Regardless of the BMR compliance extension, it is important that LIBOR transition programmes continue to progress quickly, says Matthieu Sachot at Chappuis Halder & Co.
Last week, European Union policymakers agreed to allow benchmark administrators a two-year grace period to comply with BMR (the Benchmark Regulation). The agreement to extend the BMR compliance deadline to 31 December 2021 was hailed as a potentially chaos-avoiding development.
The need for this grace period agreement was detailed in a November 2018 paper published by ISDA (International Swaps and Derivatives Association), FIA (Futures Industry Association), GFMA (Global Financial Markets Association) and EMTA (Emerging Markets Traders Association), which raised serious concerns about the lack of preparation for BMR compliance.
But it is important to remember that BMR, an EU-focused regulation, serves a different purpose than the market-led transition away from LIBOR, which is expected to be discontinued at the end of 2021 once the UK FCA (Financial Conduct Authority) stops compelling banks to submit rates.
If BMR will now conveniently match the so-called “deadline” for the new alternative secured overnight rate in the US – the SOFR (Secured Overnight Financing Rate) – a number of treasurers and heads of business lines in the US and Asia have underlined that there is no value in delaying LIBOR transition programmes. They consider 2019 only ‘luxury time’, given that banks as well as their counterparties, including large and smaller corporates, still have to prepare for the coming changes.
Continued LIBOR transition efforts required
The BMR and LIBOR transition events are not completely decorrelated, however. A delay in BMR acceptance will provide room for longer continuation of LIBOR-based programmes, products and hedges, supporting what some have already dubbed a “Zombie LIBOR” period, characterised by reducing volumes and rate contributions over time.
In November 2018, CFTC chairman Christopher Giancarlo warned that of the importance to transition away from LIBOR not just for new derivatives and securities, but also for legacy trades. Legacy contracts that still reference LIBOR but are no longer supported could put into disarray “the whole ecosystem developed to support efficient risk-transfer in our global markets,” he said.
SOFR volumes growing, but still limited
The BMR extension may also lessen the pressure for SOFR volumes to increase. Although the new rate is just 11 months old and volumes are considered to have grown ahead of schedule, the market is still developing. From July 2018 to Feb 2019, SOFR saw USD 64 billion in cumulative cash issuance, including USD 16.3 billion just for Feb 2019. This is roughly 3.5 times the aggregate of SOFR swaps transactions during that same 8-month period.
Maturities in SOFR are also starting to extend, though at a limited pace, with CME futures now seeing momentum building on both 1-month and 3-month SOFR contracts. In parallel, OIS-SOFR swaps are reaching longer maturities.
More time for legal fallbacks
The BMR extension also allows more time to finalise fallback provisions, especially to minimise the gaps observed between derivatives and cash products.
Fallback provisions are being included in new agreements, as well as existing agreements that are being amended or otherwise modified for any reason, regardless of stated maturities, as it is possible that markets will move away from LIBOR in advance of its declared end date.
With regard to the transition from Fed Funds to SOFR discounting, the plan is still set for 2020, so the BMR extension should have no particular effect.
BMR third-country representation
EU legal representation is required for third-country benchmarks whose administrators are seeking recognition under BMR. It is through this representation that regulatory oversight will be effected by an EU competent authority.
With the two-year grace period for BMR compliance, the third-country representation has just increased in cost by another 2 years. Some benchmark administrators have been finding the selection of the right EU representative and the associated costs quite challenging.
LIBOR transition – why 2019 matters
While other market and regulatory challenges will persist through 2020 – such as the final phase of OTC Uncleared Derivatives Initial Margining requirements due 1 Sept 2020, and a material workload ahead in respect of legal reviews and operational preparation for collateral pledging – the LIBOR transition will continue to hold strong value in the year ahead, with very limited delays acceptable now.
Some factors worth keeping in mind include:
- Studies of stress-tested impacts, at legal entity level, on the front-line, as well as for legal, product control, finance, ALM, scarce resources, risk, IT and operations;
- Studies of stress-tested impacts for key counterparts and/or clients to the buy- and sell-sides, who will be looking for answers on the breadth and depth of change they will face operationally, technically, legally, and business-wise;
- New rates for discounting will present a challenge if banks, clients or counterparties are unable to agree on when and how to make the changes, potentially leaving collateral disputes open for a critically long period of time;
- Fallbacks, and especially fallback gaps, which will require clarification, or at least industry leaders to endorse solutions this year; and
- Communications, not only to explain what the LIBOR transition is and its potential impacts, but where the risks and opportunities are. Financial institutions will need to ensure:
- Regular updates to staffs in relation to their respective work and cross-departmental impacts;
- Updates to shareholders on 1) business readiness, 2) regulatory cross-impacts, 3) business and revenues opportunities;
- Close monitoring and follow-up of the readiness of third-party vendors;
- Updates to regulators and industry bodies such as ISDA, ASIFMA, etc; and
- Updates to clients on the impacts specific to them, the methodology for managing these impacts proactively, and the key next steps they should expect along the way.
Ending reliance on LIBOR
Regardless of BMR compliance extension, the financial industry needs to understand the urgency to prepare for this critical liquidity topic that the transition away from LIBOR represents. The grace period from BMR provides time to both regulators and market participants alike to ensure readiness for LIBOR alternative rates, but ongoing transition programmes need to continue at a rapid pace.
Recently, in a speech entitled ‘Ending reliance on LIBOR’ delivered at the Investment Association in London, Megan Butler, the FCA’s Executive Director of Supervision, said: “if the reason you are not acting is because you think we are going to change course, I’m afraid you are wrong.”
Butler was addressing the investment managers, but the message was clearly aimed at both sell- and buy-side firms on the urgency of the LIBOR transition, encouraging them to prepare for the transition of both their new and legacy hedges and positions over to SONIA – the UK’s new risk-free reference rate – before LIBOR disappears.
Matthieu Sachot is director at Chappuis Halder & Co., Asia-Pacific, in charge of the regulatory and front office streams.