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Back to IBOR Transition

Update on IBOR Transition – Corporate and Investment Banking

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Brief Introduction to LIBOR

The London Interbank Offered Rate (LIBOR) has existed in the market for more than 30 years. LIBOR rates have been embedded in various products and market segments across the global financial system. LIBOR is the average rates at which designated “panel banks” (HSBC, Citi, Bank of America, Barclays, etc.) would lend at in the interbank market. LIBOR is published for 5 currencies (USD, GBP, EUR, JPY & CHF) and 7 maturities (overnight / spot next, 1W, 1M, 2M, 3M, 6M, 12M).

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LIBOR Reform Drivers

The cases of attempted market manipulation and false reporting of global reference rates, together with the post-crisis decline of liquidity in the interbank unsecured funding markets, have undermined confidence in the reliability and robustness of existing interbank benchmark interest rates. Uncertainty surrounding the integrity of these reference rates represents a potentially serious source of vulnerability and systemic risk. (Source: FSB Report on “Reforming Major Interest Rate Benchmarks”, 2014)

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Alternatives to LIBOR - nearly Risk-Free Rates (RFRs) and other alternatives (e.g. central bank rates)

Regulators in different jurisdictions set up specific working groups to develop robust alternatives to LIBOR. To name a few examples, the Alternative Reference Rates Committee (ARRC) was set up under the Federal Reserve Bank of New York and the Working Group on Sterling Risk-Free Reference Rates was set up under the Bank of England (UK RFR WG). RFRs are “nearly” credit risk free considering that they are overnight rates only. However, it is important to note that RFRs are floating rates and can move up or down.

Table 1. Recommended RFRs for the respective LIBOR setting
Currency Existing Rate Alternative RFR Transaction Type Status Working Group Link
USD USD LIBOR SOFR
(Secured Overnight Financing Rate)
Secured Live www.newyorkfed.org
GBP GBP LIBOR SONIA
(Sterling Overnight Index Average)
Unsecured Live www.bankofengland.co.uk
EUR EUR LIBOR / EONIA ESTR
(Euro Short-Term Rate)
Unsecured Live www.ecb.europa.eu
JPY JPY LIBOR TONAR
(Tokyo Overnight Average Rate)
Unsecured Live www.boj.or.jp
CHF CHF LIBOR SARON
(Swiss Average Rate Overnight)
Secured Live www.snb.ch

The use of RFRs as an alternative rate is not mandatory and there may be cases where it is more appropriate to replace (L)IBOR with a different rate (for example, a central bank rate).

RFRs are fully transaction based, which means that these rates are based on the actual rates used for the transactions in the selected overnight markets. For example, SOFR is based on the transactions in the Treasury repo market. RFRs could be either “secured” or “unsecured”. When the rates are based on collateralized (secured) money market instruments, they are referred to as secured rate. For example, SOFR is a secured rate, based on transactions that involve collateral, in the form of Treasuries.



Difference in the Structure of LIBOR and RFRs and its Impact

The basis for calculating LIBOR and RFRs is different. LIBOR comprise of 3 components: credit risk (AA banks), liquidity tenor adjustment and the credit risk free component. Since the RFRs are overnight, they only contain the credit risk free component. Therefore, LIBOR and RFRs are economically different.

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The fact that LIBOR and RFRs are calculated on a different basis has a direct impact on their economic value. As seen in Graph 1, historically, RFRs tend to track the Bank of England (BoE) Bank Rate. Due to the credit conditions being in-built into the LIBOR, they differ from the RFRs in magnitude. There are certain approaches that have been recommended by regulators to cater to this economic difference between the two rates and ensure that the value transfer when transitioning from LIBOR to RFRs is minimal. This concept is discussed in detail below – under “Introduction to Credit Adjustment Spread”.

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The impact of the differing composition of the rates is more pronounced during financial stress periods. They are observed to diverge in stressed economic conditions because of the fact that LIBOR tries to measure the market for unsecured wholesale term lending to banks that is no longer sufficiently active. The low levels of underlying activity make it fragile and more susceptible to liquidity and amplification effects in financial markets.

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On the onset of the Covid-19 pandemic, large outflows of money market funds were observed in mid-March 2020. Investments were kept short-dated or backed by government securities, rather than LIBOR. As seen in Graph 2, LIBOR increased in second half of March, while the BoE reduced its policy rates. 3M GBP LIBOR remained at elevated levels; only ~0.15-0.2% below February levels, compared to a 0.65% fall in Bank Rate. SONIA, on the other hand, remained closely in line with the BoE Bank Rate throughout.



Timing for Calculating Interest Payments for RFR Facilities

LIBOR is a forward-looking, unsecured term rate published in 7 tenors. This setup allows the parties to calculate the interest payable for a specific period at the start of that interest rate period itself.

On the other hand, RFRs are backward-looking overnight rates. Hence, for RFR-linked facilities, the banks will not be able to determine the interest rates until the end of the interest rate period.

To allow the banks to calculate the payable interest and generate interest payment notices prior to the due date, a lag period will be introduced between the interest rate period and the cashflow period. The expected market convention for this lag is a 5 RFR Banking Day (5 BD) lookback.


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Interest Rate Calculation Methodology for RFR Facilities

As mentioned above, RFRs are backward-looking overnight rates (as of Mar. 2021, none of the regulators for the five LIBOR currency jurisdictions have endorsed any term rates for RFRs). This means that on every RFR Banking Day, a new rate is published. These daily RFRs are compounded in arrears to arrive at an effective interest rate for a given period. Hence, for RFR-linked facilities, the banks will not be able to determine the interest rates until the end of the interest rate period. There may be scenarios where simple interest accruals may be used, as recommended by ARRC for bilateral and syndicated loans (Source: ARRC SOFR “In Arrears” Conventions for Syndicated Business Loans, ARRC SOFR “In Arrears” Conventions for Use in Bilateral Business Loans).

Please see examples of the “RFR compounding in arrears with 5 BD lookback” and “Simple Interest in arrears with 5BD lookback” calculation below. It is important to note that this is just a mathematical illustration of how interest rates are calculated for a given period. This calculation does not refer to any particular steps carried out by the Bank’s internal systems when calculating the interest rates.


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Where:
d0 number of RFR Banking Days during the Cashflow Period
i series of whole numbers from one to 𝑑0, each representing the relevant RFR Banking Day in chronological order during the Cashflow Period
DailyRatei-LP for any RFR Banking Day 𝑖 during the Cashflow Period, the Daily Rate for the RFR Banking Day which is the applicable Lookback Period prior to that RFR Banking Day 𝑖
ni for any RFR Banking Day 𝑖, the number of calendar days from, and including, that RFR Banking Day 𝑖 up to, but excluding, the following RFR Banking Day
d number of calendar days during that Cashflow Period
N Market convention for quoting number of days in the year (N = 360 for the US, N = 365 for the UK)
Currency RFR Compounding Convention Cashflow Period Interest Rate Period Principal
GBP SONIA 5 RFR Banking Day Lookback 22-Feb-2021 to 25-Feb-2021 15-Feb-2021 to 18-Feb-2021 GBP 1,000,000,000.00
SONIA Rates Input:
15-Feb-2021 0.0480%
16-Feb-2021 0.0483%
17-Feb-2021 0.0487%

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Interest Rate Compounding Methodologies for RFR Facilities

There are various ways in which one can perform the interest rate compounding calculations. 3 key methodologies have emerged in the market, namely:

  • Balance Compounding (BC): daily overnight RFR is multiplied with the outstanding balance and the unpaid accrued interest.
  • Cumulative Compounded Rate (CCR): uses the Compound Interest Formula used in section 6. Results in an annualized compounded rate for a particular interest rate period which is then multiplied with the principal over the number of calendar days in the interest period.
  • Non-Cumulative Compounded Rate (NCCR): applies the difference of the CCR of a given day and the prior day to the principal, resulting in a daily compounded accrual.

The Cumulative Compound Rate (CCR), and the Non-cumulative Compounded Rate (NCCR) equations are special cases of the Balance Compounding approach (Source: ARRC Syndicated Loan Conventions Technical Appendices). It is important to note, that each of the above-mentioned methodologies result in the exact same interest accrual. Please see the worked examples below for further understanding of each of the methods.

Balance Compounding (BC)

Simple daily accrued interest can be calculated as follows

𝐴𝑡+1=𝐴′𝑡 + (𝑖𝑡 × 𝑃𝑡 )

For compounded interest, daily interest accrual is charged both on outstanding principal and on accumulated unpaid interest.

𝐴𝑡+1=𝐴′𝑡 + 𝑖𝑡 × (𝑃𝑡+𝐴′𝑡 )

The daily interest accrual under the Compound Balance approach is simply calculated by applying the appropriate day’s ARR rate to outstanding principal and accrued unpaid interest.

𝐴𝑡+1 − 𝐴′𝑡 = 𝑖𝑡 × (𝑃𝑡 + 𝐴′𝑡 )
Where:
it the effective interest rate for date t
Pt Outstanding principal for date t
At the accumulated unpaid accrued interest for date t before any interest paydown
A't the accumulated unpaid accrued interest for date t after any interest paydown
Currency RFR Compounding Convention Cashflow Period Interest Rate Period Principal
GBP SONIA 5 RFR Banking Day Lookback 22-Feb-2021 to 25-Feb-2021 15-Feb-2021 to 18-Feb-2021 GBP 1,000,000,000.00
SONIA Rates Input:
15-Feb-2021 0.0480%
16-Feb-2021 0.0483%
17-Feb-2021 0.0487%

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Cumulative Compounded Rate (CCR)

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Where:
d0 number of RFR Banking Days during the Cashflow Period
i series of whole numbers from one to 𝑑0, each representing the relevant RFR Banking Day in chronological order during the Cashflow Period
DailyRatei-LP for any RFR Banking Day 𝑖 during the Cashflow Period, the Daily Rate for the RFR Banking Day which is the applicable Lookback Period prior to that RFR Banking Day 𝑖
ni for any RFR Banking Day 𝑖, the number of calendar days from, and including, that RFR Banking Day 𝑖 up to, but excluding, the following RFR Banking Day
d number of calendar days during that Cashflow Period
N Market convention for quoting number of days in the year (N = 360 for the US, N = 365 for the UK)
Currency RFR Compounding Convention Cashflow Period Interest Rate Period Principal
GBP SONIA 5 RFR Banking Day Lookback 22-Feb-2021 to 25-Feb-2021 15-Feb-2021 to 18-Feb-2021 GBP 1,000,000,000.00
SONIA Rates Input:
15-Feb-2021 0.0480%
16-Feb-2021 0.0483%
17-Feb-2021 0.0487%

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Non-Cumulative Compounded Rate (NCCR)

The "Daily Non-Cumulative Compounded RFR Rate" for any RFR Banking Day 𝑖 during an Interest Period for a Compounded Rate Loan is the percentage rate per annum (without rounding, to the extent reasonably practicable for the Finance Party performing the calculation, taking into account the capabilities of any software used for that purpose) calculated as set out below:


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Where:
UCCDR𝑖 Unannualised Cumulative Compounded Daily Rate for that RFR Banking Day 𝑖
UCCDR𝑖−1 in relation to that RFR Banking Day 𝑖, the Unannualised Cumulative Compounded Daily Rate for the immediately preceding RFR Banking Day (if any) during that Interest Period
dcc Market convention for quoting number of days in the year (N = 360 for the US, N = 365 for the UK)
ni for any RFR Banking Day 𝑖, the number of calendar days from, and including, that RFR Banking Day 𝑖 up to, but excluding, the following RFR Banking Day

The "Unannualised Cumulative Compounded Daily Rate" for any RFR Banking Day (the "Cumulated RFR Banking Day") during that Interest Period is the result of the below calculation (without rounding, to the extent reasonably practicable for the Finance Party performing the calculation, taking into account the capabilities of any software used for that purpose):


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Where:
ACCDR Annualised Cumulative Compounded Daily Rate for that Cumulated RFR Banking Day
tn𝑖−1 number of calendar days from, and including, the first day of the Cumulation Period to, but excluding, the RFR Banking Day which immediately follows the last day of the Cumulation Period
dcc Market convention for quoting number of days in the year (N = 360 for the US, N = 365 for the UK)
Cumulation Period the period from, and including, the first RFR Banking Day of that Interest Period to, and including, that Cumulated RFR Banking Day

The "Annualised Cumulative Compounded Daily Rate" for that Cumulated RFR Banking Day is the percentage rate per annum calculated as set out below:


IBOR
Where:
d0 number of RFR Banking Days during the Cashflow Period
i series of whole numbers from one to 𝑑0, each representing the relevant RFR Banking Day in chronological order during the Cashflow Period
DailyRatei-LP for any RFR Banking Day 𝑖 during the Cashflow Period, the Daily Rate for the RFR Banking Day which is the applicable Lookback Period prior to that RFR Banking Day 𝑖
ni for any RFR Banking Day 𝑖, the number of calendar days from, and including, that RFR Banking Day 𝑖 up to, but excluding, the following RFR Banking Day
tni number of calendar days from, and including, the first day of the Cumulation Period to, but excluding, the RFR Banking Day which immediately follows the last day of the Cumulation Period
dcc Market convention for quoting number of days in the year (N = 360 for the US, N = 365 for the UK)
Currency RFR Compounding Convention Cashflow Period Interest Rate Period Principal
GBP SONIA 5 RFR Banking Day Lookback 22-Feb-2021 to 25-Feb-2021 15-Feb-2021 to 18-Feb-2021 GBP 1,000,000,000.00
SONIA Rates Input:
15-Feb-2021 0.0480%
16-Feb-2021 0.0483%
17-Feb-2021 0.0487%

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Introduction to Credit Adjustment Spread (CAS)

As explained in section 4, there are fundamental differences between LIBOR and RFRs which means that RFRs perform differently to LIBOR. Hence, an interest rate comprising of “LIBOR + Client Margin” is not economically equal to “Compounded RFR + Client Margin”. Therefore, to minimise any value transfer while transitioning a facility from LIBOR to RFRs, a Credit Adjustment Spread (CAS) will be used. Essentially, the role of the CAS is to equate RFRs to LIBOR. Fig 5. is an illustration of this concept. An important point to note is that for all transitioning facilities, the client margin remains unchanged.

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For new RFR linked facilities, this CAS will be implicitly incorporated in the client margin, as illustrated by Fig 6. Hence, any new RFR linked facilities will continue to be quoted as a “Compounded RFR + Client Margin”.

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One of the methodologies to calculate CAS is the ISDA 5-year historical median approach. This is one of the approaches recommended by different regulatory and industry bodies (such as ARRC, UK RFR WG and ISDA). Using this method, the CAS is equal to the median of the spot spreads between the LIBOR and the relevant compounded RFR over a period of 5 years, historically.

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As seen in Graph 3, the 5Y median spread adjustment for 3M compounded SONIA has remained between 10 – 16 basis points (1 basis point = 0.01%). In July 2019, ISDA announced that Bloomberg would officially publish the 5Y median spread adjustments. Since July 2020, Bloomberg has been publishing the spreads, compounded RFRs and the all-in fallback rates (compounded RFR + spread). For more information, please visit: “Bloomberg Begins Publishing Calculations Related to IBOR Fallbacks”. The 5Y median spreads are also publicly available on a delayed basis – click here for more information.



LIBOR Cessation and Regulatory Milestones Supporting the LIBOR Transition

The FCA, on 05 March 2021, announced LIBOR cessation and non-representativeness dates. Please refer to the table below for details. The link to the above-mentioned FCA’s announcement is here. Please read the brief information provided in the table below, in conjunction with the details provided in FCA’s announcement.

Table 2. LIBOR Cessation and Non-Representativeness Dates
Currency Cessation or Non-Representativeness Date Cessation Tenors Non-Representativeness Tenors
GBP 31-Dec-2021 O/N, 1W, 2M, 12M 1M, 3M, 6M
USD 31-Dec-2021 1W, 2M -
30-Jun-2023 O/N, 12M 1M, 3M, 6M
JPY 31-Dec-2021 O/N, 1W, 2M, 12M 1M, 3M, 6M
EUR 31-Dec-2021 All 7 LIBOR settings -
CHF 31-Dec-2021 All 7 LIBOR settings -

“LIBOR cessation” refers to the permanent cessation of publication of the respective LIBOR rates. “Non-Representativeness” refers to FCA announcing that the respective LIBOR is no longer representative of the underlying market that it is intended to measure, and that representativeness will not be restored.

Please note, the LIBOR settings published beyond the “Non-Representativeness” dates are only to be used in “tough legacy” contracts. The use of these LIBOR settings for new transactions is prohibited for UK regulated firms.

In addition to the above, EONIA (Euro Overnight Index Average) is expected to be discontinued on 03 January 2022. SOR (Singapore Dollar Swap Offer Rate) relies on USD LIBOR for computation and its cessation dates are expected to be aligned with USD LIBOR cessation / non-representativeness dates.

The FCA announcement will have activated certain contractual triggers for the application of fallbacks. ISDA has confirmed that it constitutes an "Index Cessation Event" for the purposes of the ISDA IBOR Fallbacks Supplement and the ISDA 2020 IBOR Fallbacks Protocol for all 35 LIBOR settings on the basis that all LIBOR settings will either permanently cease to be published or become non-representative from the dates specified in the FCA's announcement.

Regulators and Working Groups across the world have propelled the LIBOR transition by introducing interim milestones and timelines prior to the permanent cessation of the benchmark. FAB has been monitoring the market very closely and intends to adhere to the recommended regulatory and industry guidelines.


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Additional Information for Corporate & Investment Banking Clients

Availability and Use of RFR Term Rates

In January 2020, the Bank of England Working Group on Sterling Risk-Free Rates (UK RFR WG) set up a Term Rate Use Case Task Force (the “Task Force”) to provide guidance on the need for the potential usage of Term SONIA Reference Rates. Post their analysis, the Task Force concluded that the use for SONIA compounded in arrears was operationally achievable for 90% by value of the Sterling Libor loan market sampled and that the remaining 10% by total loan value would likely require alternative rates.

These alternative rates could be fixed rates, the Bank of England Bank Rate or a SONIA term rate (if and when available). To assess the necessity of the usage of SONIA term rates, the Task Force laid out the following criteria:

  • Structure and characteristics of the product; and
  • Operational capability and the sophistication of the borrower or end-user.

The findings of the Task Force acknowledged the need for term rates or equivalents for 3 product classes: (1) Trade & Working Capital Products (including discounting/letters of credit, supply chain finance, etc.); (2) Export Finance & Lending in Emerging Markets; and (3) Islamic Finance. (Source: BoE Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives)

Please see the conclusion of the findings of the Task Force in the table below:

Table 3. Task Force Conclusions on their Study of Use Cases for SONIA
Products Client Breakdown Details Definition Balance % Recommended Rate (By UK RFR WG)
Bonds / Loans / Trade Large Corporate / Leverage Sponsor / Leverage / Large Corporate Corporate deals / Sponsor lead acquisitions / recapitalizations with a deal size £25m 50% Compounded in Arrears
Loans / Trade Mid to Large Corporate / Specialist Finance Financial Institutions Banks, insurance providers, asset managers, funds, hedge funds and broker dealers 40%
Mid to Large Corporates Annualized revenue >£25m and deal size £10m - £25m
Social Housing Lending to Social Housing firms
Education / Local Authority Lending to schools / Higher Education / Local Authorities
Project Finance Financing a major independent capital investment
Real Estate Commercial Real Estate firms
Export Finance / Emerging Market Export Finance Funding to outsized capital expenditure with export finance guarantee 10% Term / Alternative Rate
Emerging Market Lending to emerging markets
Mid Corporate / Private Banking & Retail Mid Corp Annualized revenue >£6.5m and <£25m. Excludes specialized lending
Small, Micro Size Enterprise Annualized revenue <£6.5m
Retail Mortgages Retail clients
Wealth / Private Bank Offers Banking and affluent clients, families and fiduciaries based in the UK, offshore or emerging markets
Product Exception Trade & Working Capital Trade & Working Capital All Trade & Working Capital products including discounting / Letters of credit, supply chain finance, etc.
Islamic Finance Islamic Finance Islamic facilities forbid interest payments on loans

As of March 2021, regulator-endorsed Term RFRs are not yet available. For SONIA, the administrator for the term rates has not yet been finalised. For SOFR, there is no certainty on the status of the availability at the associated timelines for Term SOFR.

Key Considerations when Opting for RFR facilities

You should consider the potential impacts of any future changes to benchmark rates for products and agreements between you and FAB. These may include amendments to the calculation of amounts payable, which may change the rate of interest that you pay or amounts that might be paid to you.

In particular, we suggest that you:

  • Ensure you understand the differences between LIBOR and the RFRs, including the key differences pertaining to the interest calculation methodologies.
  • Familiarize yourself with the different conventions and methodologies pertaining to the usage of RFRs for both new and transitioning facilities. These may include interest rate compounding methodologies, CAS calculation methodologies and other loan conventions. You may refer to the frequently asked questions page to get more information on the resources that have been provided by various Regulators and Supervisory bodies in this regard.
  • Review operational readiness, hedging considerations and any accounting changes.
  • Ensure you understand the impact of agreeing to the terms of your transitioning LIBOR facility or a new RFR linked facility.
  • Comprehensively assess your LIBOR referencing contracts/exposure and seek professional advice if required to prepare for the transition.

We recommend that you keep up to date with the latest developments in relation to the changes and the potential alternative benchmark rates that may be relevant to you. Nothing on this webpage or in our communications with you constitutes investment or other advice unless expressly agreed in writing between us. You should consider whether you need to obtain independent advice (legal, tax, financial, accounting, or other advice) on the possible impact of the LIBOR reforms on the financial products and services you use or may use in the future.


Disclaimer
This communication does not deal with every important topic pertaining to LIBOR transition. It is not designed to provide legal, financial or other advice. By reviewing this communication, you agree that First Abu Dhabi Bank is not acting as your advisor and is not providing advice or making any recommendation regarding LIBOR transition; it being understood that any information or explanations pertaining to LIBOR transition provided via this communication shall not be considered advice or a recommendation. Each recipient of this communication will make its own independent decisions regarding LIBOR transition, based upon its own judgement and upon advice from such advisors as it has deemed necessary. This communication should be read in conjunction with IBOR Transition.


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