The FCA’s recent announcement has provided clarity on the future of all LIBOR settings. But, derivatives market participants still have work to do.
The UK FCA (Financial Conduct Authority) last week confirmed the end dates for all LIBOR settings, offering market participants some much needed clarity and a nudge to push ahead with their transition plans.
The FCA declared that all seven tenors for both EUR and CHF LIBOR; overnight, one-week, two-month and 12-month GBP LIBOR; spot next, one-week, two-month and 12-month JPY LIBOR; and one-week and two-month USD LIBOR will permanently cease after 31 December 2021. Publication of the overnight and 12-month USD LIBOR settings will cease after 30 June 2023.
The remaining GBP, JPY and USD LIBOR settings may continue to be published on a non-representative, synthetic basis for a certain period after end-2021 (for the GBP and JPY settings) and mid-2023 (for the remaining USD tenors) to address difficulties amending ‘tough legacy’ contracts, but UK regulated institutions will not be allowed to use this ‘synthetic LIBOR’ in new contracts.
Similarly, supervisory guidance issued by the Federal Reserve in November stated that regulated institutions in the US generally should not use the USD LIBOR settings that will remain past end-2021 in new contracts, subject to specific exceptions. The publication of certain USD LIBOR tenors until 30 June 2023 will, however, allow most legacy USD LIBOR contracts to mature and avoid disruptions.
ISDA has confirmed that the FCA’s statement constitutes an index cessation event for all 35 LIBOR settings. As a result, the spread adjustments that are added to the relevant risk-free rates (RFRs) under a new derivatives fallback methodology were fixed on 5 March.
The amendments to introduce new fallbacks came into effect for derivatives markets on 25 January and represent the culmination of more than four years of work involving ISDA, regulators and market participants. The changes mean that an alternative reference rate will automatically apply if an IBOR permanently ceases or LIBOR is deemed to be non-representative of its underlying market before counterparties have voluntarily transitioned their contracts away from LIBOR.
In light of the FCA’s announcement, ISDA has issued new guidance indicating that the fallbacks will automatically apply for remaining derivatives contracts referencing the GBP, EUR, CHF and JPY LIBOR settings on the first London banking day on or after 1 January 2022. For outstanding derivatives that continue to reference USD LIBOR, the fallbacks will automatically apply on the first London banking day on or after 1 July 2023.
As US dollar LIBOR is a component in the calculation of the Singapore dollar Swap Offer Rate (SOR) and the Thai Baht Interest Rate Fixing (THBFIX), fallbacks for these rates will also apply after 30 June 2023.
The rates used in the fallbacks are based on RFRs, compounded in arrears to address tenor differences, and calculated with a spread adjustment to account for the credit risk premium and other factors inherent in IBORs. This is to prevent contracts which initially referenced IBORs from diverging too far from counterparties’ original interest rate expectations.
While the fallbacks eliminated a key source of market uncertainty and reduced the potential for future systemic risks, the fixing of the spread adjustment now provides additional clarity on the future terms of derivative contracts which now incorporate these fallbacks.
“The FCA announcement gives the market important clarity on the future of all LIBOR settings,” says Scott O’Malia, ISDA’s chief executive. “Market participants that have amended their derivatives to include the new fallback rates can now push forward with their transition efforts with a clear timetable in mind, and with the knowledge that viable fallbacks will automatically apply in their outstanding LIBOR derivatives contracts if transition efforts aren’t complete by the time the various LIBOR settings cease or become non-representative.”
To date, more than 13,500 entities globally – including about 1,300 in Asia – have adhered to the ISDA IBOR Fallbacks Protocol, which enables firms to incorporate the fallbacks into legacy non-cleared IBOR derivatives with other adhering parties. While some smaller firms may not have adhered to the protocol, the vast majority of large firms have, which addresses concerns over systemic risk.
In January, the FCA estimated that 85 percent of non-cleared interest rate derivatives in the UK referencing GBP LIBOR now have effective fallbacks in place. Once cleared derivatives and futures are included, approximately 97 percent of GBP interest rate derivatives in the UK are expected to be covered.
Similarly, the Commodity Futures Trading Commission (CFTC) estimates that 69 percent of notional outstanding of non-cleared interest rate swaps reported to US swap data repositories now have the updated ISDA fallback language in place. In total, legal entities accounting for almost 95 percent of gross notional outstanding (cleared and non-cleared) in interest rate swaps reported to US repositories have adhered to the protocol.
Meanwhile in Asia, where derivatives market participants are known to be heavy users of LIBOR (including USD LIBOR), regulators in Singapore, Hong Kong, Australia and elsewhere have been urging market participants to adhere to the protocol.
“Regulators have estimated that broad adherence to the protocol means the vast majority of derivatives exposure now has workable fallbacks in place based on a consistent and transparent methodology. However, actual coverage could be even higher,” says Ann Battle, head of benchmark reform at ISDA.
“As well as adhering to the protocol, firms have the option of bilaterally agreeing with their counterparties to include the new fallbacks into their non-cleared derivatives trades entered into before 25 January,’ she added.
Even with fallbacks in place, derivatives market participants still have work to do. Regulators have emphasised that once robust fallbacks are implemented, market participants may be able to better tailor the economic terms of their IBOR contracts by actively transitioning their portfolios to alternative rates before any cessation event.
This requires firms to consider the implications for client relationships, economic impacts, hedge accounting, portfolio composition and potential overlaps with other amendments.
Besides bilaterally negotiating legacy contracts, market participants will also have to ensure that new contracts reference alternative rates.
In the UK, participants are directed not to issue any linear derivatives linked to GBP LIBOR after March 2021, other than for risk management of existing positions or where they mature before the end of 2021. In Hong Kong, banks are not meant to issue any new LIBOR-linked products after end-June 2021.
More prescriptive guidance on stopping the use of IBORs in derivatives contracts is expected in the coming months.
Chicken and egg
While systems and processes need to be in place to enable participants to transition existing LIBOR trades, as well as to reference alternative rates in new trades, a key challenge is a lack of liquidity in RFR markets.
RFR-linked notional accounted for just 11 percent of total cleared over-the-counter and exchange-traded interest rate derivatives in six currencies transacted in February 2021, according to ISDA analysis.
Yet, liquidity in some RFRs has increased. In the UK, nearly 50 percent of GBP derivatives trades are now referenced to SONIA. However, SOFR liquidity is arguably still underdeveloped, while Asian RFRs lag even further behind.
“There has been an improvement in RFR liquidity over the past year, but it’s a bit of a chicken and egg problem: firms want to see more liquidity before they trade, but they need to enter the market and trade in order to foster that liquidity,” says ISDA’s O’Malia.
“Ultimately, I think there will be a steady improvement in liquidity as we approach the end of 2021. Firms have to be ready – most LIBOR setting are unlikely to exist after the end of 2021, and the vast majority of firms recognise this.”