June 2019

The LIBOR Transition Cascade Reality

INTRODUCTION

  • LIBOR will cease to exist as a ‘Benchmark’ at end of 2021. The Benchmark’s regulator, the FCA, has been very clear and consistent in this message.
  • The process to replace IBORs with Risk Free Reference Rates (RFRs) is a post-financial crisis plan. It was started by the G20 in 2013, has been driven since by the Financial Stability Board, the FCA, then the Federal Reserve Board (FRB) and ARRC – which was convened in November 2014 – and since by all 16 IBOR regulators, and US regulators including FRB, Federal Reserve Bank of New York, OCC, CFTC, SEC and FDIC amongst others. This is not new news. The regulators have been consistent and clear on the broader LIBOR cessation issues.
  • The generally accepted scenario where all LIBOR contracts, all exposures, all products – derivatives and cash (Loans, Mortgages, Bonds etc.), all currencies, all jurisdictions will somehow transition on one day at the end of 2021 is implausible.

A more plausible LIBOR transition scenario – ‘ISDA will drive derivatives transition – and produce a LIBOR transition cascade across all products and markets.’

STATUS

  • We recognize from large bank client feedback, that no one will be fully prepared for a LIBOR transition of all products, all jurisdictions, all functions, all clients by end of 2021. 
  • Decisions for LIBOR transition, unlike those for other scale transition programs like Dodd Frank, Volcker, MiFID, CCAR, Basel etc., will be made on a ‘risk-based’ approach as terms are undefined, and process is too complex to plan, test and implement.
  • The largest notional exposures to LIBOR are in Derivatives. Derivatives were the initial priority of the FRB ARRC. Derivatives were always assumed to be the first mover in the ‘Paced Transition Plan.’ Derivatives will be the catalyst for multi-product transition.
  • The great majority of participants in the Derivatives markets operate under an ISDA agreement (normally the ISDA 2006 Amendment).
  • Derivatives transition, enabled by ISDA will be the catalyst for pre-2021 legacy transition from LIBOR to new RFRs.

ISDA PROVIDES THE FRAMEWORK

  • ISDA has been negotiating with regulators and market participants on LIBOR transition since 2016.
  • A number of ISDA LIBOR Consultations recently concluded, on fallback language, pre-cessation triggers, pricing protocols and the spread adjustments that will apply as one transitions from LIBOR to the RFRs.
  • They will release a ‘Supplement’ to the ISDA 2006 Amendment. This will redefine the underlying product definitions for 16 IBORs*, include the new pricing protocols and with it the IBOR fallback conditions in the case of the cessation of LIBOR and facilitate any transition of legacy LIBOR linked derivatives to new RFRs.
  • The “permanent cessation” of LIBOR will be due to a regulator or administrator’s public announcement. The ISDA Supplement will determine a fall back to SOFR (and the other IBORs to the other designated RFRs). 
  • The “pre-cessation” Consultation was completed and reviewed and the ISDA concluding announcement was on October 21st, 2019. If there is a “pre-cessation” of LIBOR (due to regulator or administrator’s public announcement before the end of 2021), the ISDA Supplement will determine a fall back to SOFR (and IBORs to other RFRs) on a date advised in the announcement.
  • The Consultation on the final protocols for fallback adjustments was completed and reviewed, and the ISDA concluding announcement was on November 15th, 2019. This defines the new protocols, which would apply to transitioning existing IBOR benchmarked transactions – when agreed by willing participants. 
  • The SOFR pricing methodology will be “overnight, compounded, in arrears.” Not a forward-looking rate. Not a traditional LIBOR-like term rate. 
  • The protocols define the “Spread Adjustment” recognizing the rate difference between the legacy LIBOR maturities and the SOFR curve at maturities out to 12 months. This will be calculated on a 5 year look back, median basis.
  • The SOFR compounded in arrears rate, will allow a last-2-banking-day shift adjustment for operational and payments purposes. 
  • These ‘Spreads Adjustments” for the all-in fallback rates will be calculated by the FRB, transparent and be published by Bloomberg, endorsed by FRB’s ARRC and ISDA. 
  • The ISDA announcement on the these amended benchmark definitions and protocols ‘are expected to be finalized by the end of this year, with implementation in 2020.’
  • The new ISDA Supplement will be effective at a date 90 days after the announcement, therefore effective in March or at latest, in April 2020.
  • All new ISDA documented derivatives will, by default, pick up these amendments as of the effective date.
  • The Derivatives’ Exchanges (CCPs), have been consistent in their support for ISDA developments, and the critical need to be consistent with ISDA terms and language, ‘subject to their client’s support’. LCH and CME will broadly adopt ISDA language and terms.

THE MARKETS DRIVE THE ACTIVITY

  • Parties with significant derivatives exposures will have the language, contractual terms and pricing protocols to start to move legacy LIBOR-linked derivatives off their books, significantly mitigating their end of 2021 cliff-edge risk event.
  • Liquidity in RFRs will vary. SONIA is already sufficient. SOFR will increasingly have sufficient liquidity and will enable significant shifts of legacy LIBOR-linked derivatives to SOFR. 
  • This process of transitioning USD and GBP Derivative portfolios from LIBOR to RFR between bilateral counterparties, likely via compression trades, will commence between major market participants in Q2, 2020.
  • USD and GBP go first. CAD and AUD likely next movers. EUR delayed.
  • ISDA anticipate that the $200 trillion in derivatives outstanding will be largely transitioned between Q1, 2020 and end 2021.
  • The transition activity will be accelerated when the CCPs (CME and LCH) provide market participants the choice of selecting either EFFR or SOFR discounting and price alignment on all USD swap products beginning October 16, 2020. (Plans due December 2nd, 2019)
  • CME already began clearing SOFR Futures in May 2018. SOFR Swaps were cleared by LCH since July 2018 and the CME since October 2018. LCH’s SwapClear has cleared a total of $1 trillion notional of swaps referencing SOFR in 2019.
  • This LIBOR to RFR transition trade activity between major market participants pushes activity to other Derivatives participants. International Banks, Regional Banks, sub-trillion dollar Asset Managers and major Corporations until SOFR becomes the default USD market benchmark, step by step.
  • Banks who are prepared, understand and accept basis and currency risk and proceed.
  • There will be winners and losers.

CASH PRODUCTS FOLLOW

  • Derivatives are used as a hedging tool against underlying Cash positions, (Loans, Mortgages, Bonds, etc). The hedge product will have moved, leaving the underlying cash position exposed to hedging, accounting and tax mismatches; pricing and reporting and rate risk modelling mismatches. 
  • These mismatches, which will impact most functions, drive interest/demand/requirement to move the legacy underlying Cash products from LIBOR to SOFR to better align rate management, basis, accounting and tax risks with the derivative.
  • Accounting and tax are significant issues, but FASB confirm their tentative decision of June 19, 2019 that any – ‘change in contract’s reference interest rate (i.e. from LIBOR to SOFR) would be accounted for as a continuation of that contract rather than the creation of a new contract. This decision applies to loans, debt, leases and other arrangements.’
  • ARRC’s Loan and Securitization Working Groups quietly accept that their waterfalls to replace LIBOR will default to SOFR definitions.
  • The results of ARRC’s Residential Adjustable Rate Mortgages Consultation were released on November 15th, covering fallback language. The GSEs will update their uniform ARM notes in Q1, 2020 to reflect the use of ARRC recommended language.
  • This legacy LIBOR transition of cash products commences with major participants’ Syndicated Loans (small group of bank participants making decisions, deal by deal), Bi-Lateral Loans (bank and client agreements), Cross-Currency Swaps and Mortgages.
  • The SOFR ‘forward-looking’ rate proposed in the ARRC Loan Working Group fallback waterfall is not expected to be ready until end of 2021.
  • The FCA has pointed wholesale Syndicated Loans to SONIA, overnight, compounding, in arrears.
  • The Derivatives momentum into transitioning cash products on a matched RFR basis may make any new forward rate largely redundant, (and the proposed forward rate is backward starting anyway.)

Conclusions

  • Many will make the decision that aligning above mentioned risks between cash and hedging derivative may be more important than perfect readiness of systems, policies, procedures.
  • Portfolios and deals transition on a steady pace throughout the remainder of 2020 and 2021.
  • The use of excel spreadsheets as fit-for-purpose workarounds becomes prevalent again, as internal and external systems not yet ready for full implementation.
  • Securitizations, certain consumer products, Credit Cards, Student Loans will lag due to end-owner and end-user issues.
  • After 2021 LIBOR will probably still exist but not be considered a Benchmark. Neither will other alternative ‘rates.’
  • There will be a tail of legacy exposures and products, still referencing LIBOR, post 2021. These exposures will be subject to additional regulatory and financial controls and litigation risk.

Written by Graham Broyd, David Wagner, Michael Dougherty and Cathy Cullen of Broyd Partners LLC.