The foundations of world financial markets is changing, and not enough participants are paying attention. The IBOR reference rates, used for everything from cash products to interest-rate derivatives, are being replaced, and you will probably be affected.

The derivatives market is in one word – GINORMOUS. The total notional amount of all outstanding contracts is according to BIS over 500 trillion USD. In the case of Sweden, the outstanding notional value of derivatives linked to STIBOR equals more than 10 times the country GDP according to FI.

The process to replace the panel-based IBOR rates with more robust transaction-based interest rates was spearheaded by US and UK authorities. Since then, the EU launched BMR (benchmark regulation directive) and many countries around the world are now moving fast to replace the old inter-bank rates with alternative reference rates.

The benchmark directive from the EU requires every country with a reference rate to create an alternative rate that is transaction based. Wide-spread rigging and abuse of the panel-based rates at the beginning of this century led to USD 7 billion in penalties and criminal fines for some of the biggest banks in the world.

Sweden’s STIBOR, which was built in the 1980s is a panel rate, like all the other IBORS, set by 7 banks. Sweden will keep its STIBOR but is required to create an alternative in case STIBOR fails. The only viable option is the overnight rate between banks, which the Riksbank will gather and publish along with the STIBOR rate.

There is a good chance that the market will turn to the new alternative transaction-based rate even if the banking association says it will keep using the STIBOR. Think about it, if you can choose to price a derivative or asset based on a transaction-based rate or a panel rate, knowing how the panel rates were abused elsewhere in the world, which would you prefer?

Yet, not enough people are paying attention. When ISDA last asked for feedback on the process, terms and conditions, fewer than 100 responses came in from around the world. Only one comment came from Sweden.

In both the UK and the US, the markets are moving quickly to replace the old panel rates. In March, the UK derivatives market switched from LIBOR to SONIA. In the US, LIBOR will be replaced by SOFR. In September 2019, SOFR officially became a USD 1 trillion market. GBP and USD LIBOR will end latest Dec 31st, 2021.

Sweden and Euroland are in the process of developing alternative reference rates in order to be compliant with the BMR. But both foresee a continuation of using the STIBOR and EURIBOR. Euroland launched ESTR in October of 2019 and Sweden will use the O/N interbank rate as the alternative reference rate. Both the ESTR and the SEK O/N are unsecured overnight rates. The Riksbanken will administrate this alternative reference rate and publish it daily.

The new transaction-based reference rates will be reference rates that are almost risk free. In order to find a rate based on actual transactions all countries have turned to the shortest possible maturity – overnight loans. These overnight transactions seem to be the only place in the market where there is a steady flow of business between banks. The difference in credit spread on an overnight loan versus a 3-month loan is quite significant, (normally in the range 7-10 basis points but can vary a lot depending on market conditions).

If anything, the risk will lie in the transition from IBOR to the alternative reference rate, which will be a one-off adjustment. After the adjustment, you’re locked in.

Shifting from a 3-month rate to an overnight rate requires compounding arrears and calculating after the period has passed or create new term rates based on the overnight rate. Both options have been discussed and the former option is most likely. This means payments cannot be prepared in advanced and just-in-time payments systems need to be put in place.

As the UK and US conversion continues, we will most likely see more adoption in the marketplace in order to prepare for the eventual abandonment of GBP Libor and USD Libor. Last week we saw the GBP IRS market switch to SONIA based swaps. This is just an example of a divider and the market participants and providers will continuously try to adapt and second guess behavior and future demand. Markets love liquidity and changes can happen very fast, who wants to be the last one trading something that is being abandoned?

Spend a few moments considering how this may affect your business. For example, how will you react to your bank demanding to change your STIBOR-based loans to something else? Are you prepared to negotiation in such a situation? Or, if you have contracts in sterling tied to a 3-month Libor that will be see its terms changed to a one-day SONIA. How does this affect you? What about shifting from preparing payments in advance to just-in-time calculations and payments? Are you ready?

Call KPMG and set up a meeting in order to get an outsider perspective on your situation.

Engage and make your voice heard in the consultations and discussion that is still to come.

Current consultations open to the public:

• ISDA has consultations until the 25th of March pre-cessation rules.
• Bank of England has a discussion paper out until early April on SONIA Index and Period averages.

Join the discussion and don’t hesitate to contact us if you want to arrange a structured tailored work flow to address the needs of your organization.

Best regards

Patrik Sandell with colleagues
KPMG Financial Risk Management email us at: treasury@kpmg.se

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