Market participants can no longer ignore the elephant in the room – that the secular decline in interbank short-term funding poses serious structural risks for unsecured benchmarks, such as LIBOR (the London Interbank Offered Rate) and its relatives (GBP LIBOR, USD LIBOR, Euro LIBOR, CHF LIBOR, JPY LIBOR and EURIBOR/EONIA). Below, we take stock of the current status of IBOR changes, key challenges to the transition for investors, and turning points ahead as we edge ever closer to a world without LIBOR.
How we got here:
The impetus to establish more transparent and robust risk-free reference rates stems from post-crisis concerns about the level of daily transaction volumes in existing interbank funding markets. For example, there are less than $500 million of daily transactions, on average, in a $200 trillion USD LIBOR market. A 2014 white paper released by the Financial Stability Board (FSB) on the reform of interest rate benchmarks spurred global preparations to transition away from IBORs (interbank, quote-based reference rates) to a range of largely transaction-based risk-free rates (RFRs). The transition could affect some $370 trillion worth of derivatives and floating rate securities linked to LIBOR. Add to the existing confusion a set of global regulators with independent, differentiated approaches to the transition and the situation becomes quite a bit messier.
So what are the key challenges facing markets ahead of the transition?
Where are we now?
Working groups have established preferred alternatives for GBP, USD, JPY LIBOR, EURIBOR/EONIA, and CHF LIBOR, and consultations are underway to assess implementation processes for the various jurisdictions.
In the United Kingdom, the Bank of England (BoE) began publishing a reformed version of SONIA (Sterling Overnight Index Average), an unsecured overnight borrowing rate, in 2018, and has chosen it as an alternative to GBP Libor.
Separately, the European Benchmarks Regulation (BMR) will now take effect on January 1st, 2022, and will force EONIA (Euro Overnight Index Average) out of existence, and require EURIBOR (the term rate similar to EUR LIBOR) to be reformed.
In the United States, regulators have identified the SOFR as a preferred alternative for USD LIBOR. The New York Federal Reserve began publishing SOFR in 2018.
Futures for both SOFR and SONIA began trading in 2018. Daily trading of SONIA and SOFR futures and overnight indexed swaps (OIS) will continue, which should promote liquidity in these nascent markets.
The International Swaps and Derivatives Association (ISDA) working group released a final report at the end of 2018 on feedback for the preferred method of converting OTC derivatives to new RFRs on the day of transition. The report showed a preference for a compounded, setting in arrears rate and the use of a historical average for calculating the spread adjustment between LIBOR and the new RFR at transition.
Separately, the BOE has released preliminary results of its consultation on TSRR (Term Sonia Reference Rate), focusing on the GBP LIBOR transition to SONIA. The consultation explores various use cases for a term reference rate in order to address the term structure needs of GBP FRN users.
Regulators have encouraged transition to the use of SONIA for new Sterling denominated bond issuance. In 2018, seven covered bond issuers and Supranational, Sub-sovereign, and Agency (SSA) firms issued Sterling-denominated SONIA FRNs; all were well received by the market, and experienced solid subscription levels. This increased issuance has continued apace this year, with twice as many SONIA-linked bonds issued as last year already. The successful issuance suggests reason for optimism that issuers and investors are working proactively to prepare for the transition. Investors should expect new issuance referencing alternative RFRs to persist going forward.
What will the transition mean for investors?
The Financial Conduct Authority’s (FCA) Andrew Bailey warned market participants that they should wholeheartedly prepare for the discontinuation of LIBOR at the end of 2021, noting that the transition is not merely a ‘black swan event.’ The Governing Council at the European Central Bank will begin publishing the Euro Short-Term rate (€STR), the preferred replacement for EONIA, in October 2019, with the EU BMR now slated to take effect January 1st of 2022, eliminating EONIA and the current form of EURIBOR. The European Money Markets Institute (EMMI) released feedback from a second consultation regarding a reformed hybrid methodology for calculating EURIBOR at the beginning of February – EMMI has noted that it will begin transitioning panel banks to this new methodology before the end of 2019. Given the results of the ISDA consultation on a fallback methodology for OTC derivatives released at the end of 2018, the group must now focus on the implementation of these terms across the IBORs. 
In short, preparations are well underway for IBOR’s termination, but much remains to be decided as we approach the date(s) of transition. While a full picture of the post-IBOR world is not yet fully formed, it is vital that investors continue to track developments of the transition, and engage actively with regulators and market participants – so watch this space for more.