Replacing LIBOR: Transitioning to Risk-Free Rates

Brexit has effectively sealed the fate of LIBOR. The transition to global risk-free rates promises to be more taxing than most organizations are anticipating

Brian Dunton, Head of Instrument Engineering, Eagle Investment Systems

LIBOR, the most referenced interest rate benchmark in the world, is due to be phased out starting in 2021. The 2012 LIBOR scandal – in which benchmark rates were manipulated by rogue bankers to benefit their derivatives-trading operations – has resulted in a move toward risk-free rates (RFR). The momentum behind this has only become more acute as financial institutions get their arms around the impact of Brexit.

LIBOR, for the uninitiated, refers to the London inter-bank offered rate and is calculated using appraisals from leading financial institutions in which the banks estimate how much they would be charged to borrow from peer institutions. Risk-free rates, alternatively, are generally calculated as the weighted average rate from actual overnight lending between banks. Given the potential for manipulation, inter-bank offered rates are expected to gradually be replaced by global RFRs. For historical context, the LIBOR benchmark has long been used to calculate financing on swaps, bonds, mortgage-backed securities, bank loans and a host of other financial instruments. The expectation is that deals will start to gravitate toward published risk-free rates. While it sounds seamless, replacing the benchmark with a different index to calculate financing accruals is far more complex than it may appear at first blush.

Consider, for instance, that a vanilla interest rate swap would historically represent a fixed rate versus a floating interest rate hedge based upon the current LIBOR rate. Other economic indicators, such as the yield curve, are also generally factored in at the time that the deal was struck. While one leg would remain fixed throughout the life of the deal, the other would reset at each payment period. Different tenors of LIBOR were published and used to calculate swap financing fees for each period.

This will likely be changing. Overnight Index Swaps (OIS), for instance, have started accruing financing fees based on overnight rates such as the Fed Funds Rate, Sterling Overnight Index Average (SONIA), Euro Overnight Index Average (EONIA), and a host of other risk-free rates. Over the past year, the Secured Overnight Financing Rate (SOFR) – a measure of actual lending rates between banks – was introduced by the New York Federal Reserve. Over time, the expectation is that SOFR will overtake the Fed Funds Rate as the major US risk-free rate. Uncertainty still exists, but at this time it does not appear that SOFR will be offered in various tenors (as was the case for LIBOR). This means that financing fees on many instruments will now be calculated based on a daily resetting rate with a compounding component.

Additional uncertainty related to current deals also exists. Contracts will surely need to be renegotiated if the underlying benchmark changes. Transition possibilities range from a gradual phase-out to a full-fledged “big bang” conversion.

The International Swaps and Derivatives Association (ISDA) defines the formulas to accrue correctly on risk-free rates. But even with a playbook, challenges will emerge. Firms cannot simply source the risk-free rate and accrue on the published rate. Instead, an annualized, compounded rate based on the number of days in the calculation period needs to be determined based on the published risk-free rate. Using this example, a firm can have 100 instruments floating on SOFR and each instrument might calculate a slightly different coupon rate daily – assuming that each instrument has a different calculation-period tenor. Additional complications arise when comparing the ISDA-defined calculation to clearinghouse accruals. To accommodate this difference, Eagle can consume dirty prices provided by the clearinghouses and adjust accordingly to ensure correct variation margin calculations.

Given the scope of the changes ahead of the industry, it’s certain that other challenges will emerge. And in light of what’s driving the changes, investment firms can be certain that regulators, investors and other constituencies will be scrutinizing their approach to navigate these changes. This is another area, however, where technology can smooth out what would otherwise be a very bumpy – and exhaustive – period of acclimation once the transition goes into effect.

Eagle Investment Systems’ Instrument Engineering Team, for instance, has analyzed the ISDA definitions for calculating accrued interest using risk-free rates. For most major risk-free rates, the calculation is identical. Eagle’s V17 release includes the ability to accurately handle this sea change in financial instrument accruals by utilizing the ISDA-defined compounding calculations for risk-free rates. We look forward to working with our clients to navigate these changes together.

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