R.I.P. LIBOR - prepare your Temenos Transact / T24

By the end of 2021, Libor will disappear, if not completely then at least effectively. Libor’s retirement has repercussions that reach significantly beyond the interbank market. Libor is the basis of around US $200-360 000 000 000 000 (200-360 trillions USD) of loans and derivatives (10 times the size of US GDP1), from variable rate loans to interest rate swaps, and is referenced in both financial and commercial contracts globally.

LIBOR

For the past 40 years, the London Interbank Offered Rate (Libor) has been the world’s most widely used benchmark interest rate, reflecting* the reference rate at which banks lend and borrow between themselves.

In theory LIBOR is a benchmark of circa 20 panel banks for 5 currencies (GBP, USD, EUR, CHF, JPY) and 7 tenors (1D (overnight), 1W, 1M, 2M, 3M, 6M, 12M periods). It consisted of 35 rates published on daily basis. Typically, during LIBOR calculation, edge rates were thrown out and average was calculated (trimmed mean, throwing out figures in the highest and lowest quartile and averaging the remaining numbers).

Main reasons to withdraw LIBOR were:

• not always* represented market conditions being benchmark of panel banks only (not a market benchmark)
• prone to manipulations. Just recall yourself 2011/2012 LIBOR scandal.
• “no control” / “no inspection” of regulatory/central body
• no relation to currency liquidity

Replacement

Central banks and regulatory bodies are working currently on so called “RFR” (Risk Free Rates), which could replace LIBOR.

Most often following 5 reference rates for benchmarked currencies are proposed as LIBOR replacements:

Currency	Rate name	Published by	Publishing country
USD	SOFR (Secured Overnight Financing Rate)	Federal Reserve Bank	United States of America
GBP	SONIA (Reformed Sterling Overnight Index Average)	Bank of England	United Kingdom
EUR	€STR (Euro Short Term Rate)	European Central Bank	European Union
CHF	SARON (Swiss Average Rate Overnight)	SIX Group Ltd.	Switzerland
JPY	ESTER (Euro Short Term Rate)	Bank of Japan	Japan

Most of these RFRs got EU endorsement already confirming their “neutrality”.

Now you may ask a question how 5 (overnight) rates will replace 35 rates published by LIBOR?

Impacted not only financial systems / banks

Generally speaking RFR endorsed rates are NOT published “in advance” for “future” periods such as 1M or 3M. So what should happen to contracts accruing interest and based on (for example) LIBOR USD 3M variant? Options are listed below with strong preference of “compounded RFR” usage.

Forward Looking Term SOFR

Unlike LIBOR, SOFR is a secured overnight rate, not a forward looking term rate. However, some market constituents (like syndicated loan lenders/borrowers) may prefer having a forward looking term rate.
A forward looking term SOFR may be constructed based on SOFR derivatives markets once those markets have developed enough liquidity. (The development of a benchmark term rate cannot be guaranteed, and therefore, market participants that can use overnight or compounded SOFR may prefer to transition to those rates.)
Forward looking term SOFR rates are simply segments of an overnight SOFR-OIS curve that includes a fixed and floating leg. The floating leg is the compound average of the overnight rate compounded over the interest period, while the fixed leg is set at the start of the period. The fixed and floating leg must be economically equivalent at the beginning of the period. The forward rate is simply the fixed leg of the swap. In effect, the term rate reflects market expectation as to what will happen to interest rates, while the compound average reflects what actually happens to interest rates over the period.

Average SOFR, Simple Daily SOFR and Compounded SOFR

Many financial contracts have used overnight rates, but typically use an average of the overnight rate, not a single day’s reading. This is because

1. an average overnight rate will accurately reflect changes in interest rates in a time period and
2. average rates smooth out daily fluctuations in overnight rates.

Average overnight rates can be calculated on either a simple interest basis or a compound interest basis.

Simple interest is calculated by applying the daily rate to the principal borrowed, and the payment due at the end is the sum of those amounts.
Compound interest keeps track of the accumulated interest owed but not yet paid. The interest owed each day is calculated by applying the daily rate to both the principal borrowed and the accrued, unpaid interest.
Simple interest may be computationally easier; compound interest is the more economically correct convention and will allow for more accurate hedging.
Compounded SOFR could either be compounded In Advance (e.g., calculated based on the prior equivalent period and thus known in advance of the interest period) or In Arrears (e.g., calculated during the course of the interest period and thus not known in advance).

Conventions for Simple Daily and Compounded SOFR

Because interest accrues over the interest period, parties using Simple Daily SOFR in Arrears or SOFR Compounded in Arrears will not know the final interest amount due until the end of the interest period. In order to provide the counterparties sufficient time to pay interest at the end of the period, several potential conventions are feasible (and are illustrated on p. 12 of “Users Guide to SOFR” published by Loan Syndication & Trading Association, New York, USA):

• Payment delay – The averaged SOFR is paid X days after the end of the interest period.
• Lookback – For every day in the current interest period, the SOFR from X days earlier is used.
• Lockout – The averaged SOFR over a current interest period “locks” the last few days’ rates at a rate fixed X days before the period ends.

SOFR Compounded in Advance is known in advance, so lookbacks and lockouts are not necessary. However, parties may prefer to use different periods of time to determine SOFR Compounded in Advance:

• Last Reset – Use the averaged SOFR for the equivalent time period as the upcoming interest period (i.e., average of last 90 days for a 90-day SOFR contract).
• Last Recent – Use the averaged SOFR for a shorter time period than the upcoming interest period (i.e., average of last 30 days for a 90-day SOFR contract).

Additional conventions will need to be developed around either Simple or Compound SOFR, including day count conventions and how the rate should be applied over weekends and holidays.

So what now?

As explained several choices are possible, but banking has just become a bit more complicated. Generally we think that LIBOR replacement rules are subject to some national / EU regulation, but we are NOT lawyers. Banks are NOT eligible for new terms selection of interest calculation. Please correct us if you know the facts.

We anticipate that:

• regulatory body will tell whether banks should switch to RFRs or not
• you can NOT longer assume in advance availability of fixed LIBOR equivalent - such forward RFR 3M rate does NOT exist!
• EURIBOR (Euro Inter Bank Offered Rate) published by EMMI for 1W/1M/3M/6M/12M tenors may loose a battle with €STR introduced by ECB ignoring the fact that EURIBOR is forward-looking term rate.
• Risk Free Rate should be refreshed and used on daily basis in order to daily accrue interest (as opposed to LIBOR EUR 3M rate assigned in advance to contract for fixed 3M period, at the beginning of period). Compound interest calculation should be preferred.
• effective rate for preferred, Compounded RFR In Arrears calculation will NOT be known in advance like in LIBOR and customer can only see it on Maturity / Rollover / Repayment of contract. Various solutions (Payment delay/Lookback/Lockout) are available.
• mortgage/loan schedules are subject to validation/change based on regulations.
• simplified calculations (eg. averaging monthly RFRs and applying to average principal) will be WRONG - contracts might have had principal changes within calculation period
• you may need to collect RFR rates on daily basis from several places as opposed to single place before

Borrowers, lenders

Loans/mortgages should start referencing some variant of daily published RFR rate. Appropriate regulations / recommendations will likely appear soon (again: we are NOT lawyers and please pass facts if you already know)

Banks may have thousands of financial contracts maturing after 2021, which may require to be reviewed, revised or potentially renegotiated.

Treasurers

For corporate treasurers, the impact is extraordinary, from the legal validity of contracts to the cost of borrowing, hedge effectiveness of derivatives and the wider accounting implications of changes to the reference rate. Effectively, the end of Libor is one of the most significant events of most treasurers’ careers.

Treasurers should consider amid the phasing out of this widely used benchmark interest rate. They will also need to consider both the valuation and liquidity implications of variable rate financial assets and liabilities.

I live in Poland, I use WIBOR. I do not care

Yes, you can remain partially ignorant if you do not have foreign currency loan :-) Conditions related to PLN currency will NOT change. WIBOR should still be benchmarked by 13 major banks on daily basis and published by GPW Benchmark S.A.

We do not expect any changes to rate publications. WIBOR ON (overnight), TN (tomorrow/next), SW (spot week), 2W, 1M, 3M, 6M, 9M, 1Y should still be published at 11:00 CEST on daily basis.

We can help if you know your goal

Struggling with upcoming LIBOR changes and Temenos Transact / T24? Let us know! We like challenges, are responsive and cooperative. Temenos already prepared some solution to latest Temenos Transact / Temenos T24 and collects customers interested in backpatches. They assumed, that conversion of various contracts is necessary.

Do not sleep. Wake up and react!

Attributions, referenced resources

Presented slides come from Temenos presentation held by Adam Gabe, Marina Polymenakou and Vincent Galand at Temenos Community Forum Online 2020. Session “Temenos Transact: The Treasurer’s Dillema: Preparing for a Future without LIBOR” can be found on TCF Online 2020 site or directly watched on Vimeo.

Update to article (2021-11-14)

Temenos legal department contacted us asking to withdraw any Temenos assets/logos from our articles, so pictures will stay temporary like that. TCF 2020 videos are also no longer available in public. It seems somebody in Temenos changed his mind - not for the first time. We hired lawyers agency to investigate whether any copyrights and/or intellectual property rights of Temenos were violated.