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Whilst end-2021 marked a key milestone, it is not yet the end of the road. We reflect on the remaining challenges for LIBOR transition.
In brief
- Transition efforts are not yet over and market participants should continue to focus on active transition where relying on temporary synthetic LIBOR rates.
- Market participants should continue to prepare for the June 2023 USD LIBOR cessation and are urged to focus transition efforts to robust rates such as SOFR.
The transition from Interbank Offered Rates (IBOR) to Alternative Risk-Free Rates (RFRs) has an impact on all financial and non-financial institutions operating with the impacted floating reference rates.
Recognizing that an important milestone has been reached with the transition of 24 LIBOR settings immediately after the year 2021-end, in our article we reflect on recent industry developments with a particular focus on the status of the transition of GBP, CHF, EUR and USD rates as well as consider what remains to be done for LIBOR transition.
UK and GBP rates
Following the transition of most LIBOR settings on 31 December 2021, the UK Financial Conduct Authority (FCA) and Bank of England (BoE) published a joint statement reflecting on the transition.
In the statement, the FCA and BoE highlight that SONIA, compounded in arrears, is now fully embedded across sterling markets. Successful CCP conversion processes during December 2021 saw some of the largest single day amendments to financial contracts, with in excess of GBP 13 trillion LIBOR-referencing contracts converted to SONIA. As a result, there are effectively no longer any GBP LIBOR linked clear derivatives. The implementation of the International Swaps and Derivatives Association’s (ISDA) IBOR Fallbacks Protocol saw a further reduction in the legacy stock of LIBOR-linked derivatives. However, it must be noted that reliance on fallbacks also came with its own set of challenges, notably operational challenges given the possible differences in conventions or where different methodologies were applied for cash instruments.
CCP conversion
LIBOR-referencing contracts converted to SONIA.
In cash markets, it was reported that SONIA floating rate note issuance since 2018 exceeded £120bn, and new SONIA lending exceeded £100bn across a diverse range of sectors and facility types.
According to most recent statistics, the BoE estimates that across all asset types, that less than 2% of GBP LIBOR legacy stock remains. However, this does not mean that transition efforts are now over. Going forward, market participants are urged to continue to pursue the active transition of legacy GBP LIBOR contracts currently using the temporary synthetic LIBOR. Indeed, the FCA has always been clear that synthetic LIBOR is a temporary bridge to RFRs, and its availability is not guaranteed beyond end-2022. Further, transitioning these contracts to permanent robust alternatives remains the best way to retain control and economic certainty over existing agreements. The FCA will seek views on retiring the 1-month and 6-month synthetic GBP LIBOR during 2022 and at the end of 2022, on when to retire 3-month GBP synthetic LIBOR. Together with the FCA, the Prudential Regulation Authority (PRA) will continue to be closely monitoring actions to remove any remaining dependencies on LIBOR, including synthetic LIBOR.
Switzerland and CHF rates
Following a survey among National Working Group on Swiss France Reference Rates (CHF NWG) members on the success of the CHF LIBOR to SARON, the transition was deemed successfully completed not only conceptually but also operationally. It has therefore been decided to dissolve the CHF NWG by end of Q1 2022.
Whilst the transition of CHF LIBOR to SARON has been deemed successful, moving forward, market participants are encouraged to continue to actively transition if relying on other synthetic LIBOR rates and are also reminded to continue to focus efforts on the remaining USD LIBOR transition. Indeed, it is not yet the end of the road for LIBOR transition.
Eurozone and EUR rates
Despite 2021 being a landmark year for benchmark reform, the Working Group on Euro Risk Free Rates (EUR RFR WG) published its Work Programme for 2022/23 in which it announced that it will continue to contribute to reform efforts in the euro area and facilitate coordination between private sector and public sector efforts in this respect.
The EUR RFR WG will focus on fostering the use of €STR in a diverse range of financial products given that an increased use of €STR in 2022 will be beneficial to further develop liquidity of derivatives products referencing €STR, which will also support the publication of a forward-looking term rate based on €STR to be used for fallback provision. Indeed, as part of its Work Programme for 2022/23, the EUR RFR WG is launching a new call for expressions of interest from administrators for the creation of a €STR-based forward looking term structure as a fallback in EURIBOR-linked contracts. Candidates will be invited to formally present their projects in June 2022 to the EUR RFR WG.
Further, the EUR RFR WG announced it will assess the level of implementation and potential impediments to the timely adoption of EURIBOR fallback provisions by EU supervised entities. Following this, the EUR RFR WG will assess progress on the implementation of its EURIBOR fallback recommendations as well as perform a “lessons learnt” analysis. It is possible that a revised and refined set of recommendations may be issued.
Going forward, the EUR RFR WG will continue to monitor issues related to the impact of LIBOR discontinuation in the EU, notably monitoring potential financial stability risk arising from the planned USD LIBOR cessation on 30 June 2023 as well as the risks associated with the cessation of synthetic LIBOR settings in the EU. The EUR RFR WG will propose mitigating actions and solutions to any issues or risks identified. Whilst many have completed their transition following end-2021, the EUR RFR WG urge market participants to recognise the necessity for continued progress in the benchmark reform across the EU over the coming years.
US and USD rates
As we near the end of Q1 2022, we have observed increased momentum towards SOFR. According to the readout from the Alternative Reference Rates Committee’s (ARRC) most recent meeting, the use of SOFR has accelerated in both cash and derivatives markets. In the cash market, the pipeline of new loans and securitizations reflects a shift away from LIBOR towards SOFR. Further, it has been reported that sales of corporate loans tied to SOFR have continued to increase in 2022, with borrowers accelerating the shift away from issuing new debt tied to LIBOR. Large US financial institutions have also largely replaced LIBOR with SOFR for low-rated corporate loans on future debt sales. Finally, it is also expected that companies with loans that expire before the June 2023 deadline—when products both existing and new must cease referencing USD LIBOR—will likely look into refinancing debt at a SOFR rate. The shift in the derivatives market, notably in interest rate swaps and futures, also shows an acceleration in SOFR use this year. Indeed, it has been reported that efforts to remove USD LIBOR had a knock-on effect in the derivatives market where SOFR futures have achieved record levels. However, despite SOFR futures achieving such record levels, Eurodollar futures and options, which reference the 3-month USD LIBOR, continue to remain the largest US interest-rate derivatives market. Further, despite the ban from regulators, USD LIBOR has been actively traded at almost $9.8 trillion of swaps traded on USD LIBOR from 1 January 2022 to 4 February 2022 whilst only $3.4 trillion notional was pegged to SOFR.
USD LIBOR has been actively traded at almost $9.8 trillion of swaps traded on USD LIBOR from 1 January 2022 to 4 February 2022 whilst only $3.4 trillion notional was pegged to SOFR.
The readout from the 16 February 2022 meeting also covered the ARRC’s key objectives for 2022. The 2022 objectives reflect the ARRC’s efforts to continue supporting the transition away from LIBOR by preparing markets for June 2023 and encouraging the voluntary use of SOFR as a more robust and resilient alternative. According to recent market reports, companies, banks and traders said they picked SOFR partly because its stability during the Covid-19 pandemic’s market swings demonstrated it is robust enough to support large numbers of financial arrangements. However, some small or midmarket businesses are still considering other benchmarks, such as the Bloomberg Short-Term Bank Yield Index (BSBY) and Ameribor, which they say better reflect lenders’ funding costs and account for the risks from short-term lending. IHS Markit has also recently launched a series of new USD forward-looking dynamic term benchmarks that measure the daily USD cost of funding in institutional markets. The USD Credit Inclusive Term Rate (CRITR) and USD Credit Inclusive Term Spread (CRITS) benchmarks are designed to provide banking institutions a broad measure of USD funding costs on a senior unsecured basis. The publication of the CRITR and CRITS benchmarks started on June 1st, 2021, including 5 years of historical data. IHS Markit is now allowing industry participants to use these benchmarks in the creation of non-retail financial products. The rates will continue to be updated daily at 8am ET, in alignment with the Securities Industry and Financial Markets Association (SIFMA) holiday calendar. The benchmarks are available in the following tenors: overnight, 1-month, 3-month, 6-month, and 12-months. In the press release, it is highlighted that the CRITS benchmark does not impede the adoption of the rate recommended by the ARRC but rather addresses concerns of market participants who want to use SOFR but require a credit sensitive component.
Going forward, market participants need to continue to get ready for the USD LIBOR cessation on 30 June 2023 and complete the legacy USD LIBOR transition by that date through active transition or operation of robust fallbacks. Market participants should also consider carefully the risks associated with use of credit-sensitive rates and should where possible, focus transition efforts to robust alternative rates such as SOFR. Where market participants nonetheless seek to rely on credit-sensitive rates, market participants must ensure that the benchmarks are administered in compliance with the International Organisation of Securities Commissions (IOSCO) Principles for Financial Benchmarks as well as ensure they are able to demonstrate the suitability of the alternative rate compared to SOFR.
Many thanks to Rebecca Slade for her valuable contribution to this article.
Summary
Despite the end-2021 key milestone and transition of certain LIBOR rates being considered completed both conceptually and operationally, market participants must not slow transition efforts. Indeed, market participants must continue to actively transition the stock of legacy contracts using synthetic LIBOR rates and should not lose sight of the remaining USD LIBOR transition. Market participants are encouraged to continue use of SOFR in new activity across markets as well as actively transition remaining legacy contracts ahead of the 2023 end of USD LIBOR wherever possible.
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