1. What is LIBOR?
LIBOR, or the London Interbank Offered Rate, is a global benchmark interest rate for financial products dating back to 1986. It is the result of daily submissions for periods from overnight to 12 months by a reference panel of between 11 and 16 contributor banks for each LIBOR currency. LIBOR is then calculated and published for each relevant currency and tenor (GBP, USD, JPY, CHF and EUR — but only for legacy contracts).
2. Why is LIBOR being replaced?
The financial crisis of 2009 revealed weaknesses in LIBOR as it behaved inconsistently and unpredictably compared to other observable market rates. The Financial Conduct Authority (FCA), a regulatory body in the United Kingdom and regulator of LIBOR, has called for a market transition away from LIBOR and to a more robust reference rate. Other regulatory bodies have also been supportive of a transition away from LIBOR because reform efforts have fallen short of agreed standards for financial benchmarks.
3. Which currencies and reference rates are affected by the LIBOR transition?
LIBOR for USD, GBP, JPY, CHF will be affected by LIBOR Transition. As of January 1, 2022, LIBOR has ceased to be published for GPB, JPY, and CHF. LIBOR for USD is expected to cease publication from July 1, 2023.
4. In addition to EUR LIBOR, is EURIBOR impacted by the transition?
Regulators have not expressed an intention to replace EURIBOR, or the Euro Interbank Offered Rate, which has been reformed and will continue to be published by the European Money Markets Institute (EMMI).
5. What will replace LIBOR?
The Alternative Reference Rates Committee (ARRC) convened by the US Federal Reserve to oversee the transition process away from LIBOR for USD, has named the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR.
6. What is SOFR?
SOFR, or Secured Overnight Financing Rate, is a US Treasuries overnight repo financing rate published daily by the Federal Reserve Bank of New York at 8 a.m. Eastern Time. SOFR is calculated as a volume-weighted median of transaction-level data from tri-party treasury repo collected by BNY Mellon, general collateral repo data collected by the Depositary Trust and Clearing Corporation, and bilateral treasury repo data collected by the Fixed Income Clearing Corporation.
7. What is a US Treasuries overnight repo financing rate?
It is the interest rate a party will pay to a borrower overnight after posting US Treasury securities as collateral.
8. Why was the SOFR selected to replace LIBOR?
SOFR meets the following requirements for international benchmark regulation:
- Benchmark Quality—it is highly liquid, involves a large volume (difficult to manipulate) and is very resilient;
- Methodological Quality—it uses standardized terms for data inclusion, transparency and data availability; and
- Accountability and Governance—it utilizes a process and governance structures which comply with International Organization of Securities Commissions (IOSCO) Principles and is produced by the New York Fed as a public good.
9. What type of SOFR-based rates are there?
There are a variety of SOFR conventions, including compounded SOFR rate and term SOFR rate. A compounded SOFR rate is a rate where interest is determined during an accrual period by observing and compounding daily SOFR in arrears. Term SOFR rates set a SOFR based rate in advance for period of one, three, six or twelve months.
10. How does compounded SOFR differ from LIBOR?
Whereas LIBOR is a term rate, with a tenor matching the length of the interest period (e.g., 6-month LIBOR rate used for loans paying on a semiannual frequency), SOFR is an overnight rate. To determine the rate applicable for an interest period, the SOFR rate must be observed daily and then each daily observation would be averaged or compounded to arrive at the rate for the full period. Therefore, the rate applicable to the interest period is only known at the end of the period, whereas LIBOR is known at the beginning of the interest period. Finally, SOFR differs from LIBOR in that it is a secured rate (i.e., it has no credit element).
11. What is SOFR Index?
The SOFR Index measures the cumulative impact of compounding the SOFR on a unit of investment over time, with the initial value set to 1.00000000 on April 2, 2018, the first value date of the SOFR. The SOFR Index value reflects the effect of compounding the SOFR each business day and allows the calculation of compounded SOFR averages over custom time periods. Each business day, the New York Fed publishes the SOFR Index on the New York Fed's website, shortly after the SOFR is published at approximately 8:00 a.m. ET.
12. Where can I see the latest SOFR rates?
13. What kind of SOFR rate is AIIB applying to sovereign backed loans?
AIIB has selected compounded daily SOFR in arrears without lookback, lockout, or shifts as its SOFR based rate for sovereign backed financings. This compounded daily SOFR rate is implemented in the Bank’s systems via SOFR Index.
14. What is the billing mechanism for sovereign backed SOFR loans?
AIIB will employ a Proxy Rate and True-Up billing approach for every six-month interest period. This means that for the first four months the reference rate is the compounded observed SOFR rate, calculated via the SOFR Index, and for the remaining two months a Proxy Rate is based on the observed SOFR rate of the fourth month. This will be the basis of the billing that will be sent to the borrower at the beginning of month five. The borrowers will then have just under two months to process the payment.
At the end of the interest period the actual SOFR rate for the final two months, the True-Up Rates, will be determined and will be used to calculate a True-Up Amount. The True-Up Amount would be the difference between the amount billed and the amount due based on actual True-Up Rates and will be billed in the subsequent interest period. The True-Up Amount would also include any adjustment due to any changes in the loan notional that occurred after billing (as per current practice and not dependent on SOFR dynamics).
15. Is the interest rate floored for sovereign backed loans under SOFR terms?
The interest for the entire interest period is floored at zero.
16. Why is my spread on SOFR loans higher than the spread on LIBOR loans?
The replacement of LIBOR with a new SOFR based reference rate requires an adjustment spread to be added to the replacement rate to reduce any transfer of value in existing contracts. This spread represents a credit risk adjustment to reflect the difference between secured SOFR rate and unsecured LIBOR rate. The spread over SOFR reference rate only optically looks higher because SOFR reference rate is lower than LIBOR, however, there is no economic change to your all-in interest rate because of switching from a LIBOR loan to a SOFR loan.
17. How will the adjustment spread for fixed spread sovereign backed loans be calculated?
The adjustment spread for fixed spread sovereign backed loans will be based on a spread difference between SOFR and LIBOR calculated as a historical median over a five-year lookback period as defined by the International Swaps and Derivatives Association (ISDA).
18. Will AIIB offer sovereign SOFR loans that reference a forward-looking SOFR term rate (Term SOFR)?
A forward-looking SOFR term rate has been recommended for use from July 29, 2021, for certain cash products and derivatives hedging those cash products according to the announcement by the Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York in 2014 to help ensure a successful transition from USD LIBOR to SOFR as a more robust reference rate.
However, AIIB plans to offer only a SOFR compounded-in-arrears sovereign product and currently has no plans to issue a sovereign SOFR term rate product.
19. How is AIIB preparing for the LIBOR transition?
AIIB has established a LIBOR Transition Steering Group led by the Bank’s Chief Financial Officer to oversee the implementation of transitional arrangements with the Bank’s sovereign and nonsovereign clients, as soon as practicable, to facilitate the smooth transition to the LIBOR replacement rate. Part of the work involves preparing the Bank’s internal operations for the change, with primary emphasis on its IT systems and treasury operations.
20. How will AIIB’s Fixed Spread and Variable Spread sovereign-backed loans be affected by the LIBOR transition?
A new reference rate (i.e., SOFR for USD loans), including an adjustment spread to adjust for the differences between LIBOR and the replacement rate, will replace the six-month LIBOR for the Fixed Spread sovereign-backed loans.
The same methodology already used for calculating the borrowing cost for Variable Spread sovereign-backed loans (VSL)—the use of the weighted average cost of AIIB’s liabilities to price said borrowing cost—will remain the same.
21. How will AIIB mitigate the impact of the LIBOR transition on existing USD loan agreements and those signed before the LIBOR replacement rate is known?
The Bank actively manages the transition process by creating transition provisions for new and existing loan contracts and engages with sovereign and private sector borrowers and the wider community of lenders with a view to put these provisions in place to facilitate a quick and efficient transition to the LIBOR replacement rate.
22. How will existing sovereign and sovereign-backed contracts transition to the replacement rate? Will each loan agreement need to be amended?
With the approval of its Board of Directors, AIIB amended the standard or General Conditions present in each sovereign and sovereign-backed loan. With this approval the Bank is enabled to proceed to unilaterally amendment its loan portfolio to transition LIBOR to compounded SOFR.
23. Will there be any changes to AIIB’s policies for sovereign and sovereign-backed loans?
Changes have been approved to the Bank’s General Conditions on October 22, 2021.
24. How will AIIB manage the LIBOR transition for syndicated loans (with other IFIs or commercial banks)?
The syndicate of financiers, including AIIB, and the borrower will need to agree on transition provisions and/or LIBOR replacement provisions. The existence of multiple lenders will mean that more entities are required to agree to such provisions before these can be implemented. AIIB is working with other multilateral development banks (MDBs) with a view to agreeing on a consensus approach to such provisions and anticipates that commercial banks will also take a similar approach over time.
25. What will happen to existing contracts with AIIB if the transition provisions are not agreed now or if LIBOR replacement provisions have not been agreed upon when the LIBOR replacement rate is known?
It will depend on the terms of each loan. Outcomes could include: (i) the last LIBOR benchmark rate published is permanently locked in as the benchmark rate; (ii) the LIBOR rate (if it is still being published) will still be used but it will no longer be a representative rate (known colloquially as “zombie” LIBOR); (iii) references rates quoted by other financial institutions (if they are prepared to provide such quotes, which may also not be representative) will be used; or (iv) the Bank’s actual cost of funds will be used. Some contracts may not be well designed for the discontinuance of LIBOR. It is recommended that contracts be updated to include LIBOR fallback language to ensure an orderly process. AIIB plans to update all contracts.
26. How can clients best manage the uncertainty associated with the transition?
Borrowers should take a proactive approach to identifying existing LIBOR exposures, discuss their existing agreements with their lenders and hedge providers and seek agreement on transitional arrangements at the soonest possible time so as to ensure they have arrangements in place. This will facilitate the transition to the LIBOR replacement rate when it is known.
27. How can clients ensure that their loans and hedging agreements, if any, match after the transition?
Different approaches are being considered in different jurisdictions. Clients will need to liaise with each lender and each hedge counterparty to determine exposures and impact how best to manage this.
28. Are there LIBOR transition training providers that can equip clients with more knowledge?