robust fallback clauses in all new agreements linked to IBORs rates, and (ii) renegotiate existing IBORs 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.
Mediobanca 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 allow 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.
Furthermore, 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 Benchmarks Regulation for certain types of contracts, in order to outline the actions, the parties would take if a benchmark 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 IBORs transition means for clients and counterparties
Mediobanca has launched an awareness campaign to help clients understand the effects of the reform. In this context, Mediobanca invites its clients and counterparties to:
- 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 to assess the most appropriate actions to take to prepare for the transition; and
- discontinue/decrease exposure to products linked to IBORs that are due to be discontinued, evaluating as of now if and when to switch to products that refer exclusively to the new RFRs;
- keep abreast of industry developments.
If several products are IBORs-linked, there is a risk of desynchronisation, 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 hedging (which tends to be governed by ISDA definitions), there is a risk of a mismatch between the loan and its hedging. In that case, the hedging 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, clients and counterparties are encouraged to discuss with all such institutions as soon as possible, in order to establish their planning for an orderly transition to the new rates.
Mediobanca Group's strategy with respect to the rate reform
The Mediobanca Group complies with the recommendations of the competent 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 IBORs reform on their products. Clients and counterparties may in any case reach out their contact persons at Mediobanca Group to obtain information on the rate reform and its effects on their products.