This case study details a successful migration from the London Interbank Offered Rate (LIBOR) to risk-free rates (RFRs) for an investment bank. The FCA’s announcement in March 2021 regarding the phasing out of LIBOR necessitated this transition to ensure market stability and compliance.
Background
The Financial Conduct Authority announced on 5 March 2021 that as from the end of 2021 LIBOR for all currencies and tenors will either cease to be published or cease to be representative of the market it is intended to measure other than USD LIBOR for overnight, one month, three-month, six month and 12 month tenors. USD LIBOR for those popular tenors will now continue to be published until 30 June 2023 to reduce the amount of legacy USD LIBOR deals needing to transition. Regulators have emphasised the need for new transactions to move away from using LIBOR as a benchmark and to make preparations for legacy LIBOR referencing deals to transition to new benchmarks, to avoid market disruption.
Scope
A risk-free rate had been identified for each LIBOR currency.
| Jurisdiction | LIBOR Currency | Risk-Free Rate |
|---|---|---|
| USA | USD | Secured Overnight Financing Rate (SOFR) |
| United Kingdom | GBP | Sterling Overnight Index Average (SONIA) |
| Switzerland | CHF | Swiss Average Rate Overnight (SARON) |
| Japan | JPY | Tokyo Overnight Average Rate (TONA) |
| European Union | EUR | Euro Short- Term Rate (ESTER) |
The Solution
The project aimed to migrate all market data, trade data, valuation data, profit and loss (P&L), risk calculations, Value at Risk (VaR), and pricing models that relied on LIBOR to the relevant RFR methodology.
Task
Migrate all market data, trade data, valuation data, Profit and loss, risk, VAR, pricing models facing LIBOR to relevant risk-free rate methodology.
Key change attributes as part of the integration framework.
Understanding the key distinctions between LIBOR and RFRs was crucial for a smooth transition. Here’s a comparison table:
| Feature | LIBOR | Risk-Free Rate |
|---|---|---|
| Tenor | Forward-looking term rate | Backward-looking (measures previous day’s interest) |
| Measure | Average rate for unsecured funding | Varies by RFR (e.g., SOFR measures cost of borrowing USD overnight) |
| Rate Administrators | ICE Benchmark Administrators Limited | Varies by RFR |
| Publication Times | Around 11.55 am London time (before relevant period) | Varies by RFR (e.g., SOFR published at 8:00 am EST the next business day) |
| Currencies | USD, EUR, JPY, CHF, GBP | Each RFR linked to a specific currency (e.g., SOFR for USD, SONIA for GBP) |
Risk-Free Rate Calculation Methodology
Unlike LIBOR’s single screen rate, RFRs require a more complex calculation to determine the applicable rate over an interest period. Here’s an overview of the explored and adopted calculation methods:
- Cumulative Compounded Rate: Calculates the compounded rate over a specific observation period, starting before the interest period and ending before the interest payment date.
- Daily Non-Cumulative Compounded Rate (Recommended): This method proved more suitable for calculating interest mid-interest period. It involves subtracting the cumulative compounded rate for the previous day from the current day’s rate.
- Daily Simple Rate: Recommended by the Federal Reserve Bank of New York’s ARRC, this method uses a simple uncompounded rate to calculate interest. The daily screen rate for the relevant RFR benchmark is multiplied by the principal to determine the interest due on each day within the interest period.
| Interest Calculation | Description |
|---|---|
| Cumulative Compounded Rate | Calculate the cumulative compounded rate over the observation period commencing the relevant look back prior to the start of the interest period and ending the relevant look back prior to the interest payment date. |
| Daily Non-Cumulative Compounded Rate | During our testing we found difficulties in determining interest midinterest period when using a cumulative compounded rate, the London loan market now favours the use of a daily non-cumulative compounded rate in loan documentation. The daily non-cumulative compounded rate for a given day is the cumulative compounded rate for the prior day subtracted from the cumulative compounded rate for that given day. Overall, the use of a daily non-cumulative compounded rate to determine interest over an interest period should result in the same amount as if a cumulative compounded rate been used over the same period. However, the use of a daily non-cumulative compounded rate enables a more accurate calculation of interest mid-interest period. |
| Daily Simple | The Alternative Reference Rates Committee of the Federal Reserve Bank of New York (ARRC) has also recommended the use of a simple uncompounded and non-cumulative rate (sometimes known as “Daily Simple”) for the purposes of calculating the rate. This calculation method was tested and we found the interest rate per annum is derived from the daily screen rate for the relevant risk free rate benchmark. This is then applied to the principal to determine the amount of interest due on each day during the interest period. |
| Margin and Credit Adjustment Spread | In order to calculate the total applicable interest rate over an interest period, the margin and credit adjustment spread (if any) need to be added to the relevant benchmark rate. For compounded rates, it is generally expected that the margin and credit adjustment spread (if any) will be added to the interest rate after compounding to calculate the amount due. |
| When is compounding performed? | Compounding was performed on banking days in the relevant currency jurisdiction only. If there is a need to determine interest on a non-banking day, then the rate from the previous banking day would be used. |
Key approaches adopted when transitioning from LIBOR to Risk free rate.
The following table summarizes the key approaches adopted for a smooth transition:
| RFR Approach | Description |
|---|---|
| Calculation Method | Daily non-cumulative compounded rate recommended. |
| Observation Shift | Without observation shift (although it remains a viable alternative). |
| Credit Adjustment Spread | ISDA historical median approach. |
| Compounding | Only on banking days. |
| Compounding Rate vs. Balance | Compounding the rate (other methods available for market participants). |
| Compounding Margin | Margin added after rate compounding (not compounded). |
| Compounding Credit Adjustment Spread | Credit adjustment spread added after rate compounding (not compounded). |
| Rounding Convention | SONIA rounded to four decimal places, interest payment rounded to two decimal places. Additional rounding conventions for calculating the daily non-cumulative compounded rate. |
| Business Day Convention | Modified Following |
| Lookback Period Length | 5 London banking days |
| Day Count | Actual/365 |
| Zero Rate Floor | Parties can decide on applying a floor and its level. The floor should be applied daily, not at the end of the interest period. For legacy contracts, SONIA can be adjusted to ensure it exceeds the floor (including the credit adjustment spread). |
Conclusion
This project successfully transitioned all relevant data, calculations, and systems from LIBOR to the new RFR methodologies. This ensures the bank’s continued operations and compliance in a post-LIBOR environment.
