Back to IFC's LIBOR Transition
Why is LIBOR being phased out, and when?
LIBOR is the most commonly used interest rate benchmark to price or value a wide range of financial products, including corporate and personal loans, mortgages, bonds, securitizations and derivatives, underlying over $370 trillion of transactions across the globe. LIBOR is calculated based on the average estimates of a group of several banks on the cost of their borrowings in five currencies (USD, EUR, GBP, JPY, and CHF) with seven maturities (between one day and 12 months).
Due to the declining amount of unsecured, wholesale borrowings by banks, LIBOR has increasingly been based on the expert judgment of panel banks, causing the rate to be susceptible to manipulation, an issue that surfaced during the 2008 global financial crisis. Given the fundamental weaknesses of the rate, global regulators and market participants began a process of phasing out the use of LIBOR across all currencies and tenors and identifying appropriate alternative benchmark rates. U.S. Dollar LIBOR (the largest in terms of financial exposure) is expected to be phased out by December 31, 2021.
What are the implications on financial markets of LIBOR
The transition process to phase out LIBOR is continuously evolving and represents a significant change that will impact all participants in financial and capital markets globally. Given the size and structural differences in rates, moving from LIBOR to alternative reference rates is a massive undertaking across capital markets and includes several key elements: new benchmarks must be widely adopted by a variety of participants; technology needs to be upgraded to process products linked to the new benchmark(s); legal teams must amend trillions of dollars of existing contracts tied to LIBOR; and the financial markets need to model structural adjustments to integrate the economics of the new rate.
are the key regulatory bodies stewarding LIBOR transition in the market?
The UK Financial Conduct Authority (FCA), currently regulates and oversees LIBOR. To address LIBOR’s shortfalls as a funding cost benchmark for global financial markets, it has announced that it will no longer compel the LIBOR panel banks to make LIBOR submissions beyond the end of 2021.
For the U.S. Dollar LIBOR market, the determination of an alternative benchmark rate is being led by the Alternative Reference
Rates Committee (ARRC). The ARRC is comprised of private market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York.
For derivatives markets, the
International Swaps and Derivatives Association (ISDA) was mandated by the Financial Stability Board (FSB), a consortium of national and international regulators, to remediate the derivatives contracts with adequate fallback provisions, select the fallback rates and mechanisms, draft amendments to the 2006 ISDA Definitions, and develop a plan to amend legacy contracts referencing LIBOR.
For the syndicated loans market, the Loan Market
Association (LMA), a trade association for the Europe, Middle East and Africa region, is working with the market participants, other trade associations, and regulators to represent the interests of the syndicated loan market, developing key compounding conventions and standard documentation for risk-free rate referencing transactions.
U.S. Dollar LIBOR Replacement
are the implications on the cash products market, including bilateral and
In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the rate to represent best practices in U.S. Dollar derivatives and financial markets. SOFR is based on observable repo rates, or the cost of borrowing cash overnight collateralized by US Treasury securities.
LIBOR and SOFR are not economic equivalents. LIBOR has a term structure, is an unsecured rate, and contains a credit premium, representing the credit risk inherent in interbank lending. SOFR, on the other hand, is an overnight and secured, and almost risk-free rate. There is a clear understanding among market participants, including IFC, that the impact of the LIBOR transition should not involve (or should minimize, to the extent possible) any transfer of economic value between lenders and borrowers in a transaction, and therefore, the credit spread over LIBOR is not intended to be changed. However, certain underlying spread adjustments may be required to reflect both the term nature and interbank lending risk characteristics of LIBOR. See below:
- Absence of term structure can be addressed, in part, by calculating term rates from derivatives on overnight risk-free reference rates. The robustness of such rates will depend on having liquidity in the underlying markets, which still do not have sufficient depth for a term structure. In the meantime, to address the deficiencies in tenor, ISDA has endorsed two methodologies: “compounded setting in arrears” or “average setting in arrears.” For the loan market, this is also a possible solution, even though predominant market practice is yet to be determined (i.e. the rate to be used until a “term SOFR” develops).
- Adjustment Spread: a spread is expected to be added to the new base rate to capture the difference between LIBOR, which reflects credit risk on an interbank lending basis, and the successor rate (an almost risk-free rate).
With regards to implementation of LIBOR transition, following consultations, ARRC published its recommendations on U.S. Dollar LIBOR fallback language for syndicated and bilateral business loans, covering three main parameters:
- Triggers: Circumstances that would result in the reference benchmark rate being replaced;
- Benchmark replacement rate: Identifying the rate, or waterfall of rates, that will replace current benchmark;
- Spread adjustment: Spread added to replacement rate to account for difference with current rate.
Under its overall approach to the LIBOR transition, IFC has adopted ARRC’s recommendations in the process of designing the fallback mechanism and implementation of a new benchmark rate.
have been recent market developments and their impact of COVID-19 on the LIBOR
phase out timeline?
Extreme volatility in markets in response to the coronavirus pandemic has reinforced the need to discontinue the use of LIBOR interest rate benchmark by the end of 2021. During rocky markets, as was the case in March 2020, LIBOR rose even though the Bank of England and the Federal Reserve cut interest rates. Outflows from money market funds were a key driver of frictions in markets underpinning LIBOR, leading to the rise in LIBOR rates amid poor liquidity.
The COVID-19 fallout had two primary consequences for financial markets that reference LIBOR as a benchmark:
- Market volatility and the decoupling of LIBOR from alternative benchmarks have focused attention on the adjustment spread;
- Institutions have understandably shifted their resources to maintaining business continuity and mitigating market risk in the near term, raising questions about need to adjust key LIBOR transition milestones.
The FCA and FSB have confirmed that the ultimate timing of the LIBOR transition has not changed and should remain the target date for all firms to meet. At the end of 2021, LIBOR panel banks will not be compelled to continue making LIBOR submissions and firms will not be able to rely on LIBOR being published after the end of 2021.
IFC’s LIBOR Transition
- Implementation of new
benchmark rate in new loan documentation
While IFC expects markets will begin using a SOFR-based loan following the discontinuation of LIBOR, the details of how the rate will be calculated and applied was still not clear at the time of writing. In order to ensure that there is always a rate to reference in the loan agreement, IFC and other lenders also require a final fallback rate that may apply, if needed, until the time when an agreement between the parties has been reached.
IFC is monitoring market developments and working toward a smooth transition to a successor benchmark rate. IFC is collaborating with partners—particularly with other multilateral development banks and development finance institutions—to track industry announcements and identify best practices, including fallback language that would be used for bilateral and multilateral transactions to address the transition away from LIBOR.
As part of this process, IFC has adopted fallback language to address the replacement of LIBOR with a successor benchmark rate that it is already incorporating into new loans. This language represents the first step of implementing the
replacement benchmark, and reflects approaches recommended by the ARRC and the LMA, including potential trigger events signifying the end of LIBOR as a liquid lending benchmark. The occurrence of such trigger events would then initiate a second step of implementing the replacement benchmark. This further step would require IFC to propose specific loan amendments to incorporate the new benchmark and make other conforming changes to the loan to reflect appropriate data sources, calculation periods, and payment dates required by the new benchmark, as determined at the time.
of new benchmark rate in existing loan documentation
For existing clients where IFC has invested with LIBOR benchmarked products, IFC is planning to complete the transition also using a two-step
approach – first, by amending the legal agreements to implement the fallback language; and second, inserting the replacement benchmark in the legal agreement following a trigger event defined under the fallback language. IFC has set-up a centralized Core Team responsible for directly executing such amendments for all investments in IFC’s portfolio. The first step is likely to take place in the second half of 2020, potentially extending to early 2021, while the timing of the second step depends on the timing of the aforementioned trigger events.
of new benchmark rate in multi-lender projects
In transactions involving multiple
lenders, investors, and/or IFC Loan participants, IFC will coordinate, where
appropriate and to the extent possible, a fallback mechanism to ensure that all
such lending parties can identify and accommodate a replacement interest rate
for the loan following the discontinuation of LIBOR.
- Basis risk
inherent for loans with related hedging products
All LIBOR-based loans and hedging transactions between IFC and its clients will respectively transition to a new benchmark. As described above, the transition is likely to be based on SOFR. Given the varying groups involved and the timing of progress, it is not yet possible to determine whether the transition will result in the development of derivative and loan products with fundamentally similar characteristics, as is currently the case, or whether divergences emerge between LIBOR-based derivatives and loan products. By way of example currently the derivatives market participants, acting largely through ISDA, are more advanced than ARRC and other loan market industry groups. Currently the groups are contemplating differing timing related adjustments to address the differences between LIBOR and SOFR. The groups communicate and may converge. Or differences may remain.
Consequently, following LIBOR discontinuation, it may not be possible to adjust transactions hedging LIBOR-based loan products to match the terms of the related variable rate dollar loan. For IFC clients, this means there is the potential for a mismatch and some degree of resulting
basis risk associated with differences between the structure of loans and related hedging. IFC is closely monitoring developments
both in the derivatives and loan markets.
By way of illustration: At the time of writing derivatives market participants, acting largely through ISDA are more advanced than ARRC and other loan market industry groups. ISDA participants are expected to replace LIBOR with a compounded SOFR rate to which an “adjustment spread” will be added to address differences between LIBOR and SOFR. While ISDA continues to consult market participants regarding the evolution of SOFR-based derivatives products, discussions are currently focused on a product with a “two-day
backward shift”. SOFR would be compounded during a calculation period, with the observation of SOFR rates during the relevant period occurring two days prior to a payment date. Related discussions led by the ARRC and other loan market industry groups are less advanced. Consequently, the groups may not converge on overlapping adjustments to the rate (e.g. there are discussions that suggest standardizing loan practices to involve a five-day backward shift and to adopt interest accrual periods).
Last updated: August 27, 2020