The end of LIBOR is imminent and we are beginning to see significant volumes of new issuances of both derivatives and cash products referencing risk free reference rates (RFRs). The LIBOR transition period, which terminates at the end of December 2021, is designed for market participants to prepare themselves operationally, technologically and financially for the cessation of LIBOR. With less than one and a half years to go, there are still many questions regarding documentation, fallback language, standardization, term rates, spread application, lags/lookbacks, lockouts and more. Nevertheless, market participants must be able to accommodate both LIBOR and RFR-based transactions during the LIBOR transition period.
The benefits of RFR rates include:
- Based on actual observable transactions
- Overnight in nature (little or no counterparty risk)
- Derived from active and well-defined markets, which are nearly impossible to manipulate or influence
- Produced in a transparent and direct manner (vs. LIBOR, which is based on estimates)
While there are fewer risks and more reliability with RFR rates than LIBOR, there are still a number of challenges to the market, including:
- Mixing of secured and unsecured rates in financial products
- Currently, there are no term RFR rates, although there are plans in place to develop term RFR rates for some of the currencies
- Given that RFRs are daily rates, the rate applicable between two periods can be obtained only after compounding (or averaging), typically with adjustments, e.g., lookback and lockout periods
Despite the challenges associated with RFR, rates regulators stipulate that firms must ensure they are prepared for LIBOR cessation by the end of 2021, warning that firms must act now in preparing for the transition. Download our whitepaper Operational and Technological Implications of Market Transition from LIBOR to Risk Free Reference rates (RFRs) to learn about the key challenges associated with the transition as well as its associated impacts on valuation and other processes.