Understanding the IBOR Transition

By the end of 2021, Interest rate benchmarks (IBORs) will no longer exist in the form they are now.

What is an IBOR?

An IBOR is an Interest rate benchmark and includes, among others, the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), the Euro Overnight Index Average (EONIA) and Tokyo Interbank Offered Rate (TIBOR).

They are widely used in the global financial system as benchmarks for a large volume and broad range of financial products and contracts.

Derivative products that reference Interest rate benchmarks

  Swaps Forward rate agreements
  Options Swap futures
Interest rate futures and options

Whilst the largest outstanding volumes of IBOR related products relate to Over the Counter (OTC) derivatives, Exchange Traded derivatives (ETD) form a non-negligible proportion of reference rate linked derivatives. The Market Participants Group (MPG) has estimated that between 60% and 90% of all interest rate OTC derivatives and ETDs are linked to LIBOR, EURIBOR, or TIBOR.

The London Interbank Offered Rate (LIBOR) is the most widely known and seen as the most important interest rate in finance, upon which trillions of financial contracts rest.

What is LIBOR?

LIBOR is used in financial products denominated in a number of currencies and is published in GBP (British Pound), USD (US Dollar), EUR (Euro) and JPY (Japanese Yen).

It is set each day by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions. These are averaged together to provide a range of LIBOR rates.

As well as helping to decide the price of other transactions, it is also used as a measure of trust in the financial system and reflects the confidence banks have in each other's financial health.

Why is LIBOR being replaced?

LIBOR is on the way out as a loan benchmark because of the role it played in worsening the 2008 financial crisis as well as scandals involving LIBOR manipulation among the rate-setting banks. 

In 2012, extensive investigations into the way LIBOR was set uncovered a widespread, long-lasting scheme among multiple banks—including Barclays, Deutsche Bank, Rabobank, UBS and the Royal Bank of Scotland—to manipulate LIBOR rates for profit.

In the wake of those scandals, the UK Financial Conduct Authority (FCA) shifted supervision of the index to the Intercontinental Exchange Benchmark Administration (IBA).

Despite steps taken by the IBA to strengthen the benchmark, the ongoing slowdown in unsecured debt market activity has diluted IBOR’s relevance – three-month US dollar LIBOR, the most heavily referenced IBOR benchmark, is supported by less than $1 billion in transactions per day.

In a speech in July of 2020 Bank of England Governor, Andrew Bailey said: ‘So the paradox of LIBOR is that if we are looking for a robust way to create transparency on bank funding costs, LIBOR is not that rate.

Adding that ‘the market volatility we saw during March and April only served to underscore the long-standing weaknesses of the LIBOR ’benchmark. LIBOR rates – and hence costs for borrowers – rose as central bank policy rates fell to support the economy’.

What will replace LIBOR?

So if LIBOR isn’t a robust and transparent basis for determining funding costs for firms and households – is it possible to create such a benchmark that is sufficiently robust?

In 2014, the G20 asked the Financial stability board (FSB) to undertake a fundamental review of major interest rate benchmarks and plans for reform to ensure that ‘those plans are consistent and coordinated, and that interest rate benchmarks are robust and appropriately used by market participants’.

They along with other industry participants in IBOR jurisdictions recommended near Risk Free Rates (RFRs) as an appropriate alternative. But recognised that this should not exclude the use of other robust benchmarks.

What is the benefit of an RFR?

RFRs offer the following benefits for derivatives:

  • a pure GBP interest rate position without bank credit risk
  • for collateralised swaps, lower basis risks between the valuation curves (e.g. OIS) and the swap reference rate

In sterling, the chosen alternative is SONIA, produced by the Bank of England. The market for SONIA linked derivatives is well established. The share of swaps traded using SONIA is broadly equivalent to that linked to LIBOR, with continued growth at longer maturities. Volumes in LIBOR linked options are decreasing and there are promising signs of a SONIA options market developing; we have also seen growth in SONIA futures during the first half of 2020. There is now a fully functioning SONIA linked bond market.


When do the changes take place?

The Risk Free Rate Working Group and the Bank of England says ‘it remains the central assumption that firms cannot rely on LIBOR being published after the end of 2021’ and ‘the transition from LIBOR remains an essential task that will strengthen the global financial system’.

The Covid pandemic caused concerns that the deadline of December 2021 may not be met, but good progress has been made:

  • Lenders are now in a position to offer non-LIBOR linked products to their customers;
  • All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 have now ceased.

What do the changes mean to me as a trader

Currently if you hold a short-term trade and want to keep it open overnight, you’ll be charged a daily interest fee.

The financing charges reflect the cost of borrowing or lending the underlying asset and are charged at LIBOR (or equivalent IBOR) +/- 2.5% on the total value of the position.

From 7 May 2021 you will be charged a rate approximating to the new benchmark +/- 2.5%. These charges will remain competitive in order to keep the cost of trading low.

  Country Financing on long positions Financing on short positions
   UK  SONIA +2.5% SONIA -2.5%
   US  SOFR +2.5% SOFR-2.5%
   EU  €STR +2.5% €STR -2.5%