We take a look at recent market developments relating to IBOR transition and anticipate an urgent scramble in the coming months. With a fast decreasing time window and potentially lengthy
We take a look at recent market developments relating to IBOR transition and anticipate an urgent scramble in the coming months. With a fast decreasing time window and potentially lengthy consent processes, structured product manufacturers are seeking to quickly complete their identification exercises, start remediation, and repapering trades onto the new set of interest rates.
For something that was once described over a decade ago as ‘the rate that banks don’t lend to each other’, with seemingly little or no connection to the real world market of transactions, Libor has thus far proved a remarkably difficult quantity to get rid of. The real call for action kicked off in 2017, when Andrew Bailey of the FCA announced plans to target the discontinuance of Libor from the end of 2021. At the time, four or five years looked to be a sufficient time frame for banks and counterparties to plan the migration and move millions of open contracts and transactions onto the new benchmark rates.
So why is it that we find ourselves entering the Spring of 2020, with little over 9 months left before the deadline, and much still to resolve about the transition?
There is uncertainty still in many areas: Will USD Libor continue in some ‘synthetic’ form after December 2021? Who can use it if it does persist? When will fallbacks trigger?
This article seeks to offer a summary of recent developments, the risks and uncertainties involved, and what the big issuers of securities, derivatives and structured products still have to do in the short time left.
Even before the investigations on the 2008 financial crisis revealed widespread rate manipulations and fraud in 2011 through 2014, banks and authorities had been keen to move away from Libor. So the July 2017 announcement from the FCA and other regulators, which strongly advised market users to transition away from IBOR by 31st December 2021, came as no surprise.
For large chunks of the industry, this transition has been well underway. Cessation triggers have been enacted for Canadian Dollar Libor, and for GBP. The ‘RFR Working Group’ has set the goal that no new origination for cash products or linear derivatives*1 in GBP Libor should occur beyond the end of Q1 2021. This group has also set as a top priority that firms should complete their identification of all legacy GBP contracts expiring after 2021 by end of Q1 2021.
Even for sterling, with a relatively established and liquid SONIA benchmark, SONIA accounted for less than 4% of the open interest in GBP short term futures versus GBP Libor’s 96% at the end of Dec 2020. And just 168 SONIA linked FRNs were issued and outstanding at the year-end*2.
For derivatives markets, the ISDA IBOR Fallbacks Supplement and Protocol, now live since 25th Jan, allow for fallback provisions to be applied to any contract transacted under an ISDA Master Agreement in the event of cessation of IBOR or pre-cessation of Libor (assuming both parties to the contract each adopt the protocol). The primary fallback rates themselves are adjusted versions of the risk-free rates (RFRs) that have been identified by designated working groups for each jurisdiction.
In other words, there is a lot still to be done in a short space of time.
*1: Except for hedging purposes
*2: Source: Sterling Working Group Jan-21
But what about securities issued and referenced to Libor without reference to ISDA definitions? And what is happening to USD Libor?
Anticipating the IBA consultation announced in Dec 2020, which laid out its proposal to delay five USD tenors for a further 18months, the FCA launched two consultations in Nov 2020.
The first addresses when a benchmark becomes unrepresentative of its market (rather than ceases). This will be designated an ‘Article 23A benchmark’ and the FCA will be able to require the benchmark to be calculated by an alternative methodology if necessary. The second consultation considers the scope and use of such a ‘23A’ designated benchmark, which may be restricted only to ‘tough legacy contracts’.
Basically, even if USD Libor is extended to 2023, there is a chance that at any point before then, that the rate is deemed unrepresentative and the FCA could force a switch to a new ‘synthetic Libor’ determined by an alternate method. The exact details of this alternate method are the subject of another consultation by the FCA but are expected to follow the adjusted risk-free rates detailed in the ISDA protocol.
Following the IBA consultation, we can expect all currencies except USD to cease at the end of December 2021.
The 5 most popular tenors of USD-Libor will likely continue to be published through to Jun 2023. And while the IBA states in its consultation that it is “anticipating there being a representative panel” to continue to publish USD Libor, there is no guarantee of this. Furthermore, until the FCA provides more clarity on exactly which ‘tough legacy’ contracts can make use of an Article 23A designated benchmark, issuers and noteholders who choose to not remediate their outstanding trades still bear some uncertainty of outcome. Meanwhile, issuers of structured products have to plan for longer consent periods given the potentially large set of noteholders, and the likely greater variety of outstanding trades with limited or no fallback clauses depending on when they were issued.
Issuers must complete their assessment of legacy GBP contracts expiring after the end of 2021 by end of March. Industry participants are forecasting a scramble to get things done in the coming months and should be starting remediation exercises to reduce the tough legacy component of their portfolio, while we wait for some finality on scope and approach to the ‘synthetic Libor’.
The ISDA protocol and actions of the FCA have served to put some safety netting in place, but risks exist. Continued reliance on USD Libor in 2022 could cause market liquidity problems if a pre-cessation or cessation trigger happens.
There are also rumblings of discontent from buy-side interests in feeling that the influence of the bigger banks has been too dominant in forming policy. It will be interesting to see if these noises become louder as the legal infrastructure finalises this spring, and whether indeed IBOR is able to leave the stage on cue without disrupting the show.
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