Since 2017, Interbank Offered Rate (IBOR) reform has been on the cards in many markets around the world. The use of the London Interbank Offered Rate (LIBOR) as a benchmark, is set to be discontinued.
This has significant implications across the financial industry, as LIBOR is used as a reference rate for interest rates charged in many countries on everything from home loans and credit cards to floating rate notes and corporate bank loans. It underpins hundreds of trillions of dollars worth of financial contracts.
A change is however necessary because of concerns around the liquidity of the underlying markets that LIBOR measures. A lack of trading data makes LIBOR inefficient as an interest rate benchmark, and raises the risk of manipulation.
In the UK, a March 2021 deadline has been set for banks to stop using sterling LIBOR as a reference for new loan agreements. In the US, a date has been set for June next year to stop using dollar LIBOR, but the authorities are currently consulting on plans to push this back to June 2023. The challenge is that regulators want institutions to stop using LIBOR, but they don’t want to force changes that will disrupt the financial system.
Settling on an alternative
Even with deadlines nearing, the question of how to effectively use an alternative has not been settled. The Loan Market Association has made proposals for wording that could be used in contracts, but there are still various iterations of where this could land.
Essentially, when LIBOR can no longer be used, financial institutions will have to fall back on some form of a risk-free rate as a benchmark. These risk-free rates will be determined from published overnight rates.
This is a critical distinction - IBOR rates are forward-looking, based on assumptions and judgements. Risk-free rates are inherently backward looking, based off transactions.
Risk-free rates also do not include any credit or term premium that would appear in IBOR. If they are to operate as an effective replacement, they therefore have to be adjusted in some way to reflect those differences.
How to do this efficiently and effectively is still being debated in international markets. We are advising clients not to prematurely write their own language into agreements until this is settled.
What is happening in South Africa?
Until recently, this was not something we felt would need addressing in South Africa. The market did not expect that the Johannesburg Interbank Average Rate (JIBAR) would be reformed in the same way.
Last month, however, the South African Reserve Bank (SARB) made its position clear: JIBAR will cease to exist at some point in the future because, like IBOR, there are shortcomings with using JIBAR as benchmark rate. The SARB has also advised that it will follow international progress on IBOR reforms to guide its decisions on a suitable reference rate for South Africa, whilst taking into account idiosyncrasies relevant to the local market. It will also observe best practice to avoid causing market instability.
This reform has meaningful consequences for South African financial sector institutions. The three-month JIBAR rate in particular is one of the country’s most-used benchmarks. It is referenced extensively for a range of purposes, including loans, derivatives, and money market unit trusts.
In order to replace JIBAR, three steps need to take place:
- A suitable Alternative Reference Rate (ARR) will have to be determined (and at present the SARB has short-listed three possibilities);
- Sufficient liquidity needs to be created in that ARR; and
- JIBAR needs to be transitioned into the new reference rate.
This process may take a minimum of five years.
Steps towards reform are not entirely new. In 2018 the SARB established the Market Practitioners Group (MPG) to look at local interest rate benchmarks. The MPG includes workstreams looking at both ways to strengthen JIBAR as a temporary measure, and to establish a permanent, credible ARR.
These workstreams are made up of stakeholders across the industry: from the SARB itself, insurers, banks, asset managers and market infrastructure providers. In identifying a suitable ARR, they will be guided by the principles for financial benchmarks set out by the International Organization of Securities Commissions (IOSCO). These principles cover a range of factors from the governance of the benchmark, to the factors that inform its quality, and its transparency.
As an interim step, the SARB has decided to improve the sufficiency of the JIBAR calculation by increasing the obligation size of each of the contributing banks so as to satisfy IOSCO sufficiency principles. This interim measure is likely to be in place for a few years until a credible alternative is established.
What should financial institutions do?
While the discussion around what will replace JIBAR is still some way from being settled, it is necessary for financial institutions to be aware of the implications. In future, any contract based on JIBAR will need to consider its fall-back for when the benchmark is discontinued.
It is, however, a challenge to introduce fall-back language into agreements before there is certainty. If language is prematurely drafted into agreements, it is likely that these agreements will have to be amended again once the market lands on an agreement. The other risk of writing fallback language into agreements at this stage is that it will make syndications challenging.
What some of our clients have done, however, is to start including wording in contracts that notes that once there is a switch to an alternative benchmark, the parties will negotiate to amend the agreement. That is a potentially safe approach – creating an obligation to adjust the contract, without stipulating what the switch will be.
For now, the SARB has put together a team of market-leading expert for purposes of transitioning JIBAR and will keep South African financial institutions abreast of any developments.
Thank you to Dhiren Mansingh, Head: Treasury Sales & Structuring at Investec for contributing to this insight.