As the cessation of Japanese yen LIBOR draws closer, we analyze the recommended alternatives, such as TIBOR, TONA, and TORF.

The U.K.'s Financial Conduct Authority (FCA) announced March 5, 2021, the permanent cessation of the publication of London Interbank Offered Rate (LIBOR) at the end of 2021 for most currencies, including the Japanese yen. In Japan, the Cross-Industry Committee on Japanese Yen Interest Rate Benchmark (the committee), which consists of various market participants, started discussions on alternative benchmarks to Japanese yen LIBOR in 2018. The Bank of Japan (BOJ) acts as the secretariat of the committee.

In preparation for the permanent discontinuation of LIBOR quotes, the committee developed a Japanese yen LIBOR transition plan.

The Japan plan contemplates that new bond issuance and new lending referencing Japanese yen LIBOR ceases by the end of June 2021. The plan also expects a substantial reduction in legacy bonds and loans referencing Japanese yen LIBOR by the end of September 2021.

Most likely, this reduction will be achieved through transaction amendments, where feasible. In addition, the committee recommends first- and second-priority fallback rates in waterfall structures for legacy bonds and loans (see table 1). These fallback rates are based on the results of a survey of targeted market participants.

The committee's recommendations were supported by a majority of market participants. However, these recommendations do not preclude contracting parties from selecting other reference rates.

Among the recommended alternatives, term risk-free rates (called term reference rates by the committee) involve the periodic exchange of two different interest rates. They are calculated based on fixed rates observed in overnight index swaps.

Meanwhile, the use of alternative reference rates selected by the International Swaps and Derivatives Association (ISDA) is widely accepted for derivatives referencing Japanese yen LIBOR, just as it is for those referencing non-Japanese yen LIBOR. Specifically, the compounded Tokyo Overnight Average Rate (TONA) (fixing in arrears) is assumed as the benchmark for transactions referencing Japanese yen LIBOR.

Table 1

The committee indicated five alternative benchmark options in the report published in 2019. These included, TONA (fixing in advance), the Japanese yen Tokyo Interbank Offered Rate (TIBOR), and the uncollateralized overnight call rate futures.

Table 2

Discussions on LIBOR cessation are also ongoing for LIBOR for non-Japanese yen currencies. We have identified a few differences between Japanese yen LIBOR and non-Japanese yen LIBOR transition plans. Term rates calculated by daily compounded overnight call rates are the most accepted as alternative reference rates for contracts referencing non-Japanese yen LIBOR benchmarks. For bonds and loans referencing Japanese yen LIBOR, on the other hand, term reference rates are the preferred alternative in most cases, although TONA-compounded in-advance and TONA-compounded-in-arrears term rates calculated using daily overnight call rates in Japan are included as two of five alternative benchmark options to replace Japanese yen Libor. TIBOR--an interbank offered rate (IBOR) like LIBOR--is another alternative benchmark options in Japan. In contrast, a European market's interbank offered rate, EURIBOR, is not generally recommended as a LIBOR replacement.

TONA And LIBOR: Divergent On Term Structure

TONA is a widely recognized short-term money market rate in Japan. It is an uncollateralized overnight call rate for interbank transactions and considered nearly risk-free. The Study Group on Risk-Free Reference Rates, consisting of various market participants, officially identified TONA as the Japanese yen risk-free rate in a 2016 report. In relation to the depth of market underlying risk-free rates required by Financial Stability Board (FSB), the study group in its report noted that TONA had a sufficient transaction volume and variety of participants.

LIBOR is an interest rate benchmark with a term structure. In contrast, TONA is an overnight rate and lacks a term structure. To use TONA as the LIBOR successor, a compounded rate must be generated over a time period matching the relevant LIBOR maturity setting. The results of our comparison of LIBOR and TONA for tenors of one, three and six months are below.

Chart 1

Table 3

All one-, three- and six-month LIBOR rates trended higher than corresponding compounded TONA rates during the observation period, which started in 1998. Compounded TONA is based on TONA, which is considered risk-free. On the other hand, LIBOR represents borrowing costs between financial institutions. Thus, the credit risk of financial institutions is embedded in LIBOR.

Mean and median of long-term historical LIBOR rates are higher than those of compounded TONA. We attribute this to credit risk reflected in market rates. Conversely, we have seen compounded TONA exceeding LIBOR, mainly one-month LIBOR, since 2016, with the spread limited to about 10 bps.

We consider the correlation between compounded TONA and LIBOR to be relatively high. LIBOR increased more than compounded TONA in 2007-2009. We attribute this to increased credit risk for financial institutions during the financial crisis. LIBOR also rose dramatically at the end of 1999. In our view, this is due to the Y2K problem, which involved the potential for informational technology failure as calendars moved to the year 2000 and fueled concerns over settlement system uncertainty. Based on the above, we consider compounded TONA to be less sensitive to changes in environment, such as economic slowdowns and deteriorations in financial institution credit quality.

TIBOR And LIBOR: Reference Banks Make A Difference

Most of the reference banks submitting rates for TIBOR are Japanese. The Japanese Bankers Association (JBA) TIBOR Administration (JBATA) publishes TIBOR rates daily. Given TIBOR is one of the five alternative benchmark options, JBATA implemented reform in 2017 to integrate and clarify the process of TIBOR calculation and determination.

TIBOR's similarities with LIBOR include term structure and embedded credit risk premium. According to the committee's 2019 report on Japanese yen LIBOR alternatives, TIBOR provides cash flow certainty since fixing occurs in advance. It also has basic characteristics similar to those of Japanese yen LIBOR, such as exposure to the credit risk of banks. Therefore, the committee considers TIBOR to be highly compatible with the current administration and systems, accounting practices, and market conventions. We compare TIBOR and LIBOR below.

Chart 2

Table 4

TIBOR trended higher than LIBOR for all tenor categories, but their historical movements are similar.

Looking at data from the last 25 years, the gap between the two rates widened in 1997-1998. During this period, major Japanese financial institutions filed for bankruptcy, and uncertainty over credit risk associated with the financial sector rose.

Meanwhile, Japanese yen LIBOR reference banks are mostly non-Japanese. Therefore, we believe increased credit risk associated with Japanese financial institutions pressured Japanese yen LIBOR less than TIBOR. Additionally, both TIBOR and LIBOR rose in 2007-2008, which we consider a consequence of the global financial crisis. Since 2015, LIBOR has been declining, while TIBOR has been almost flat.

TORF And LIBOR: Credit Risk Exposure Is Key

The committee recommended giving first priority to term reference rates (term risk-free rates) in the fallback waterfall for bonds and loans referencing Japanese yen LIBOR. However, no such rate existed at the time of recommendation. In February 2020, the committee selected Quick Co. Ltd. to calculate and publish the rates. Quick started to publish prototype Tokyo Term Risk Free Rates (TORF) as Japanese yen term risk-free rates in May 2020. This was followed by the establishment of Quick Benchmarks Inc., which started publishing production TORF for actual transactions in April 2021.

TORF is a Japanese yen term risk-free rate that is nearly free of credit risk associated with financial institutions. According to the committee's 2019 report, as with Japanese yen LIBOR, TORF provides cash flow certainty because fixing occurs in advance. The committee considers it highly compatible with the current administration and systems, accounting practices, and market conventions.

Table 5

Theoretically, TORF is risk-free and should be lower than LIBOR, as it does not involve financial institution credit risk.　A comparison of published prototype TORF and LIBOR data during 2020 shows that prototype TORF remained higher than LIBOR rates in the one-month term category. However, for three- and six-month tenors, LIBOR was higher.

Notes

• The prototype TORF are intended for use only by the recipient(s) of this report and shall not be distributed to any third parties, modified, or replicated.
• All rights related to prototype TORF are reserved by the provider, Quick Corp. Quick shall accept no responsibility whatsoever for any mistakes, regardless of the cause.
• Prototype TORF and the process by which they were calculated do not comply with the data quality, methodology, governance, and other principles for financial benchmarks established by the International Organization of Securities Commissions (IOSCO). The rates are published for informational purpose only and are not intended to be used as reference rates in actual financial contracts. Calculation requirements for prototype TORF differ from those for production TORF.

Related Research

• LIBOR Transition: Laws Won't Eliminate All Uncertainty, May 14, 2021
• Japanese Securitizations: Time Ticking On LIBOR Transition, March 17, 2021
• SOFR Emerging As Alternative To LIBOR In U.S. Debt Markets, Dec. 4, 2020
• Credit FAQ: SONIA As An Alternative To LIBOR In U.K. Structured Finance Transactions, Feb. 6, 2019