We are officially nearing the last stretch for LIBOR - the number often described as the “world’s most important number”. Despite an exceptionally turbulent year, which has delayed other deadlines in the Financial Sector, statements from Regulators have emphasised that the deadline for LIBOR succession remains as the end of 2021. So firms should be in no doubt, this is LIBOR’S final curtain call.
To outline the roadmap to get us there, we look at the following:
- Recent developments in LIBOR transition - Covid-19 has not stopped a flurry of updates over the past few months, which must be incorporated into transition plans
- Key, upcoming milestones - Firms should have visibility over, and plans to meet, upcoming milestones and guidance outlined by Regulators
- What do you need to do now? - Ensuring that everything is in place can seem like a daunting task – we outline the key steps to ensure an orderly transition, as well as those activities that your firm should already have undertaken
1. Recent developments in LIBOR transition
Over the past few months there have been developments across currencies and from regulatory bodies that have impacted transition timelines and planning.
Key developments from Industry Bodies
On 23rd October 2020, ISDA launched their highly anticipated LIBOR Fallback Protocol - designed to assist trillions worth of derivatives move away from LIBOR, with the amendments expected to take effect from 25th January 2021. Firms had been waiting on this announcement with baited breath ever since ISDA announced the initial delay, as the Supplement and Protocol are seen as crucial for the smooth transition in the derivatives markets, and will also have an impact on guiding the transition for cash products too.
On Tough Legacy, a consultation was launched on November 18th 2020 about proposals which would give power to the FCA to: designate a benchmark as non representative, prevent its use in new contracts; compel publication of a benchmark for up to 10 years; and give the FCA complete discretion to impose new methodology requirements on the benchmark administrator to keep a synthetic version on screen.
More uncertainty has been introduced through the publication of the IBA LIBOR cessation consultation plans. During December, the IBA issued a consultation on its intention to cease the publication of all GBP, EUR, CHF and JPY LIBOR settings immediately following the LIBOR publication on 31 December 2021. The IBA, FCA, and U.S. regulators also issued announcements and supervisory guidance encouraging banks to stop new USD LIBOR issuances as soon as practicable but no later than the end of 2021. However, the announcements also state that only one week and two month USD LIBOR settings will cease on 31 December 2021, and that publication for other USD LIBOR tenors will continue to June 2023 to support a smooth transition away from LIBOR. Clarity from the FCA is expected in Q2 2021 on the scenarios under which its regulated firms can continue to reference USD LIBOR beyond end 2021. However, the expectation is that referencing of USD LIBOR beyond the end of 2021 will be reserved for tough legacy transactions.
Key developments in the USD market
On October 16 – 19th 2020, the LCH and CME switched to using SOFR to value and pay interest on cash collateral for ~$134 billion of cleared US dollar swaps. Although this followed on the heels of the €STR switch, this was arguably more complex given the market had to fundamentally change how it valued USD derivatives – requiring a considerable change to how curves were constructed in systems. This was one of the biggest steps towards building liquidity in the SOFR market, with results that were encouraging initially – c.$57bn in notional hit the market across the two days, the largest SOFR trading days on record although the initial spike in volumes quickly tailed off again.
Key developments in the GBP market
To support the discontinuation of new GBP LIBOR linked linear derivatives expiring after 2021 by end-Q1 2021, the BoE announced that the GBP swap market would use SONIA rather than GBP LIBOR as the default price from 27th October 2020. This was announced on the 28th September – highlighting the BoE’s desire to accelerate the transition to SONIA.
2. Upcoming milestones
GBP LIBOR Deadlines
At the beginning of this year, the FCA/PRA/WG on Sterling Risk Free Rates released its LIBOR transition plan to 2021, which included deadlines that firms should work towards in order to be ready for LIBOR to be succeeded by that date. Although the regulators reconfirmed the view that LIBOR would end by December 2021 (despite Covid-19 induced volatility), the deadline for ending the use of the LIBOR in new loans was extended from Q3 2020 until Q1 2021. Firms should also cease new issuance of GBP LIBOR bonds, securitisations and linear derivatives that expire post 2021 from this date, with non-linear derivatives and cross-currency derivatives with a GBP leg from the second half of 2021.
With ISDA recently announcing the launch date for their Supplement and Protocol, firms should be ready to sign up before the effective date on the 25th January 2021. Comments from Edwin Schooling Latter of the FCA underscores its importance, highlighting that under EU Benchmark Regulation, supervised firms are required to have a plan for a cessation or material change in a benchmark rate - signing the ISDA protocol will meet this requirement. Additionally, firms who do not sign the ISDA protocol should be ready to explain to supervisors how they will mitigate remaining risks and be ready for potentially cumbersome bilateral renegotiations of fallback terms.
USD LIBOR Deadlines
Despite the launch of fallbacks in LIBOR referencing contracts and the switch to SOFR discounting in U.S. interest rate swaps, significant challenges remain in the development of term SOFR before the end of 2021. Sufficient liquidity in derivatives is needed to develop a term rate, with SOFR referencing derivatives still remaining thin and lagging other alternative rates – according to ISDA, ~$20bn of weekly SOFR-traded OTCs were traded for the week ending October 2nd, vs. the ~$473bn for total weekly SONIA-traded notional.
Client Transition / Repapering of Legacy Contracts
While c.250 entities adhered to the ISDA Protocol by the launch date of 23rd October, firms still face a monumental task repapering bilateral and other tough legacy contracts. A proactive repapering approach will be a critical part of a firms programme strategy throughout 2021 - failing to take active steps could adversely affect relationships with both customers and regulators.
3. What do you need to do now?
Firms should have already undertaken the following main tasks:
- Assess exposure to IBORs and continued monitoring ARR and LIBOR exposure trends
- Conduct impact assessment and highlight required changes to systems, processes, controls, etc.
- Begin to implement on the required operational and technology changes
- Legal contract consolidation, and define approach for repapering (including tools)
- Continue to deliver new capability, balancing with Covid-19 induced changes and volatility
- Improved fallback on any new LIBOR transactions
- 3rd party vendor and internal engagement to execute model, process and system changes
- Internal and external communications
It’s now time to focus on these five actions:
1. Internal and External Communication Strategy
A multi-channel communications strategy that keeps internal employees, external clients, vendors and regulators informed on the LIBOR transition should have been set up to be executed during 2021. If not started, we recommend defining the strategy and testing the communication approach with a sample set of clients. Client targets should be set for each month in 2021, with the bulk of activity complete earlier in the year. To support the process, we recommend creating a LIBOR Transition “Reference Document” for Relationship Managers This would include client outreach looking to agree, at a minimum; a date or event to transition (e.g. next maturity reset, cessation event), the mechanism to rebook trades in the future, agreement to default to fallback language on the transition event and repaper existing contracts to get the fallback language in place. As part of this, firms should have analysed any potential value transfer from fallbacks.
Given the increasing reporting requirements, scrutiny on conduct risk management and fair treatment of clients from regulators, particularly in the UK, firms should also have a robust external communications strategy in place that automatically tracks exposures through multiple lenses. Firms should think about how the MI gathered for regulatory exposure reporting can also be used to support monitoring the reduction in exposures by the rest of the firm for control purposes – such as “flashes” to the Front Office. All communications with clients should be available in the future to support any Conduct or Legal challenges that may occur. Firms could also look to extend their Monitoring & Surveillance technologies to track the use of LIBOR, RFR and ARR references to monitor conduct and keep records of client communications.
2. Execute Product Milestones defined by Official Working Groups
Where firms are not yet ready to offer products linked to alternative rates alongside the existing LIBOR offerings, new capabilities should be targeted in line with interim product milestones defined by official Working Groups and regulators - with key dates outlined above. In a similar vein, firms should also understand and implement outcomes from official bodies, with the major focus on signing up to the ISDA Supplement and Protocol. Non-adherence by one party to the ISDA Supplement and Protocol is likely to lead to more time intensive bilateral renegotiations and greater uncertainty surrounding valuation– therefore, firms should also have a plan to track exposure with non-adhering counterparties and plan for a longer renegotiation process.
Operational readiness should be prioritised with relevant models identified, remediated and stress tested and financial implications of the transition analysed. Engagement with Third Party vendors should be underway, in order for systems and processes to be updated to meet those targets.
3. Proactive Repapering and Transition Approach
While substantial progress has been made to incorporate new fallback language in contracts, or to update them to reference alternative rates, significant challenges remain in repapering legacy LIBOR referencing contracts before the end of 2021. A proactive transition approach will be critical– this means not relying on existing fallbacks or the prospect of “synthetic LIBOR”. While this might be tempting given the UK’s Tough Legacy Taskforce’s recent update that LIBOR may be stabilised via synthetic methodology for a short period, there are several risks involved. This includes increased litigation risk, given value transfer is more visible, and there is no certainty that the FCA will exercise these powers. Similarly, existing LIBOR fallback language is often inadequate and largely caters for situations where LIBOR is not available for a period of a few days, which often leads to unattractive financial implications – for example, a fallback rate to the lender’s own cost of funds plus the margin.
Therefore, firms should proactively assess the exposure of outstanding tough legacy contracts and develop a repeatable mechanism by which this can be monitored. We recommend Compliance input into the Legal process, with the contract renegotiation strategy prioritised with conduct considerations in mind, e.g. contracts with exposure to consumer clients. The options around dealing with tough legacy contracts generally falls between inserting fallback language or amending the contract so that it references alternative rates – so the appropriate strategy for the customer should be evaluated. For areas with significant exposures, understand if “bulk” repapering exercises can be undertaken. However, a flexible approach is likely needed between products given the different approaches markets have taken – e.g. derivatives are going towards backwards looking rates, while other markets have indicated a preference for forward looking ones.
4. Conduct Risk Mitigation
Throughout the process, regulators from all geographies have highlighted the importance of conduct risk mitigation during the transition. As liquidity builds and barriers to alternative reference rate adoption continues to fall, firms must ensure that proper conduct has been maintained at all times, is identifiable to any regulator and can be validated by Internal Audit. Examples of appropriate controls in place are: internal training to staff, appropriate client communications, and engagement of Legal and Compliance teams in the renegotiation of new contract terms for transitioning portfolios.
5. Transition Programme
Regulators have been increasingly focused on the governance surrounding transition programmes and how robust they have been. Given recent volatility and changing milestones, firms should ensure that their programmes are flexible enough to incorporate these changes and have the adequate resources to be able to respond quickly.
There is still a lot to be done by all firms to ensure they are ready for the LIBOR transition in a way that considers the needs of the firm and their clients. We expect further clarity across the industry to drive each bank’s activities and the associated effort to continually increase over the course of next year. This will be driven by industry deadlines, client responses to outreach and increased scrutiny from regulators as we get closer and closer to the December deadline. There is a high level of complexity and some uncertainty surrounding LIBOR transition across various products, currencies and activities.
A unique insight can make the difference. Our team at Baringa provides support, helps navigate the changing environment and keeps LIBOR transition programmes on track.
If you have any questions or would like to discuss LIBOR reform, please contact IBORTransition@baringa.com.