BRIEF HISTORY OF LIBOR AND EURIBOR, INITIAL CALLS FOR REFORM AND FINALLY TRANSITION PROPOSALS; STERLING WORKING GROUP, BENCHMARKS REGULATION AND EURIBOR REFORM
LIBOR (London Interbank Offered Rate) was originally developed for pricing transparency in the syndicated loan market – its purpose being to reflect the ‘average rate’ at which major banks could obtain unsecured finance in the London Interbank Market, in a specified currency and for a particular period.
In 1986 the British Bankers’ Association (BBA) began publishing the averaged LIBOR rate (known then sometimes as ‘bbalibor’ or the ‘screen rate’). The rate was calculated by asking a panel of banks to submit their respective estimated rates for borrowing by ‘asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m.’ The highest and lowest 25% of rates which were submitted were omitted and the remaining estimated rates were averaged.
BBA LIBOR was published until ICE Benchmark Administration Limited (an entity of Intercontinental Exchange, Inc. (ICE)), took over administration in 2014. ICE LIBOR is published for five currencies (US dollars, pounds sterling, euros, Japanese yen and Swiss francs). Each has seven maturities quoted – from overnight to 12 month periods, and a reference panel of 11 to 16 contributor banks is used for each currency.
Previously, each of the panel banks used its own methodology to estimate its own borrowing rate. Since 1 April 2019, all LIBOR panel banks have been using the ‘waterfall methodology’ – in accordance with the ICE IBOR Output Statement which specifies that LIBOR must be anchored in panel banks’ unsecured wholesale transactions to the greatest extent possible, with a waterfall to enable a rate to be published in all market circumstances. This means that the panel banks must use actual transactions complying with specified criteria when submitting their rates, failing which transaction derived data should be used, and in the absence of that, expert judgement can be used to submit the estimated rates.
EURIBOR, (the rate at which euro interbank term deposits are offered within the eurozone by one bank to another at 11.00 a.m. CET for value (T+2)), was introduced in 1999 to replace domestic reference rates across the eurozone. The European Money Markets Institute (EMMI) is responsible for administering EURIBOR and seeks submission from a panel of 18 reference banks. It is currently published for periods of one week, one month, three/six/twelve months.
Since January 2019, the EURIBOR Governance Framework has been adopted – this defines the rate-setting process and the roles of all the stakeholders and outlines the criteria which the panel banks must use to determine their calculation.
The problem with IBORs
Concerns arose in 2007 that the interbank offered rates were subject to manipulation by false submissions, and IBORs became to be considered inaccurate and unreliable reference rates. In parallel, unsecured interbank lending had decreased and so for many banks, it may not have represented the true cost of funding. In 2009, UK, EU and international regulators commenced an investigation into suspected misconduct in setting LIBOR and EURIBOR.
Following a review1 commissioned by the UK Government (the Wheatley Review named after Martin Wheatley, then the head of the FCA) in 2014, ICE took over administration from BBA and five currencies (Australian, Canadian and New Zealand dollars, Danish and Swedish krona) were dropped from IBOR quotation, and the number of maturities calculated for the quoted currencies was reduced.
The calls for reform
The Wheatley Review concluded that LIBOR should be retained as a benchmark but with wholesale reform, and made with three recommendations:
- a comprehensive reform of LIBOR rather than replacing the reference rate – on the basis that replacement would cause significant disruption to the financial markets;
- strict and detailed verification processes for LIBOR submission and sufficient transaction data to be provided to corroborate LIBOR submissions; and
- continued significant market participant involvement in the production of LIBOR.
LIBOR reform remained the default position until the middle of July 2017, when Andrew Bailey, then Chief Executive of the FCA, made a speech in which he announced that the FCA would no longer compel panel banks to submit rates to enable the LIBOR calculation, and as such the market should not rely on IBOR being available after 2021. The FCA’s view was that the absence of active underlying interbank lending markets in the various currencies and tenors that made up IBOR raised a serious question about the sustainability of the IBOR benchmarks that were allegedly based upon those markets.
Then, in July 2018, Mr. Bailey confirmed the FCA’s view that the best option for market participants would be to actively transition to alternative benchmarks.
Since then the focus has been on replacing IBOR with risk free reference rates (RFRs) that can be calculated on the basis of real transactions.
The calls for transition
Following Mr Bailey’s speech, in September 2018, the FCA and Prudential Regulation Authority (PRA) wrote a Dear CEO letter to major banks and insurers in the United Kingdom in relation to their transition preparation from IBOR. Each firm was asked to provide a board approved summary of its assessment of key risks relating to IBOR discontinuation and its planned mitigation strategy. Then in January 2019, the FCA urged those creating new contracts referencing IBOR to progress to new risk-free reference rates (RFRs) and EURIBOR. The FCA has called on market participants to implement their transition strategy sooner before contingency plans are required.
In January 2020, the PRA and the FCA wrote a joint letter2 to the CEOs of major banks and insurers setting out their initial expectations of firms’ transition progress through 2020. That letter set out the following targets:
- a further shift of volumes from IBOR to SONIA in the derivative markets;
- by the end of Q3 2020, no further issuances of sterling IBOR products in the cash markets that mature beyond 2021; and
- significantly reducing the stock of IBOR based contracts by Q1 2021.
Sterling Working Group
The Working Group on Sterling Risk-Free Reference Rates (Sterling Working Group) was established in 2015 to implement the Financial Stability Board's recommendation to develop alternative RFRs for use instead of IBOR-style reference rates.
The Sterling Working Group has been working with market participants to establish market norms for alternatives to IBOR. It has issued a number of publications, but in particular, in January 2020, it published a number of documents, including an updated roadmap for 2020 highlighting important events and clarifying action market participants should take to reduce IBOR exposure and transition to alternative rates.
For a further update on progress since January 2020 please refer to our Current Transition to Risk Free Reference Rates page.
Benchmarks Regulation (BMR)
In addition to the UK’s own response to IBOR, the EU independently commenced investigation of the use of benchmarks throughout the EU. Their response was the EU Benchmarks Regulation which aims to ensure that the benchmarks produced and used across the EU are fit for purpose, robust, reliable and representative of the market in which they operate.
‘Administrators, Contributors and Users’ of benchmarks within the meaning of the EU Regulation (including any replacement to IBOR) will therefore need to observe its provisions.
What about EURIBOR?
IBOR transition has been operating slightly differently in the euro area.
Firstly as it is not compliant with BMR, EONIA will continue until 3 January 2022 at which point it will be discontinued. EONIA is the Euro Overnight Index Average which reflects the rate at which banks of sound financial standing in the EU and EFTA countries lend funds in the Interbank Money Market in euro.
In 2018, the working group on euro RFRs (comprising the European Central Bank, the Financial Services and Markets Authority, the European Securities and Markets Authority and the European Commission) (the Euro Working Group) recommended the €STR as the new euro risk free reference rate in place of EONIA. €STR is a short term rate administered by the European Central Bank and reflects the wholesale euro unsecured overnight borrowing costs of euro area banks. Its recalibrated methodology calculates the benchmark as the sum of €STR and a fixed spread of 0.085%.
In July 2019, the Euro Working Group published its recommendation for the smooth transfer to €STR (Legal Action Plan)3 and in August it published a further report it on the impact the EONIA - €STR transfer will have on cash and derivatives product, with a number of operational/valuation4) recommendations.
The Euro Working Group issued a follow up report in February 20205 (a) highlighting that EONIA contracts maturing beyond 3 January 2022 entail significant risks and recommending replacement with €STR as soon as possible; and (b) recommending market makers proactively price in the €STR as their default and that the nettability on EONIA/€STR should be considered.
Secondly in terms of EURIBOR, EMMI has been working since the end of 2013 to develop a new determination methodology for EURIBOR fully anchored in real transactions. In 2016 it concluded that a seamless transition to a fully transaction–based methodology was not feasible. Since then it has been developing a hybrid determination methodology for EURIBOR, being a three level waterfall using market transactions (whenever available) and relying on other related market pricing sources, and failing that expert judgement. EMMI has been assisting with the transition of panel banks from the current EURIBOR methodology to the new hybrid methodology and the gradual implementation was due to be concluded by the end of 2019, with EURIBOR available since 1 January 2020.
However, the future of EURIBOR in the long term remains unclear especially considering that the Sterling and the US dollar markets are transitioning towards RFRs rather than reformed IBORs. The Euro Working Group is, like the Sterling Working Group and the US Alternative Reference Rates Committee (ARRC), considering options for a term €STR- most likely using tradeable Overnight Index Swaps quotes (See further - Current Transition to Risk Free Reference Rates.)6.
1 See https://www.gov.uk/government/publications/the-wheatley-review for copies of the relevant document.
2 See https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/letter/2020/initial-expectations-fca-pra-of-firms-libor-transition-progress-during-2020.pdf?la=en&hash=240F859F88E6E9855449EFCCB5B89D4C3DEC12E6
3 See https://www.ecb.europa.eu/press/pr/date/2019/html/ecb.pr190716~0383b60ab0.en.html
4 See https://www.ecb.europa.eu/pub/pdf/other/ecb.wgeurorfr_impacttransitioneoniaeurostrcashderivativesproducts~d917dffb84.en.pdf
5 See https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200219~8bf72afd89.en.html