End of an era for LIBOR paves way for AONIA to win in Australia
LIBOR has served as the globally accepted benchmark interest rate for financial markets for over 40 years. Published in five currencies and seven maturities, it included daily estimates of unsecured market borrowing costs provided by a panel of major banks.
The problem was that when the liquidity of this borrowing market dried up – as it did after the global financial crisis of 2007-2008 – LIBOR was no longer anchored in a robust underlying market, which made it unsuitable as a widely used reference rate. Its disappearance would impact billions of dollars of financial contracts worldwide, from derivatives to bank loans and overdrafts to mortgages.
Major financial markets around the world, including Australia, have moved to identify and adopt alternative benchmark rates to operate alongside, and ultimately in place of, their respective LIBORs. This was not only done out of concern for the long-term viability of LIBOR: many contracts referencing LIBOR did not really need a reference rate that reflected bank credit risk in the first place. The alternative was to adopt so-called “risk-free” overnight rates, or RFRs.
Since RFRs are overnight rates and not forward-looking forward rates like LIBOR, the operational use of these new rates required considerable preparation. That wasn’t the only challenge: what to do with all those “legacy” contracts still referencing LIBOR?
Industry groups have developed widely used standard clauses that would allow these contracts to transition from LIBOR to an RFR, upon termination of LIBOR. These clauses generally include an adjustment to limit any unjustified economic transfer that would otherwise result from replacing one reference rate with another. Relying on such a fallback solution is one of many ways to make the transition, and proactively restructuring exposures is another.
Most LIBOR rates, with the exception of the US dollar parameter, were successfully transferred late last year. The life of USD LIBOR has been extended to June 30, 2023, to allow more time for the transition of large quantities of LIBOR contracts denominated in the global reserve currency – although USD LIBOR is no longer used in new contracts.
What does this mean for Australia?
Although LIBOR has a definitive end date, all benchmark interest rates that reflect banks’ funding costs – “IBORs” – should not be phased out. IBORs that will remain for the foreseeable future include, for example, EURIBOR, as well as the Australian local credit benchmark BBSW.
BBSW measures the cost to highly rated Australian banks of issuing short-term bank notes for each monthly maturity between one month and six months. Australia has an active bank notes market, where major banks issue notes as a regular source of funding, and a wide range of wholesale investors purchase notes as a cash management product. AONIA is the name of what is commonly known as the official exchange rate (OCR). It is administered by the Reserve Bank of Australia and calculated as the weighted average interest rate on unsecured overnight loans between banks.
BBSW remains robust and is expected to continue and our regulators are not advocating a wholesale transition from BBSW to an RFR. Instead, Australia takes a multiple rate approach: market participants must choose the reference rate that best suits the particular product and situation. As most of the world embraces risk-free rates, the Australian market could see a move towards referencing AONIA for certain products, such as, for example, currency swaps and multi-currency loan facilities.
The transition from LIBOR was an outstanding example of a “market-driven” transition guided by prudential guidelines. Ultimately, global markets will have undergone a historic transformation, with LIBOR rates being replaced by more robust alternatives.
This article was first published by Commonwealth Bank of Australia – CommonVersion. The author is Pieter Bierkens, Head of Interest Rate Benchmark Reform at Commonwealth Bank of Australia and Chair of Australia’s IBOR Transformation Task Force.