LIBOR: the final countdown
Vice President - Legal
Monday 14 October 2019
In 2017 Andrew Bailey, Chief Executive of the FCA, signalled the upcoming discontinuation of LIBOR as a global benchmark. During a speech in London he announced that, in light of concerns over the sustainability of LIBOR, the FCA would not compel panel banks to provide submissions indefinitely. An agreement with these panel banks will see LIBOR sustained until the end of 2021 in order to mitigate the risks and costs associated with a more sudden shift.
Two years on, the industry is in the midst of a concerted effort to affect an orderly transition to nearly risk-free rates (RFRs). In July, at the LIBOR Transition Briefing in New York, Andrew Bailey outlined the significant progress made, particularly in the derivatives and securities markets. The speech highlighted, however, the scale of the challenge still faced by the industry in other markets and reaffirmed the importance of timely transition.
Despite the FCA’s clear message that it will soon no longer be considered representative and publication will cease, LIBOR still underpins an estimated $400 trillion of contracts worldwide.
Reform or replace?
LIBOR, a series of benchmarks of the average cost to banks of unsecured borrowing, is currently published in five major currencies across seven tenors ranging from overnight to one year. The primary issue with LIBOR is the absence of active underlying markets for the benchmark to measure.
In 2008 Mervyn King, the then Governor of the Bank of England, said “It is in many ways the rate at which banks do not lend to each other… it is not a rate at which anyone is actually borrowing.” Post-crisis, the interbank market has endured a period of rapid decline and all but disappeared. Moreover, when submissions are based on largely subjective judgements, rates become prone to manipulation. An infamous series of rigging scandals discredited LIBOR and catalysed significant reform of the benchmark.
The Wheatley Review that guided this reform warned of the risk of abruptly replacing such a ubiquitous benchmark. It found that “a transition to a new benchmark or benchmarks would pose an unacceptably high risk of significant financial instability.” Several Wheatley recommendations to bolster LIBOR were therefore implemented: the IBA replaced the BBA as administrator, currencies and maturities were reduced and a 3-month lag was introduced on bank submissions.
There is consensus that these steps to reform the benchmark have been largely successful. Reform, however, was never intended to permanently address LIBOR’s shortcomings, rather to shore up its integrity while replacements were identified and developed. In a speech in 2019 Michael Held, General Counsel of the Federal Reserve Bank of New York, noted that “efforts to ‘fix’ LIBOR proceeded alongside the program to identify better alternatives.”
Despite reform boosting reliability, LIBOR’s fundamental flaw (an absence of active markets) remains. As summarised by ICMA, “Manipulation can be prevented but liquidity cannot be invented.” Though a move to RFRs may therefore have been inevitable, hopes that the firms would transition of their own accord have not materialised. A firm deadline imposed by the FCA has set in motion coordinated efforts to identify and implement RFRs by the end of 2021.
Rise of risk-free rates
Notwithstanding the large volume of outstanding contracts still referencing the benchmark, the replacement of LIBOR through a transition to RFRs is gathering momentum. Public authorities and private sector working groups have identified and developed risk-free rates across a number of major currencies. Unlike the interbank rates they replace, they are anchored to active, liquid underlying markets.
The growing adoption of SONIA, in particular, has provided encouragement to those concerned about the feasibility of transition. The FCA’s LIBOR Transition Briefing noted that, as of July 2019, the notional of cleared SONIA swaps exceeds £10 trillion and it has become the norm for Sterling floating rate notes. Making ground in the bond and loan markets may prove more challenging, but the first steps have already been taken.
In the U.S., while there is consensus that SOFR represents a robust, reliable replacement for LIBOR, early adoption is modest. Unlike SONIA which was first established in 1997, SOFR is a new creation. This breeds caution - not to mention a more complex and therefore costly transition. A further complication is that the Alternative Reference Rate Committee’s (ARCC) Paced Transition Plan only anticipates a SOFR term rate by the end of 2021.
Another factor complicating transition is the continued industry desire for a credit-sensitive benchmark. For many banks, rates tied to a benchmark which is sensitive to bank credit risk provide “valuable insurance for banks against stressful times”. The viability of a ‘synthetic’ LIBOR, a RFR incorporating a credit spread, has repeatedly been dismissed, with Andrew Bailey stating that users “must not rest any hopes in a synthetic solution to continuing LIBOR publication.”
ISDA – Benchmarks Supplement and IBOR fallbacks
In light of the potentially chaotic disruption that incomplete preparation would bring, regulators continue to push for timely transition. One market which merits particular focus is OTC derivatives, which accounts for a significant majority of LIBOR linked contracts. ISDA is playing a key role in mitigating disruption through the publication of the ISDA Benchmarks Supplement and development of IBOR fallbacks.
The Benchmarks Supplement, published in 2018, “gives firms the ability to improve the contractual robustness of derivatives that reference interest rate, FX, equity and commodities benchmarks.” It was published in response to the EU Benchmark Regulation (“BMR”) and also addresses recommendations by the International Organization of Securities Commissions (“IOSCO”). Although materially different, these two initiatives share a common goal: ensuring market participants have robust plans in place in the event that a benchmark materially changes or ceases to be published.
For the Benchmarks Supplement to apply, parties must bilaterally incorporate it into their contracts. It introduces an “Index Cessation Event” trigger, which takes effect when a benchmark or administrator is no longer approved. The parties must then act in good faith to apply one of a number of “Alternative Continuation Fallbacks” during a specified window. The Benchmarks Supplement is therefore an interim arrangement insuring against an IBOR discontinuing before ISDA’s IBOR fallbacks are implemented.
Work on ISDA’s IBOR fallback initiative began in 2016 at the request of the Financial Stability Board’s Official Sector Steering Group (OSSG). The intention is to implement ‘emergency’ provisions which would be triggered upon the permanent discontinuation of an IBOR. Following industry consultations, it was confirmed that fallbacks for derivatives will be the identified RFRs. In order to ensure that fallback rates operate as closely as possible to the intended rate in legacy contracts, overnight RFRs will be adjusted to reflect the multiple tenors of IBORS as well as the bank credit risk factor.
In 2018 ISDA conducted a public consultation on the approach to these adjustments, followed by supplemental consultations in 2019. Two key issues the consultations sought input on were the various approaches to ‘term’ and ‘spread’ adjustments to RFRS.
The consultation results on ‘term’ adjustment (i.e. accounting for a move from an IBOR term rate to the RFR which is an overnight rate) concluded that the overwhelming majority of respondents preferred the ‘compounded setting in arrears rate’. In this scenario the fallback would be to the “…relevant RFR observed over the relevant IBOR tenor and compounded daily during that period”.
The ‘spread’ adjustment reflects the (nearly) risk-free nature of the overnight RFRs versus IBORs which have a bank credit risk component. A significant majority of respondents preferred the “historical mean/median approach” which would be based on the “…mean or median spot spread between the IBOR and the adjusted RFR.”  This would be calculated over a significant, static lookback period.
The expectation is that ISDA will soon finalise fallbacks based on these adjustments. The 2006 ISDA Definitions will be updated and will apply to new IBOR trades, while a protocol will give the option of implementing for legacy contracts. Although much work remains in order to avoid disruption, ISDA’s contributions are well-advanced.
With approximately two years until the cessation of LIBOR and the fate of other IBORs still unclear, time for transition is running out. The continued dominance of LIBOR linked contracts remains a real cause for concern.
Positive, collaborative steps have been taken across the industry to effect a smooth transition. The identification and development of RFRs with broad industry consensus is a crucial development.
ISDA continues to drive progress in the OTC derivative market, facilitating pre-cessation planning and developing robust fallback positions.
The transition from LIBOR is an “unprecedented global financial engineering project of massive scale.”  To accomplish it without major systemic disruption requires close coordination and cooperation across the industry. For many market participants, urgent action is required as the clock continues to run out on LIBOR.
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1. Bailey, A (2017), ‘The future of LIBOR’, speech at Bloomberg London, 27 July.
2. Bailey, A (2019), ‘LIBOR: preparing for the end’, speech at SIFMA New York, 15 July.
3. King, M (2008), Oral evidence taken before the Treasury Committee, 25 November
4. HM Treasury (2012), ‘The Wheatley Review of LIBOR: final report’, September 2012.
Held, M (2019), ‘SOFR and the transition from LIBOR’, speech at SIFMA C&L Society New York, 26 Feb.
5. CMA (2019), ‘Could a repo rate benchmark replace LIBOR or EURIBOR?’
6. Bailey, A (2019), ‘LIBOR: preparing for the end’, speech at SIFMA New York, 15 July.
7. Nelson, B (2019), ‘Why Is LIBOR Being Replaced Rather Than Reformed?’, 2 April.
8. Bailey, A (2018), ‘Interest rate benchmark reform: transition to a world without LIBOR’, speech at Bloomberg London, 12 July.
9. ISDA Press Release (2018), ‘ISDA Publishes Benchmarks Supplement’, 19 September.
10. SDA Press Release (2019), ‘ISDA Publishes Preliminary Results of Supplemental Benchmark Fallbacks Consultation’, 30 July.
11. LIBOR to SOFR Working Group, FRAC, OFR, (2019) ‘The End of Libor’, 11 July.
12. ISDA website (2018) ‘Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR Euroyen TIBOR and BBSW’, 12 July.
14. LIBOR to SOFR Working Group, FRAC, OFR, (2019) ‘The End of Libor’, 11 July.
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