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”) have been 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 IBOR 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 reliable and, where not possible, to develop more robust alternative reference rates, known as risk free rates or RFRs.
Over the last few years, market authorities recommended the replacement of some IBORs (LIBOR, EONIA) with RFRs. An orderly transition within the timeframe recommended by the market authorities is crucial to avoid market distortions and detrimental effects also for bank clients and counterparties. For this reason, it is important that clients and counterparties 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.
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 are €STR, SONIA, SOFR, SARON e TONA and have been determined by national and international working groups, with the cooperation of the central banks of the relevant countries:
- for €STR, European Central Bank (Working Group on Euro Risk-Free Rates)
- for SONIA, Bank of England (Working Group on Sterling Risk-Free Rates)
- for SOFR, Federal Reserve (Alternative Reference Rate Committee)
- for SARON, Swiss National Bank (The National Working Group on Swiss Franc Reference Rates)
- for TONA, Bank of Japan (The Study Group on Risk-Free Reference Rates)
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 and, in some cases, obtained the development of a forward-looking term structure on RFRs that ensures knowledge of the period rate well in advance of the contractual maturity;
- 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 the difference between the RFRs and the IBORs rates to be replaced;
- The 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;
- IBOR 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 euros - 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 Benchmark Regulation (EU) 2016/1011 ("Benchmark Regulation") - by developing a new calculation methodology, defined hybrid, according to which EURIBOR is calculated on the basis of:
- the transactions that have actually took 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 is no longer available. Only €STR it is published in its place.
The European Commission, with the Implementing Regulation 2021/1848 of October 21st, 2021, established, for EONIA-linked contracts which as of January 3rd, 2022 did not have fallback clauses or did not have robust fallback clauses (es., covering the permanent cessation of EONIA), a statutory replacement of EONIA with €STR plus a fixed spread adjustment of 8.5 basis points. The statutory replacement did not affect contracts that have been successfully renegotiated by January 3rd, 2022 to cater for the cessation of EONIA.
London Interbank Offered Rate (LIBOR)
What is LIBOR
LIBOR has been one of the most widely used variable rates at global level, 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 12 months) and for five currencies (USD, GBP, EUR, JPY and CHF).
On March 5th, 2021, the Financial Conduct Authority ("FCA") announced to the market the dates on which the cessation of LIBOR would have taken place (31 December 2021 for all LIBORs, excluding some maturities of LIBOR USD). Therefore, as of January 1st, 2022, LIBOR (for all maturities and currencies, except USD LIBOR (o/n, 1month, 3 months, 6 months, 12 months)) has no longer been available.
Even though the USD LIBOR (o/n, 1 month, 3 months, 6 months, 12 months) will continue to be published until 30 June 2023, the FCA discouraged supervised entities (including banks) from entering into new USD LIBOR-linked contracts after 31 December 2021.
However, in order to deal with the risk that many LIBOR-linked contracts concluded before the end of 2021 (so-called legacy contracts) might not be amended in time, the FCA has also decided that a synthetic USD LIBOR (1, 3 and 6 months) shall be published until 30 September 2024.
As regards the synthetic JPY LIBOR and GBP LIBOR, on the other hand, the FCA announced the discontinuation of the former on 31 December 2022 and extended the publication of a synthetic 3-month GBP LIBOR until 30 March 2024. The methodology used for the purpose of publishing LIBOR on a synthetic basis corresponds to the forward-looking methodology of the corresponding risk-free rates to which a fixed spread adjustment should be added. Synthetic LIBORs are not considered representative for the purposes of the Benchmark Regulation; therefore they can be used only for contracts entered into before the LIBORs cessation dates (e.g. January 1st, 2022 for GBP LIBOR and July 1st, 2023 for USD LIBOR).
LIBOR and SOFR
USD LIBOR (o/n, 1 month, 3 months, 6 months, 12 months) will cease to be published on 30 June 2023, in order to allow legacy contracts to reach maturity.
Nonetheless, on November 2021 the FCA, supported by the Federal Reserve Board, discouraged to supervised entities (including banks) not to enter into any new contracts linked to USD LIBOR after 31 December 2021, subject to certain exceptions.
Under the guide of the Federal Reserve Bank of New York ("FED"), banks and other private entities formed a committee with the task of identifying a successor to the USD LIBOR. As a result, the Alternative Reference Rate Committee ("ARRC") has been formed and it identified the Secured Overnight Financing Rate ("SOFR") as the replacement rate for USD LIBOR. SOFR measures the cost of borrowing cash overnight in the United States Treasury securities repo market and is administered, calculated and published by the Fed in collaboration with the U.S. Office of Financial Research (OFR) since April 2018. Furthermore, in order to support the transition from USD LIBOR, the ARRC has recommended, for certain products, the use of the methodology to use, such as:
- CME TERM SOFR: a term rate based on SOFR and calculated using a forward-looking methodology. The CME TERM SOFR is provided and calculated by CME Group Benchmark Administration Limited for 1, 3, 6 and 12 month maturities and is published at 06:00 (New York time) on each business day in the United States.
- SOFR Average: which is a compounded average of the daily SOFR rate calculated using a backward-looking methodology over specified time periods (i.e. 30, 90 and 180 days prior). The SOFR Average is calculated by the Fed and is published shortly after the SOFR, at approximately 08:00 (New York time) on each business day in the United States.
Amendment of LIBOR-linked contracts
In order to avoid disruptive effects on markets, markets participant have conducted campaigns to increase awareness among clients and counterparties to modify existing LIBOR-linked contracts and have modified contracts standards in order to contain robust fallback clauses that allow for the identification of the applicable RFR at the time of LIBOR’s cessation.
Only for those contracts linked to CHF LIBOR, which did not include fallbacks on December 31st, 2021, the European Commission has provided, with the Implementing Regulation (EU) 2021/1847 of 14 October 2021, a statutory replacement of CHF LIBOR with the RFR denominated SARON compounded, plus a fixed spread adjustment calculated in accordance with the Regulation.
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 Benchmark Regulations; 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 IBOR transition purposes is to (i) include robust fallback clauses in all new agreements linked to IBOR 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 Benchmark 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 IBOR 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 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 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's strategy with respect to the rate reform
Mediobanca complies with the recommendations of the market authorities and continuously updates the fallback clauses in contracts.
Mediobanca has also:
- carried out a campaign to raise awareness among clients and counterparties in order to change the terms and conditions of products linked to discontinued IBORs; and
- adapted its commercial offering limiting the offer of products linked to discontinued rates only where permitted by applicable regulations.
Clients and counterparties may in any case reach out their contact persons at Mediobanca to obtain information on the rate reform and its effects on their products.
Mediobanca has robust written plans ("Contingency Plans") to be triggered in the event of cessation or significant changes in the benchmarks used by Mediobanca to determine the value, yield or coupons, of products for counterparties and clients. Such reference indices include both the benchmark interest rates (EURIBOR, LIBOR, EONIA), whose ongoing reform is illustrated here, and other reference indices (e.g., equity indices such as S&P500 or FTSE MIB).
What are Contingency Plans
Pursuant to article 28(2) of the Benchmarks Regulation (EU) 2016/1011 (“Benchmarks Regulation”) Mediobanca draws up and maintains Contingency Plans to be triggered in event of cessation or significant changes of one or several benchmarks (cessation or substantial changes of one or more benchmark indices is defined, for the purposes of this description, as a "Benchmark Event").
The content of Mediobanca’s Contingency Plans
The Contingency Plans set out the procedures that the Bank implements in case of a Benchmark Event; where feasible and appropriate, the Plan indicates one or several alternative benchmarks that could be referenced to replace the one that is to be ceased or undergo significant changes (significant changes may be, for example, those that significantly alter the way in which the reference index is calculated) indicating the reasons why they are a viable alternative.
Following a cessation or material change of one or several benchmarks, Mediobanca will take the following steps:
- performs a qualitative assessment to determine the impact of the Benchmark Event on exposures and the number of contracts, clients and transactions affected;
- considers, if not already identified, a feasible and suitable alternative benchmark for existing financial instruments and contracts consulting the administrator of the benchmark due to cease or be significantly changed;
- defines a precise timeline and related milestones for the transition to the alternative benchmark supporting, where possible, an orderly transition;
- informs clients and counterparties of the Benchmark Event and the replacement by the alternative benchmark, providing them contact details if any questions arise;
- reflects, where possible, changes in relevant contractual relationships to which the ceased or modified benchmark refers.
When assessing alternative benchmarks, Mediobanca will refer to change and cessation policy published by the administrator of the benchmark that is to be ceased or undergo significant changes. In the event that the alternative benchmark identified prior to the occurrence of a Benchmark Event is subsequently found to be inadequate the Bank, on its own or – where possible - through a calculation agent, will refer to the alternative benchmark indicated by the competent authorities, including Central Banks, Working Group liable to manage the Benchmark Event or monetary authorities.
When selecting the alternative benchmark, the Bank will consider the following factors:
- compliance of the alternative benchmark with the requirements of the Benchmarks Regulation and suitability in measuring the underlying interest;
- presence on the register maintained by the European Securities and Markets Authority (“ESMA”) or provision of the benchmark by EU administrators approved by ESMA and listed in the register kept by ESMA;
- guidance and definitions provided by professional associations (e.g., ISDA, ICMA or LMA), where possible and appropriate;
- market practices, if any;
- ability to implement the replacement of existing indices by alternative ones without undue delay;
- compliance with the characteristics of existing instruments linked to the benchmarks to be replaced.