(L)IBOR Transition – Understanding Alternative Reference Rates (ARR)

While ARRs are intended to replace the IBORs in their respective jurisdictions, there are some fundamental differences between ARRs and IBORs. Understanding these structural differences is important for successful IBOR transition planning. Author: Kelly Chingrailroad tracks

Moreover, the transition timing between various IBOR currencies is not aligned and, in some cases, extremely tight. Despite last week’s announcement of ESTER as the replacement for EONIA and Euribor at the end of 2019, the industry is concerned about the ability to transition on time.

What is the difference between London Interbank Offered Rate (LIBOR) and ARRs?
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Among the greatest differences between LIBOR and other ARRs is that LIBOR is a forward-looking term rate, published for tenors up to 12 months (e.g., three-month or six-month LIBOR), while SARON, for example, is an overnight rate.

A term rate provides certainty of funding costs, as the interest payable will be known in advance. This is important for cash flow management, especially in the cash markets, and generally for pricing and risk management purposes.

Therefore, the term rates will have to be derived from the overnight ARRs. Taking the example of SARON, the main solutions* being considered now are:
• Cash flow approach: compounded SARON backward-looking
• Cash flow approach: compounded SARON forward-looking
• Term rate approach: using data from SARON-based futures/swap/OIS/repo products

Both buy and sell sides will be consulted by the Swiss National Bank on the most appropriate methodology to be used in connection with SARON.

Which alternative rates and methodologies are being proposed in other jurisdictions?

The market is likely to transition at different times in various currencies, as the transition process is not coordinated globally. While SARON was designed as the alternative to TOIS and Swiss franc LIBOR already in 2017, the alternative to the EUR reference rates – Euro Short Term Rate (ESTER) – was recommended by the Euro ARR Working Group only on 13 September 2018**. ESTER is intended to replace Euro Overnight Index Average (EONIA) which does not meet the criteria of the EU Benchmark Regulation (BMR) and is therefore banned from being used after 1 January 2020. It should also serve as an alternative to Euribor if the current reformation efforts for compliance with BMR are not successful. Considering that ESTER has not yet been published, this leaves a very short time to transition.

This can cause issues, particularly for products referring various currencies e.g. cross-currency swaps or multi-currency facilities until the ARRs in each relevant currency are identified and liquid. Moreover, different rates and methodologies are being proposed in different jurisdictions. For example, certain ARRs are secured and others unsecured.

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* Minutes from the meeting of the NWG on CHF Reference Interest Rates (4 June 2018)
** https://www.ecb.europa.eu/press/pr/date/2018/html/ecb.pr180913.en.html

Interested in more? Read about IBOR Transition: A Swiss Perspective or reach out to Kelly Ching