What are RFRs?

Risk Free Rates (“RFRs“) have been developed on a currency-by-currency basis. RFRs are fundamentally different from IBORs.  This is because IBORs, representing an average of the rates at which Panel Banks believe that they could borrow money in the interbank market, reflect the credit and liquidity risk involved in lending in that interbank market.

By contrast, RFRs:

  • Do not have a “term” element (e.g. 1 week, 1 month, 3 month)
  • Are “backward-looking” rates – i.e. are calculated by reference to historical transaction data
  • Do not price credit risk to the extent IBORs do (being based on overnight borrowing rates often on a secured basis)
  • Do not include a premium on long-dated lending – i.e. RFRs do not compensate lenders for making funds available long-term
  • Are calculated on a currency-by-currency with no uniform calculation methodology across all currencies.

RFRs are generally considered to have the following requisites:

  • Be based on sufficient and reliable market data
  • Have robustness to changes in market structure
  • Be subject to appropriate controls and governance
  • Reflect actual market funding rates

RFRs are constitutionally and economically fundamentally different from IBORs.

This difference leads to a credit and liquidity spread (or ‘pricing gap’) between IBORs and RFRs.  This is well illustrated by the LIBOR-OIS spread (also known as the FRA-OIS spread, LIBOR-OIS basis or FRA-OIS basis) which is a common way to gauge the perceived level of risk associated with interbank markets.

This spread is constructed by taking an IBOR for a particular tenor (typically 3 months) and subtracting from it the fixed rate associated with an overnight indexed swap (“OIS”) of the same tenor.

An OIS is a fixed-floating interest rate swap whereby the floating rate is based on a return calculated from a daily compounded interest investment.  The index rate is typically the rate for overnight unsecured lending between banks.  Examples of these rates include SONIA, EONIA, and SOFR.

In essence, under an OIS:

  • A fixed rate is paid in exchange for the floating RFR (e.g. SONIA)
  • The floating leg is reset on a daily basis (i.e. present value of floating leg is accounted for every day over the life of OIS)

The OIS rate is generally considered to be a good proxy for a term risk-free rate, and is therefore less risky than the corresponding IBOR, because there is less credit risk associated with it due to the parties to an OIS not being required to exchange the principal amount during the life of the transaction and only one party needing to make a single swap-related net payment at maturity.

Accordingly, the LIBOR-OIS spread represents the incremental rate of interest demanded by the interbank market over a close to risk-free rate (i.e. the OIS rate) to compensate for the increased credit risk.

Which RFRs have been identified?

A number of working groups have identified preferred RFRs, as follows:

  • In April 2017, a Bank of England working group recommended the Sterling Overnight Index Average (“SONIA“) for unsecured loans as an alternative to sterling LIBOR. The working group aims to establish SONIA as the primary sterling interest rate benchmark in the sterling loan, bond and derivatives markets by the end of 2021. A reformed SONIA rate has been available from 9am on Tuesday 24 April 2018. Work is ongoing.
  • In June 2017, the Alternative Reference Rates Committee in the US recommended the Secured Overnight Financing Rate (“SOFR“) as an alternative to US dollar LIBOR. SOFR has been available from 3 April 2018. Work is ongoing.
  • In September 2018, the European Central Bank Working Group on euro risk-free rates selected the euro short term rate (“ESTER“) as the alternative to EONIA. It has since undertaken various consultations and published various materials, including a Legal Action Plan dealing with the transition from EONIA to ESTER. These have culminated in a transition plan whereby EONIA, which will cease to be published late 2021, has, effective 2 October 2019, become ESTER plus a fixed spread of 8.5 basis points. In July 2019, the Working Group published its final recommendations on the transition from EONIA to ESTR with respect to cash and derivative products and a related impact paper. In November 2019 it published a further paper on ESTER fallbacks. ISDA has various ongoing work-streams relating to EONIA transition and its implications for ISDA collateral and other documentation – see the Q&A in the Derivatives section for further information in this regard. In October 2019, the LMA issued its own guidance on the issue.   
  • In December 2016, the Study Group on Risk-Free Reference Rates, a working group in Japan, recommended the Tokyo Overnight Average Rate (“TONA“) for uncollateralised overnight calls as an alternative to Japanese Yen LIBOR. Work is ongoing
  • In October 2017, a Swiss National Bank working group recommended the Swiss Average Rate Overnight (“SARON“) for secured loans as an alternative to Swiss franc LIBOR. Work is ongoing. 

Click here for a table which lists the key IBORS and the RFRs which are scheduled to replace them. 

Is it possible to have forward-looking RFRs or “term RFRs”?

RFRs by their nature are backward-looking and do not have a “term” element (as LIBOR does) being overnight borrowing rates. However, it is possible to create or construct a term rate using an RFR as the foundation of such a rate. One way in which this may be done is by using the prices of derivative instruments (e.g., futures and OIS) that reference the RFR to infer the market’s expectation of the average value of the RFR over a particular period of time. 

ICE has developed a preliminary methodology based on futures contracts data (with a view to potentially include OIS data in its calculations) to derive a term rate SONIA (the GBP RFR) across one, three and six month terms- for further information see here. The intention is that ICE will then use this methodology to publish a series of SONIA-derived term rates on a daily basis, much in the same way that ICE currently publishes LIBOR for a variety of tenors. This same methodology could also be used to derive term rates based on other RFRs. Once published, these term rates could then be directly referenced by market participants in new products (e.g. loans, bonds or derivatives) or be used as a fall-back in an existing product once the relevant IBOR has been permanently discontinued.

The work that ICE is doing to produce these RFR-derived term rates is separate to the work that ISDA is doing and serves a different purpose.

As set out in more detail here, ISDA intends to amend its 2006 Definitions to provide for methodologies to derive a term rate from an RFR and determine a credit spread adjustment to be applied to that derived term rate. These methodologies will only be applied to the extent that an IBOR referenced in an existing transaction has been permanently discontinued. They are therefore fall-back methodologies that aim to maintain the economics of affected legacy transactions, rather than to be used as a method of calculating a “synthetic” IBOR that can be referenced in new transactions.        

Recent developments

In June 2019, the FSB published a user’s guide to (and an overview of) alternative RFRs. The guide explains how RFRs are calculated and how they can be applied to cash products.

In January 2020, the UK RFR WG published its top level priorities and a roadmap for 2020. Priorities include transitioning legacy derivatives and cash products to SONIA (and, as part of that, dealing with so-called ‘tough legacy’ e.g. securitisation structures) and ceasing LIBOR-based cash product origination by Q3.

In February 2020, ISDA published a paper, available on www.ISDA.org, examining several major upcoming developments related to the adoption of RFRs, including the publication of new benchmark fallbacks for derivatives contracts and central counterparty changes in discounting and price alignment interest for certain currencies.

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