Back to IFC's LIBOR Transition
What is LIBOR?
LIBOR, or the London Inter Bank Offer Rate, is the most widely 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 by a group of banks of the cost of their borrowings in five currencies (U.S. dollar, euro, British pound sterling, Japanese yen, and Swiss franc) with seven maturities (between one day and 12 months).
Why is LIBOR being
phased out and when?
With LIBOR based on estimates quoted by a panel of banks, the rate has become susceptible to manipulation. This issue surfaced during the 2008 global financial crisis and was exacerbated by a reduction in intrabank lending. Given the fundamental weaknesses of the rate, global regulators and market participants began a process of phasing out LIBOR across all currencies and tenors and identifying appropriate alternative benchmark rates. LIBOR will be phased out across all currencies and tenors between Dec. 31, 2021, and June 30, 2023. (For ongoing updates, please go to this link.)
What are the
implications on financial markets of LIBOR phasing out?
Given the quantum of financial products that use LIBOR, phasing out LIBOR has a significant impact on all participants in financial and capital markets globally.
Moving from LIBOR to alternative reference rates (ARRs) is a massive undertaking across capital markets and includes several key elements:
- new benchmarks must be widely adopted by a variety of participants;
- technology must 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
- financial markets must model structural adjustments to integrate the economics of the new rate.
What are the key regulatory bodies stewarding LIBOR transition in the market?
The UK Financial Conduct Authority (FCA) regulates and oversees LIBOR. To address LIBOR’s shortfalls as a funding cost benchmark for global financial markets, it announced that it will not compel LIBOR panel banks to make submissions for three-month and six-month LIBOR beyond the end of June 2023.
For the U.S. dollar LIBOR market, the Alternative Reference Rates Committee (ARRC) is determining an alternative benchmark rate. 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 draft fallback provisions, select the fallback rates and mechanisms for the 2006 ISDA Definitions, and develop a plan to amend legacy contracts referencing LIBOR. ISDA published these proposed fallback provisions, fallback rates, mechanisms, and draft amendments on Oct. 23, 2020, in the IBOR Fallbacks
Supplement and IBOR Fallbacks Protocol.
For the syndicated loan market, the Loan Market Association (LMA), a trade association for the Europe, Middle East, and Africa region, works with 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
What is the replacement for U.S. dollar LIBOR? 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 U.S. Treasury securities.
What are the implications on the cash products market, including bilateral and syndicated
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, secured, and almost risk-free rate. Market participants, including IFC, clearly understand LIBOR transition should not involve – or at least minimize – any transfer of economic value between lenders and borrowers in a transaction. Thus, the credit spread over LIBOR is not intended to change. However, certain underlying spread adjustments may be required to reflect both the term nature and interbank lending risk characteristics of LIBOR.
- 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 the level of liquidity in the underlying markets, which today do not have sufficient depth for a term structure.
- Adjustment Spread is expected to be added to the new SOFR 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).
Following consultations on the LIBOR transition, ARRC published recommendations on U.S. dollar LIBOR fallback language for syndicated and bilateral business loans, covering three main parameters:
- Triggers: Circumstances that would trigger the replacement of the reference benchmark rate;
- Benchmark replacement rate: The rate, or waterfall of rates, that will replace the current benchmark;
- Spread adjustment: Spread added to the replacement rate to account for difference with current rate.
In its LIBOR transition, IFC has adopted ARRC’s recommendations within our process of designing the fallback mechanism and implementation of a new benchmark rate.
IFC’s LIBOR Transition
- Implementation of new benchmark
rate in new loan documentation
On Dec. 1, 2020, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation
issued a statement, strongly recommending the cessation of issuing any new LIBOR-based contract including loans after Dec. 31, 2021.
Consequently, IFC is preparing to shift to offering SOFR-based loans in 2021 with a complete switch over starting January 2022. IFC will update its website regularly with developments, including when SOFR-based loans are available to borrowers.
IFC is monitoring market developments and working toward a smooth transition to a successor benchmark rate, and it is collaborating with partners, particularly with other multilateral development banks and development finance institutions, to track industry announcements and identify best practices, including model fallback language.
As part of this process, IFC is incorporating fallback language to ensure there is a mechanism to replace LIBOR with a successor benchmark rate. This language reflects approaches recommended by the ARRC and the LMA, including potential trigger events signifying the end of LIBOR as a liquid-lending benchmark. When trigger events have occurred and replacement benchmarks have been defined.
of the replacement benchmark rate after the trigger event for the cessation of
On March 5, 2021, FCA announced the dates that panel bank submissions for all LIBOR settings will cease, after which representative LIBOR rates will no longer be available. The dates for different currencies and tenors are:
- Dec. 31, 2021, for all pound sterling, euro, Swiss franc and Japanese yen settings, and the one-week and two-month U.S. dollar settings
- June 30, 2023, for all other U.S. dollar settings
Subsequent to the trigger event, IFC will 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 at the appropriate time. This provides IFC and its borrowers assurance that a process is in place for continuity.
- Implementation of new benchmark rate in existing loan documentation
For existing LIBOR transactions, IFC expects to complete the transition using a two-step approach: firstly, by amending the legal agreements to implement the fallback language, and secondly, by inserting the replacement benchmark in the legal agreement after such rate has been determined.
- Implementation of new benchmark rate in multi-lender projects
IFC expects to implement this fallback language in transactions involving multiple lenders, investors, and/or IFC loan participants.
- Basis risk inherent for loans
with related hedging products
IFC offers client risk management swaps to loan clients, helping clients manage their interest rate risks and foreign currency risks by synthetically converting their underlying floating rate U.S. dollar loans to fixed rate U.S. dollar loans or converting U.S. dollar loans to local currency loans. IFC will strive to offer the SOFR structure for overlay swaps and underlying floating rate U.S. dollar loans (to the extent these are IFC’s own loans).
As the loan market and derivative market move into different SOFR compounding methodologies, IFC is working on pricing, modelling, and hedging solutions to minimize interest rate mismatch between loans vs. funding and the SOFR swaps.
Eventually all U.S. dollar LIBOR-based loans and hedging transactions between IFC and its clients will transition to 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 identical terms, as is currently the case in a LIBOR world, or whether divergences between LIBOR-based derivatives and loan products emerge.
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 in the derivatives and loan markets to gauge the ongoing potential for this basis risk.
IFC will continue to update systems, develop valuation models, identify exposures in legal agreements, and prepare to negotiate LIBOR’s replacement, with the goal of crafting a seamless transition from LIBOR.
Last updated: February 5, 2021