The alphabet soup of alternative reference rates post-LIBOR
SOFR, SONIA, EONIA, SARON, and TONAR
With LIBOR likely to be discontinued by 2021, financial institutions and regulators around the world are getting ready by developing alternate rates such as SOFR, SONIA, TONAR, SARON and EONIA. How can you prepare for their impact?
April 11, 2018
A blog post by Val Srinivas, Banking & Capital Markets research leader, Deloitte Services LP, and Tiffany Ramsay, senior market insights analyst, Deloitte Services LP.
The new alphabet soup of alternate reference rates could be a big challenge for financial institutions when the world’s most-referenced financial benchmark—the London Interbank Offered Rate (LIBOR)—likely is discontinued in 2021.1 Since the UK’s Financial Conduct Authority (FCA) announced in July 20172 that LIBOR will be phased out, leading financial institutions and regulators around the world have been working feverishly to design replacements, at the behest of the Financial Stability Board (FSB), the multinational body that monitors and makes recommendations about the global financial system.3
This transition will not be easy. Financial institutions will need to contend with a number of operational, technical, governance, and other issues. Clarity is emerging on the most likely alternate benchmarks, but plenty of uncertainty still exists.
The fuss around these alternatives is amply justified given that LIBOR is the referenced interest rate underpinning nearly $350 trillion worth of financial products—including derivatives, mortgages, and corporate and student loans.4 We cannot think of any benchmark more entrenched in financial markets than LIBOR.
The search for alternate reference rates was motivated by the “rigging scandal” that occurred during the financial crisis, and the decline in liquidity in interbank unsecured deposit markets.5 There is a more robust LIBOR system now in place, with the ICE Benchmark Administration (IBA) the entity engaged by the FCA to administer LIBOR. Even so, another major issue remains: LIBOR is a panel-derived, judgment-based benchmark, potentially subject to manipulation, as opposed to a transactional reference rate, based on real contracts.
The desire for transaction-based LIBOR alternatives is a global phenomenon. This exploration so far in advance of 2021 is fueled by the concern among market participants about the possibility of LIBOR’s sudden termination. A recent report from the US Alternative Reference Rates Committee (ARRC), which operates under the auspices of the Federal Reserve System and the Federal Reserve Bank of New York, summarizes this sentiment accurately:
Without advanced preparation, a sudden cessation of such a heavily used reference rate would cause considerable disruptions to and uncertainties around the large gross flows of USD LIBOR-related payments and receipts between many firms. It would also impair the normal functioning of a variety of markets, including business and consumer lending.6
Financial institutions will need to contend with a number of operational, technical, governance, and other issues. Clarity is emerging on the most likely alternate benchmarks, but plenty of uncertainty still exists.
Alternate reference rates around the globe
The ARRC has recommended the Secured Overnight Funding Rate (SOFR) as the preferred alternative to US dollar LIBOR. Based on overnight repurchase agreements backed by Treasury securities,7 SOFR rates were first published on April 3, 2018. As an alternate reference rate, SOFR could increase transparency in financial markets, since it relies on transactional data. The Chicago Mercantile Exchange (CME) is developing SOFR futures,8 which could serve as reference rates for durations that match the current LIBOR tenors, or maturity dates, such as three- and six-months.
The UK has also made progress with the Sterling Overnight Index Average (SONIA). The Bank of England (BOE) took over the administration of SONIA in April 2016. This reference rate includes not only overnight unsecured transactions negotiated bilaterally, but also broker-intermediated loans. One advantage of SONIA is that it has been in existence since 1997. A “reformed SONIA” becomes live on April 23, 2018.9
In the Euro market, the European Central Bank (ECB)10 identified the European Overnight Index Average (EONIA) reference rate; it was first published in 1999. The Euro market has been served for years both by LIBOR and the more popular Euro Interbank Offered Rate (EURIBOR). EONIA is based on unsecured, overnight transactions.
Meanwhile, the Swiss National Bank has already put in place an alternate reference rate for the Swiss Franc (CHF) market. The Swiss Average Rate Overnight (SARON), originally introduced in 2009, was adopted officially as a LIBOR replacement in December 2017.11 SARON is the secured, overnight interest rate for the Swiss franc (CHF) repo market. Term rates—spanning the spectrum up to 12 months—already exist for this alternate reference benchmark.
In Japan, the LIBOR alternative identified by Bank of Japan is the Tokyo Overnight Average Rate (TONAR), which has served as the reference rate for the Japanese yen (JPY) overnight index swap (OIS) market.12 JPY LIBOR co-existed with the Tokyo Interbank Offered Rate (TIBOR). TONAR is based on unsecured, overnight transactions.
Transitioning from an established reference rate
At this point you may be wondering why we are headed towards multiple and diverse reference rates. According to the FSB, given the differences in underlying data and market needs:
Having a range of reference interest rates might offer more appropriate options that better fit the needs of heterogeneous market participants.13
In our view, dealing with multiple reference rates for different markets/currencies that are not uniform, in that they may be secured or unsecured, with differing underlying references, and in varying stages of implementation will increase complexity for financial institutions operating globally. This may be especially so in the early phases of transition. An example is determining how best to apply nearly risk-free rates to lending products that ideally should reflect reference rates with a credit risk component, similar to LIBOR now. For instance, one key challenge with SOFR, given it is based on secured transactions, is the absence of credit risk. Thus, stakeholders of legacy loans will have to account for the resulting credit spread between LIBOR and SOFR, especially when LIBOR is no longer published.14
And, of course, before the alternate reference rates are adopted, a robust term-rates market needs to exist for most financial transactions. In the United States, SOFR futures could well be what the market needs to make a successful transition from LIBOR.
Lastly, although documentation citing these alternate rates is beginning to take hold for new financial contracts, revising the language for legacy transactions will be one of the thorniest challenges.
But this is the rite of passage financial markets must endure when transitioning from such an established reference rate as LIBOR. The good news is that financial industry and regulators globally have already demonstrated their commitment to overcoming obstacles along the way. Any other outcome would be highly problematic for global financial markets.
We are watching these LIBOR-related developments very closely. Please look out for additional perspectives in the near future. What are your thoughts? Join the conversation on Twitter at @DeloitteFinSvcs.
1 It should be noted that the ICE Benchmark Administration (IBA) may continue to offer LIBOR after 2021, even though other alternate reference rates may be in use by that time.
2 Andrew Bailey, “The future of LIBOR,” Speech given at Bloomberg London, July 27, 2017; https://www.fca.org.uk/news/speeches/the-future-of-libor .
3 Financial Stability Board, “Reforming Major Rate Benchmarks,” July 22, 2014, http://www.fsb.org/wp-content/uploads/r_140722.pdf.
4 Liz McCormick, “Libor’s Rise Matters for Trillions of Debt,” Bloomberg Markets, December 13, 2017, https://www.bloomberg.com/news/articles/2017-12-13/love-it-or-hate-it-libor-s-rise-matters-for-trillions-of-debt, accessed March 29, 2018.
5 James McBride, “Understanding the Libor Scandal,” Council on Foreign Relations website, https://www.cfr.org/backgrounder/understanding-libor-scandal, accessed March 29, 2018; Financial Stability Board, “Reforming Major Rate Benchmarks,” July 22, 2014, http://www.fsb.org/wp-content/uploads/r_140722.pdf.
6 The Federal Reserve Bank of New York, Second Report of the Alternative Rates Committee, 2018, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report, accessed March 29, 2018.
8 CME Group, “CME Group Announces New SOFR Futures Launch Date and Contract Specifications,” press release, March 1, 2018, http://www.cmegroup.com/media-room/press-releases/2018/3/01/cme_group_announcesnewsofrfutureslaunchdateandcontractspecificat.html, accessed March 29, 2018.
9 Bank of England, SONIA reform to be implemented on 23 April 2018, 2017, https://www.bankofengland.co.uk/news/2017/october/sonia-reform-to-be-implemented-on-23-april-2018, accessed March 29, 2018.
10 European Money Markets Institute, “Eonia,” https://www.emmi-benchmarks.eu/euribor-eonia-org/about-eonia.html, accessed March 29, 2018.
11SIX Swiss Exchange, SARON Swiss Average Rate Overnight: The new Swiss franc benchmark, 2017, https://www.six-swiss-exchange.com/downloads/indexinfo/online/swiss_reference_rates/saron_factsheet_de.pdf, accessed March 29, 2018.
12 Bank of Japan, Report on the Identification of a Japanese Yen Risk-Free Rate, 2016, https://www.boj.or.jp/en/paym/market/sg/rfr1612c.pdf, accessed March 29, 2018.
13 Financial Stability Board, “Reforming Major Rate Benchmarks,” July 22, 2014, http://www.fsb.org/wp-content/uploads/r_140722.pdf.
14 Barry Mills, “From LIBOR to SOFR,” ABA Banking Journal, February 21, 2018, https://bankingjournal.aba.com/2018/02/from-libor-to-sofr/.
QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The views expressed in this blog are those of the blogger and not official statements by Deloitte or any of its affiliates or member firms.