Libor transition: World of worry?

By the end of 2021, the global rates market must prepare for an environment in which most of the centrally-administered LIBOR set is replaced by a variety of alternative risk-free and near-risk-free rates (RFRs), mostly administered by central banks. LIBOR’s replacements in the five major currencies chosen – SOFR (USD), SONIA (GBP), €STR (EUR), SARON (CHF) and TONA (JPY) – will soon become familiar names as the switch to the new rates requires market participants to have transition plans in place to manage the process.

LIBOR vs. RFRs: The key differences between LIBOR and the alternative rates is that while LIBOR is a forward-looking rate available for a variety of tenors, the replacement RFRs are backward-looking overnight rates. Therefore, changing LIBOR as the reference requires adjustments to be made to account for both the credit risk inherent in LIBOR and the term structure. The derivatives market has reached key milestones in the preparation process as major derivatives clearing houses have already switched over to discounting based on the new rates. The International Swaps and Derivatives Association (ISDA) recently published a standardised approach to the term- and spread-adjusted versions of risk-free rates to be used as fallback rates for OTC contracts when LIBOR is discontinued. These developments should lead to a significant pickup in activity based on the new rates, which in turn will encourage the shift in the cash markets.

The LIBOR transition process: While the development of fallback rate protocol is necessary to ensure stability in financial markets, fallbacks are a backstop, not best practice. The best approach for most market participants in handling the transition is to identify exposures and actively mitigate risks by amending existing contracts and by negotiating new contracts based on the alternative rates. It is not merely a legal process but a complex project that will involve a multitude of changes and requires both time and resources to complete successfully. The Financial Stability Board (FSB) provided a transition preparation roadmap (Appendix A). Considering the notional value of transactions referencing LIBOR, it is not surprising that the cash market lags while the derivatives market is well advanced in defining the necessary steps in the transition process. Any unexpected changes, such as the announcement that the termination date for certain US LIBOR rates might be delayed until mid-2023, have already led to sharp moves in the derivatives markets.

The LIBOR transition encompasses a whole panoply of risks. Yes, legal risk, but also operational risk, credit risk, regulatory risk, reputational risk, you name it – LIBOR has it all… Because having a LIBOR transition office and a high-level plan is not enough. Do not underestimate the operational, technical, legal, communications, and risk management work that will be required to move existing transactions off of LIBOR and prepare to use an alternative rate. It will take time and resources, and the price of failure or delay in any of those areas could be high.

The LIBOR Countdown Has Not Stopped, 29 September 2020, Speech by Michael Held, Executive Vice President and General Counsel, Federal Reserve of NY

LIBOR REFERENCE RATES – THE END IS NEAR

The process of reforming IBORs has been going on for nearly a decade and transitioning to the new world of alternative rates will take a few more years, but the end is near for the LIBOR refence rates. LIBOR is computed for five currencies (US dollar, euro, pound sterling, Swiss franc and Japanese yen) and seven different maturities ranging from overnight to 12-months. LIBOR is administered by the Intercontinental Exchange (ICE) and the benchmark determination is based on submissions of 11 to 18 banks that contribute for each currency. By the end of 2021, the sterling, euro, Swiss franc and yen LIBOR panels will cease, while certain term US LIBOR rates may get a reprieve to June 2023. While the exact timing of official sector statements about the end of LIBOR is uncertain, market participants have been advised to act on the assumption that LIBOR will end as of 31 December 2021. Entering new contacts referencing LIBOR rates is actively discouraged by regulators, while transitioning legacy contracts to the new reference rates is strongly encouraged.

Why LIBOR replacement is needed

LIBOR as a reference rate has been used in both lending and borrowing contracts since 1986, serving to transmit changes in banks’ funding cost to borrowers so that when the benchmark rate changes, both the banks’ cost of funds and loans linked to this rate move simultaneously. However, bank funding has undergone structural changes, especially following the implementation of the Basel III accord. Greater focus on liquidity and limitations on the maturity mismatch banks can run have made them significantly less reliant on negotiable short-term funding. The proportion of funding banks get from deposits, term instruments and secured borrowing has increased significantly. Daily LIBOR rates are increasingly calculated not on the basis of actual trades, but hypothetical borrowing transactions submitted by the panel of banks and based on expert judgment. The nature of the calculation plus the lack of an active market of observable transactions, especially in the key 3-month tenor, called into question the validity and representativeness of the rate. Furthermore, LIBOR’s reputation was tarnished by the rate-rigging scandal dating back to 2005.

In its recent report1 on the progress in reforming major interest rate benchmarks, the Financial Stability Board (FSB) noted that in times of market stress, such as the disruption in March this year, “…LIBOR rates – and hence costs for borrowers – rose as central bank policy rates fell, and underlying market activity was low, reinforcing the importance of completing the transition to alternative rates by end-2021”. Furthermore, transaction volumes evaporated – in the US, the median number of trades and daily volumes declined by roughly three quarters, while in the UK, during the week of 16 March, the three-month sterling rate had no ‘transaction- based’ inputs.

What is replacing LIBOR

Under the auspices of FSB – which in a 2014 report illustrated the structural decline in liquidity in the interbank unsecured funding markets underpinning IBOR benchmarks – alternative interest rate benchmarks have been developed. The focus has been on the alternative overnight risk-free rates (RFRs) that rely on observable market inputs, while term rates have not been a priority.

The FSB notes that while all major IBORs have been strengthened since 2014, there is a concerted effort to reduce reliance on IBORs and promote the adoption of the more robust alternative rates. While certain jurisdictions have adopted a “multiple-rate” approach, where it is considered possible for the IBOR to coexist with the RFR, the alternatives to five key LIBOR rates have been settled (Table 1). The rates chosen take into account the characteristics of the markets in each jurisdiction and are therefore not uniform – the overnight reference rates for USD and CHF are secured (SOFR and SARON), while the GBP, EUR and JPY rates are unsecured.

South Africa’s own reference rate reform2 is in a comparatively early stage. Recommendations have been made for strengthening the Johannesburg Interbank Average Rate (JIBAR) rate setting process, which will probably come into effect in 1Q21. The strengthened JIBAR will be a hybrid between actual transaction data and binding quotes. The development of a purely transaction-based alternative will take longer since data collection is a major challenge. The South African Rand Overnight Index Average (ZARONIA) has been recommended as the reference unsecured overnight near-risk-free rate. The development of a secured rate, the South African Secured Overnight Financing Rate (ZASFR), is also recommended, but it first requires significant progress in establishing a robust market-wide collateral management platform and an efficient repo market.

1. ¹ Reforming Major Interest Rate Benchmarks 2020 Progress report, FSB, 20 November 2020
2. ² See our note SA’s reference interest rate reform: Recommendations made, 17 September 2020

TABLE 1: LIBOR ALTERNATIVE REFERENCE RATES

FICC: Fixed Income Clearing Corporation, GCF: General Collateral Financing, MMSR: Money Market Statistical Reporting, SMMD: Sterling Money Market Data collection reporting

Source: PwC, October 2020 (adapted)

Some key differences between LIBOR and the alternative rates

The critical difference between LIBOR rates and the alternative rates is that LIBOR is a forward-looking term rate published for various tenors, whereas RFRs are backward-looking overnight rates which requires certain adjustments to be made to enable the transition process. From a credibility point of view, the major difference between LIBOR rates and the alternatives is the reliance on methodologies for rate determination that are based on actual observable transactions, rather than using expert judgement. However, from the point of view of the users of RFRs, the key considerations are the differences related to credit risk and term structure.

• Spread adjustment: While the procedures for the calculation of the new rates are similar, the data sets on which the alternative RFRs are based are determined by idiosyncrasies of the market mechanics in each currency. The LIBOR rates, by design, reflect a degree of bank credit and liquidity risk since they were intended to serve as a proxy for the average cost of borrowing by a bank. All the alternative rates are overnight rates, and either risk-free or near-risk-free. Consequently, an additional spread must be added to alternative rates to make them comparable to LIBOR rates. The technicalities of how spread adjustments are to be calculated are not completely finalised, but the consensus revolves around a historical median over a five-year lookback period, most likely with a one-year transition period (ISDA recommendation).
• Term adjustment: The new rates are overnight rates, while LIBOR rates exist for a variety of terms – overnight (O/N); one-week; and 1, 2, 3, 6 and 12 months. Therefore, the daily setting of an O/N rate and a LIBOR rate will be different if the yield curve is not completely flat. Therefore, adjusted alternative rates need to be calculated to reflect a term structure so that they are comparable to the various LIBOR term rates. The term-adjusted new rates are calculated by compounding in arrears the daily O/N rates over the appropriate periods. The technicalities of compounding differ between alternative rates, reflecting issues such as day-count conventions in different markets, lookback periods and observation shift considerations.

Reconciling these key differences is critical to ensure that the transition from LIBOR to alternative rates does not result in a transfer of value between counterparties as a result of the switch. Due to spread and term differences, the daily setting for most LIBOR term rates will most likely be higher than the alternative rate setting for the same day. Therefore, a change of LIBOR as a reference in an existing contract requires an appropriate adjustment.

THE MARKET DEVELOPMENT PROCESSES

The approaching end of LIBOR as a reference rate implies a certain urgency to the transition to alternative rates and the process is rapidly accelerating as the recommendations of various working groups become the market norm, supported by regulators and relevant legislation. The transition process is dependent on market-wide adoption of the new reference rates in both the derivatives and cash markets.

The derivatives market

Reaching key milestones in the transition to RFRs is expected to encourage further development of derivatives markets based on the alternative RFRs. While a wide range of derivative contracts based on the new rates are available, the biggest challenge in the transition process is the management of legacy contracts that reference LIBOR rates, specifically what to fall back on as a reference rate when LIBOR is discontinued. Bilateral negotiations are the best way to replace references to IBORs with RFRs ahead of the cession of the publication of IBORs, but it is often not a feasible solution given the sheer number of OTC contacts based on IBORs. Considering the widespread use of the International Swaps and Derivatives Association (ISDA) Master Agreements, and the fallback provisions for various rates in the relevant ISDA definitions, the practical resolution was amendments that allow a standardised approach to determining fallback rates (Box 1).

Box 1: Fallback rates

What are fallbacks and why are they required?

Fallbacks are contractual provisions that set out the consequences of a certain event, such as the discontinuation of a benchmark. Historically, fallbacks in derivatives contracts for key interbank offered rates (IBORs) have required the calculation agent to obtain quotations from reference banks if an IBOR is not available on the screen. However, there is widespread concern that this fallback would not be sufficiently robust or sustainable in the event that an IBOR is permanently discontinued.

What are the new ISDA IBOR fallbacks?

For this reason, ISDA has developed new fallbacks based on adjusted versions of risk-free rates (RFRs). The alternative RFRs will be term- and spread-adjusted to account for the differences between IBORs and RFRs. These fallbacks will be triggered following a permanent discontinuation of a covered IBOR or, in the case of LIBOR, a non-representativeness determination.

How are the fallbacks calculated and where can I find them?

The new IBOR fallbacks are based on the alternative RFRs, which will be term- and spread-adjusted to account for the differences between IBORs and RFRs. Bloomberg was selected as the vendor to calculate and publish the term-adjusted RFR (i.e., the RFR compounded in arrears), the spread adjustment and the ‘all-in’ fallback rate (i.e., the term-adjusted RFR plus the spread).

Source: ISDA, 2020 (adapted)

The critical tipping point was reached on 23 October 2020 when ISDA published the much-awaited documentation (amendments to the 2006 ISDA definitions to include IBOR fallbacks and related protocol) to deal with the IBOR transition. These changes will enable market participants to incorporate the revisions into their legacy non-cleared derivatives trades with other counterparties that adhere to the protocol. These changes will come into effect on 25 January 2021. Adherence to the protocol is not limited to ISDA members, and non- members who adhere before the effective date do so for free. Thereafter, the cost of adherence is US$500 for ISDA primary members and for non-members. Adherence requires that each market participant explicitly opts in to accept the changes. However, it is important to note that adherence has a universal impact on all outstanding ISDA-governed contracts as they will be automatically amended to incorporate the IBOR fallbacks provided the counterparty in the transactions also adheres to the protocol. This extends to the referencing of IBORs not only in ISDA Master Agreements and Credit Support Annex (CSA), but also, for example, in certain credit support documents and trade confirmations, and some other contracts that are not ISDA-governed such as Global Master Repurchase Agreements (GMRAs).

The amendments published to the 2006 ISDA definitions for each rate specify what the primary fallback RFRs would be by amending the relevant wording and stipulating that the rates will be spread- and term-adjusted, as calculated by Bloomberg Index Services. The amendments also cover the various types of events that will trigger the fallback (such as a public statement by a relevant authority that the rate has ceased or will cease to be provided from a certain date or LIBOR is no longer representative). The IBOR fallback protocol provides details on the mechanics of adherence and the various documents that are covered by the adherence.

A strong impetus for transition was provided by the changes made by two major clearing houses with regards to the discounting rate for most USD IRD swap products. On the weekend of 16 October 2020, the Chicago Mercantile Exchange (CME) and the London Clearing House (LCH) completed the transition to discounting swaps and principal interest alignment from the Effective Federal Funds Rate (EFFR) to the SOFR. The switch for EUR Swaps from EONIA to €STR happened on 27 July 2020.

All of these developments should rapidly encourage increased activity in derivative contracts based on the alternative RFRs and speed of the adoption of the new rates. ISDA’s report for 3Q20 on the transition to RFR indicated that contracts based on the new rates still account for a small proportion of the global IRD traded notional amounts, including OTC and exchange-traded IRD (Figure 1).

However, the detailed published data for October shows that change is happening relatively quickly, and the level of adoption differs significantly across currencies and tenors. The ISDA-Clarus RFR Adoption Indicator3 was at 7.7% in 3Q20, compared to 4.5% in 2Q20. But the month-to-month comparison shows the indicator rising from 10.5% in September to 11.6% in October. At 40.4%, GBP recorded the highest percentage of RFR-linked IRD risk traded (as measured by DV01), while the USD was at 9.7% (up from 5.8% in the previous month).

Figure 1: Global IRD traded notional (including OTC and ETD)

Source: ISDA (data as at 30 September 2020)

The ISDA data clearly illustrates that while the proportion of derivative contracts linked to the new rates is growing, the transition is anything but rapid. However, a look at the data based on the tenor of traded derivatives indicates that the proportion of RFR-linked transactions with a tenor longer than two years is falling.

³ ISDA-Clarus RFR Adoption Indicator tracks how much global trading activity (as measured by DV01) is conducted in cleared over the counter (OTC) and exchange-traded interest rate derivatives (IRD) that reference the identified risk-free rates (RFRs) in six major currencies

The cash market

In comparison to the progress in the transition away from LIBOR in the derivatives market, the cash market has been much slower at adopting alternative RFRs. The growth in new contracts that reference the RFRs entered into by large non-financial corporates has been partially limited by the lack of liquid derivatives market which can be used to hedge risks. A major stumbling block has also been the slow emergence of consensus on how to calculate fair credit adjustment spreads for a myriad of legacy cash products such as floating rate notes, covered bonds, capital securities, securitisations, structured products, syndicated loans, retail loans and bilateral loans. However, once the ISDA recommendations became available, there were swift announcements from various alternative reference rates working groups which not surprisingly recommended the same methodology. One such example is the US’s Alternative Reference Rates Committee (ARRC), which on 8 April 2020 recommended the spread adjustment methodology for cash products exactly matching ISDA’s historical median over a five-year lookback period with one-year transition. The same recommendation was made for syndicated business loans on 30 June 2020.

Arguably, however, most of the reluctance to move to alternative RFRs has been based on the lack of term rates. There are several reasons why non-financial market participants prefer rates that are determined in advance rather than calculated in arears (Box 2). An additional consideration in emerging markets, especially in countries where access to foreign currency is constrained, is purely operational. For example, a lookback period of five business days for in-arrears SOFR calculation would work for a US-based corporate but would be a challenge for an EM corporate which may need to obtain regulatory permission and source the USD required. The Working Group on Sterling Risk-Free Reference Rates examined the difficulties in some specialised areas and explicitly acknowledged that compounding in arrears creates operational difficulty in areas such as trade and working capital (e.g. supply-chain finance and receivable facilities), export finance and emerging market loans, and Islamic facilities.

The development of term rates is underway for USD, GBP, EUR and JPY, but agreement on how those rates are to be determined is not imminent, and it is very likely that most LIBOR rates will cease to be published before robust term rates are available. Therefore, market participants are strongly encouraged to put in place transition arrangements. Industry organisations, such as the Loan Market Association (LMA), have developed standardised documentation to help facilitate the transition in syndicated lending and club loans.

Box 2: Why do some end-users prefer a pre-determined term rate

Consultations with end-users of financial benchmarks in various currency areas indicate that there are some important groups of users, notably small to medium-sized corporates and retail clients, that have expressed a preference for pre-determined term reference rates. To these market participants, cash flow certainty has the following advantages:

Cash flow management: Smaller market participants do not have a sophisticated treasury team and therefore would need to increase their liquidity holdings to mitigate the increased cash flow uncertainty. This would result in higher costs for those market participants.

IT systems: Most IT systems that are currently in use require cash-flow certainty. In a standard ‘in arrears’ structure, the final interest rate is known on the last day of an interest period.

Current hedging instruments: LIBOR has been a cornerstone of financial markets for decades, and many hedging instruments and market conventions have evolved around it. Market participants with assets and/or liabilities in several currencies use FX swaps and/or cross-currency basis swaps (CCBS) to concentrate cash flow management in a single currency. These instruments are based on knowing the rate at the beginning. Experience tells us that market development for such new instruments is not a rapid process as new conventions need to be established and that it takes time until these markets are liquid.

Legal restrictions: In some jurisdictions, retail loans require a longer notification period. In the US, for instance, consumer regulations define a minimum notification period of 45 days for retail loans, while an ‘in arrears’ structure is not compatible with Islamic finance, which requires a pre-determined interest rate.

Source: BIS, At the crossroads in the transition away from LIBOR: from overnight to term rates, BIS WP 891, October 2020

WHAT NEXT FOR LIBOR USERS?

There is no doubt that LIBOR rates will cease to be a viable reference for interest rate contracts in both the cash and derivatives markets at the end of 2021, although certain US LIBOR rates may get an 18-month reprieve. Entering new contracts based on LIBOR rates that have a term extending beyond 31 December 2021 is increasingly difficult as financial sector companies, especially banks, have very strong incentives, both regulatory and operational, to minimise LIBOR exposure. Financial products based on the alternative RFRs are available, and although liquidity is still lower than for LIBOR-based instruments, a step change is expected as the end of 2021 draws nearer.

Transitioning away from IBORs in legacy contracts in derivative markets can be complex, and adherence to the ISDA protocol provides a standardised and efficient means of transitioning derivatives contracts currently referencing IBORs to risk-free rates. It is a fail-safe solution, but both counterparties have to opt in, and it should not be the primary choice for any market participants. ISDA specifically notes that “Fallbacks are not intended to be a primary means of moving from IBORs to RFRs. Once the fallbacks are in place, it is recommended that market participants focus on voluntary transition before the cessation of any key IBOR. Moving away from key IBORs voluntarily by amending or closing out contracts that reference those rates allows counterparties to tailor their strategies to their specific portfolios and could allow firms to negotiate terms that avoid the adjustment mechanisms for fallbacks.”

Proactive management of IBOR exposures, especially the five LIBOR rates, offers an opportunity to fine-tune risk management strategies, especially for non-financial corporates whose circumstances and prospects might have changed after the disruption caused by the COVID-19 pandemic. Analysing existing cash market contracts is the obvious starting point, and depending on the position, size and complexity, a re-negotiation of the underlying exposure and the hedges that often accompany it allows for custom-made alignment.

Any risk-mitigation actions taken, however, require detailed consideration of not only the financial, legal and operational functions, internal controls and IT impact, but critically the accounting and tax consequences. The International Accounting Standards Board announced an amendment to the IFRS Standards on 27 August 2020, while the Financial Accounting Standards Board (FASB) addressed remaining accounting issues related to the transition in a standards update released in March 2020. Various practical implementation checklists have been published, providing a useful starting point for the development of transition plans for all market participants. Given the increased complexity of the transition for financial institutions, especially banks, and potential risks for the global financial system, the Financial Stability Board (FSB) was even more explicit by providing a roadmap suggesting not only what should be done but also by when (Appendix 1).

APPENDIX 1: FSB’S GLOBAL TRANSITION ROADMAP (GTR)

Firms should already have at a minimum (and if not, should promptly):

• Identified and assessed all existing LIBOR exposures, including an understanding of:
• Which LIBOR settings they have a continuing reliance on after end-2021, by currency and tenor.
• What fallback arrangements those contracts currently have in place.
• Identified other dependencies on LIBOR outside of its use in financial contracts – for example, use in financial modelling, discounting and performance metrics, accounting practices, infrastructure, or non-financial contracts (e.g. in late-payment clauses).
• Agreed a project plan, including specific timelines and resources to address or remove any LIBOR reliance identified, to transition in advance of the end of 2021 including clear governance arrangements.
• Understood industry or regulator recommended best practices in relevant jurisdictions, including timelines for intermediate steps in transition ahead of end-2021, and built these into their plans.
• Assessed what changes may be needed to supporting systems and processes in order to enable use of alternative reference rates in new and existing contracts, including through fallbacks. This may include, for example, treasury management systems and accounting processes.
• Those who currently provide clients with this infrastructure should have developed alternative solutions/offerings to ensure continuity of provision.
• Those who currently provide clients with products that reference LIBOR should have begun to implement a plan for communicating with end-users of LIBOR-referencing products maturing beyond end-2021 to ensure they are aware of the transition and the steps being taken to support moving those products to alternative rates.

By the effective date of the ISDA Fallbacks Protocol (25 January 2021):

• Adhere to the ISDA protocol, subject to individual firms’ usual governance procedures and negotiations with counterparties as necessary. Adherence to the protocol is strongly encouraged and where the protocol is not used, other appropriate arrangements will need to be considered to mitigate risks.
• Providers of cleared and exchange-traded products linked to LIBOR should also ensure that these incorporate equivalent fallback provisions as appropriate.

By the end of 2020, at a minimum:

Lenders should be in a position to offer non-LIBOR linked loan products to their customers. This could be done either in terms of giving borrowers a choice in terms of the reference rate underlying their loans, or through working with borrowers to include language for conversion by end-2021 for any new, or refinanced, LIBOR-referencing loans, for example if systems are not currently ready.

By mid-2021, firms should:

• On the basis of a full assessment of their stock of legacy contracts, have determined which can be amended in advance of end-2021 and establish formalised plans to do so in cases where counterparties agree.
• Where LIBOR-linked exposure extends beyond end-2021, make contact with the other parties to discuss how existing contracts may be affected and what steps firms may need to take to prepare for use of alternative rates.
• Have implemented the necessary system and process changes to enable transition to robust alternative rates.
• Aim to use robust alternative reference rates to LIBOR in new contracts wherever possible
• Take steps to execute formalised plans, where realistic, to convert legacy LIBOR-linked contracts to alternative reference rates in advance of end- 2021.

By end-2021, firms should:

• Be prepared for LIBOR to cease.
• All new business should either be conducted in alternative rates or be capable of switching at limited notice.
• For any legacy contracts for which it has not been possible to make these amendments, the implications of cessation or lack of representativeness should have been considered and discussed between the parties, and steps taken to prepare for this outcome as needed. The scope and impact of any steps taken by authorities to support tough legacy contracts, if available, should have been clearly understood and taken into account.
• All business-critical systems and processes should either be conducted without reliance on LIBOR or be capable of being changed to run on this basis at limited notice.

Source: FSB, 16 October 2020

More information about LIBOR

These websites contain and publish additional information and updates:

• Loan Markets Association
• ISDA
• The Association of Corporate Treasurers
• Alternative Reference Rates Committee (ARRC)
• International Accounting Standards Board (Board)