Opinion: the transition from IBORs to RFRs is not a competition
The transition from Libor and its many iterations to risk-free rates is finally picking up pace, but should not be considered a race
The move from interbank offered rates (Ibors) to risk-free rates (RFRs) is pushing industry participants globally to determine what will replace the various Ibors and what fallback language will be necessary for legacy contracts before the overhaul, planned for 2021, takes place. It's a hefty task for practically every jurisdiction in the world to collectively decide on how to best handle the alleged $370 trillion notional contracts in exposure to key Ibors.
The International Swaps and Derivatives Association's (Isda) consultation on fallbacks for derivatives showed that the majority of respondents are in favour of a compound setting in arrears approach for the fallback rate, and a historical mean/median approach for determining the spread adjustment. Isda is consulting on pre-cessation triggers for derivatives and developing the final parameters and mechanics for fallbacks. It says that new fallback language will be created for derivatives referencing certain Ibors by the end of 2019.
The US and UK are further along in their various Ibor transition plans, as these markets are more sophisticated – and more liquid – than others. Some Asian jurisdictions, such as Hong Kong, Japan and Australia, are reportedly contemplating a multi-rate approach.
A major pro of a multi-rate approach is that it largely avoids the need for fallbacks and prevents significant IT challenges. But it risks market fragmentation in that different parties are referencing different rates, hitting liquidity hard. For other markets such as the PRC, where there are significant funds frequently raised from offshore US dollars, as well as Korea and Taiwan – both of which invest heavily in US dollar products – questions remain about whether these will shift to products based on the secured overnight financing rate (SOFR), the replacement for USD Libor.
For some products, such as derivatives, the industry is working together effectively to create solutions and test the new rates like SOFR or the UK's sterling overnight index average (Sonia). Market participants already observe that there is enough volume building, and that SOFR products will become a viable option in 2019.
Yet for others, the long road to transition has only just begun. For instance, for cash products, the biggest challenge is education, especially when addressing changes with retail customers. Although a one-size-fits-all approach would be helpful, the characteristics of products, and thus their requirements, vary greatly. Fallbacks, replacement rates and the transition process in general all represent a major balancing act for the industry.