LIBOR transition – the critical tasks ahead of us in the second half of 2020

Speaker: Edwin Schooling Latter, Director of Markets and Wholesale Policy
Location: The International Swaps and Derivatives Association (webinar)
Delivered on: 14 July 2020

Highlights:

• The four to six months ahead of us are arguably the most critical period in the transition away from LIBOR. The time to act is now.
• ISDA is now close to finalising the protocol and other documentation through which outstanding derivatives contracts which reference LIBOR can transform, more or less seamlessly, to work on the new RFRs
• The FCA has repeatedly urged market participants from all sectors – sell side, buy side, non-financial, to ensure they are ready for the end of LIBOR by adhering to the protocol that ISDA is producing.

Note: this is the speech as drafted and may differ from delivered version.

The swaps and derivatives industry faces, now, one of the biggest changes in its history.

LIBOR – the critical benchmark referenced in so many swaps and other derivatives contracts, is being replaced by risk-free-rates (RFRs), chosen by the market.

While we know LIBOR will continue to be published until end-2021, this does not mean the need to act is still more than a year away.

Nor has the need to act on LIBOR transition been pushed back by the impact of coronavirus (Covid-19).

In fact, the 4 to 6 months ahead of us are arguably the most critical period in the transition away from LIBOR. The time to act is now.

ISDA protocol

I imagine this impacts every firm attending this event (virtually), and that nearly all the individuals listening on this call will have at least some personal responsibilities to fulfil in ensuring their firm has done what it needs to do in the months ahead. So I am going to focus my remarks on the LIBOR transition task that faces us in the second half of this year – 2020.

International Swaps and Derivatives Association (ISDA) quickly recognised the fundamental and strategic importance of this change 3 years ago, when, in July 2017, Andrew Bailey, at that time CEO of the FCA, announced that markets had four and half years to get ready for life without LIBOR.

Thanks to its relentless work over the past years, ISDA has prepared the essential tools that derivatives market participants are going to need to make this transition from LIBOR successfully.

In particular, it plans later this month to finalise the protocol and other documentation through which outstanding derivatives contracts which reference LIBOR can transform, more or less seamlessly, to work on the new RFRs. I am going to mention that protocol a lot..

But first we should pause to reflect on the substantial successes that have already been achieved through ISDA’s work.

ISDA’s work has established consensus across the globe, across currencies, across sell side and buy side, across private and public sector, on a preferred and on a fair way to calculate fallback replacement rates for LIBOR, and indeed other IBORs. This chosen fallback is of course the combination of the relevant overnight RFR, compounded in arrears, and a fixed spread to reflect the premium associated with unsecured lending at term. Those two elements have been carefully and wisely chosen.

The overnight risk free rates provide the most robust benchmark interest rate available, derived from markets that have remained active and reliable through times of stress.

Compounding in arrears rather than taking forward-looking expectations derived from a short trading window provides the most robust way of adjusting for term, and the power of averaging helps protect users from day-to-day spikes driven by varying liquidity.

And the consensus on fallbacks established through ISDA’s work in derivatives markets has also been embraced by cash markets in the UK and the US.

That is a huge step forward.

ISDA’s work has also enabled consensus to form on ensuring that these fallbacks make derivative markets robust not only to the final cessation of LIBOR, but also to the possibility of a messy pre-cessation period, preceding LIBOR’s final end, in which LIBOR can no longer be published on a representative basis. ISDA was able to announce in May that a resounding 91% of their consultation respondents agreed that derivatives should move from LIBOR to the RFRs upon LIBOR’s official loss of representativeness if this precedes final cessation. We and other authorities have made clear our own agreement with that 91%.

That is another huge step forward.

The FCA and other authorities have consistently and repeatedly urged market participants from all sectors – sell side, buy side, non-financial, to ensure they are ready for the end of LIBOR by adhering to the protocol that ISDA is producing.

Andrew Bailey spoke again on this yesterday – noting the importance of the ISDA protocol to the journey through the LIBOR end-game, and encouraging early adherence by market participants. John Williams, President and CEO of the Federal Reserve Bank of New York, also yesterday urged protocol adherence.

Scott, Ann, Katherine, Rick and others in the ISDA team from have done almost everything they possibly can to make the adherence process as easy for you as possible. But the next and crucial step sits with firms themselves, with you. You now need to ensure you have signed the protocol within the four-month adherence period that ISDA will offer after the protocol is published this Summer.

ISDA has extended its helping hand. Regulators and central banks have shouted for your attention and encouraged you towards it. But it is now up to you to take it. That’s a key task for you over this summer and this autumn.

Let me briefly rehearse why we are encouraging you so strongly and consistently – why this is so important.

I think it is accepted across the board that the current arrangements in older uncleared derivatives contracts for the end of LIBOR just aren’t fit for purpose any more. These arrangements, designed when the world was different from now, envisage counterparts ringing round major banks for quotes. That is a similar sort of quote to those that underpin LIBOR itself through panel bank submissions. But if LIBOR is disappearing because the market it measures has been fading away and panel banks don’t feel able to support the LIBOR benchmark, even with all the authorisations and robust governance around that benchmark, it’s just not credible to think those arrangements will work for thousands of market participants trying to do this on their own. I question the plausibility of relying on ringing round dealers to offer substitute rates. You could be left with a contract that no longer works. Not signing the protocol therefore seems a huge risk to take.

As regulators, we don’t think financial firms can afford to take that risk, for themselves, or for their clients, or for the wider financial system. That’s why, under UK and EU law there is more than just regulatory exhortation to be ready for the end of LIBOR. In fact, under the Benchmark Regulation (Article 28(2) for those who like precision), it is a Regulatory requirement for supervised firms to have a plan for cessation or material change in a benchmark like LIBOR. As a matter of policy, the FCA considers that signing the protocol meets that requirement. Conversely, any UK regulated firm with major uncleared derivative exposures that chooses not to sign will need to be ready for some serious questions from our supervisors on how they will mitigate these risks.

So, I hope the message on the importance of signing this protocol is clear.

And I hope the message on the urgency of doing so is clear enough too.

As I have said previously, decisions about what will happen to the various LIBOR settings at the end of 2021 could be announced as soon as the final weeks of this year. There could be announcements by the end of 2020 of cessation of settings at the end of 2021. There could also be announcements that it will no longer be possible to produce LIBOR settings on a representative basis from the end of 2021.

Firms need to be prepared for these possibilities.

New powers and 'synthetic' LIBOR

For the remainder of my remarks I want to cover a few other points.

On 23 June, HM Treasury – the UK’s Finance Ministry – announced that it will put forward legislation to give some additional powers to the FCA to enhance our ability to manage the LIBOR end-game. These powers would kick in only when it became clear that the administrator could no longer produce a representative LIBOR rate based on panel bank submissions. Providing certain other circumstances prevail, and I shall briefly describe the most important of these, the FCA would have the ability to require the administrator to change the methodology by which LIBOR is produced. Often this is known as creating a 'synthetic' LIBOR. This would not make LIBOR representative again, but it could provide a way of reducing disruption and dislocation in the LIBOR end-game in certain circumstances.  

The FCA very much welcomes the intended legislation.

But I want to underline again, emphatically, that these powers are not an alternative to transition. Firms still need to be ready for life without LIBOR. Let me give you 4 reasons for that.

First, these powers are intended to provide a potential way of resolving issues around existing or so-called 'tough legacy' LIBOR contracts – those that cannot practicably be converted. They do not support continued use of LIBOR in new business. Indeed, for many, there will be a legal prohibition on the use in new business of a benchmark which will no longer be representative.

Second, we will only use these powers in respect of legacy transactions if doing so is necessary to protect consumers or market integrity. There may be consensus that these interests are better served by simply stopping some LIBOR settings. 

Third, even if it would be desirable to use the powers, this might not be possible in all circumstances or for all LIBOR currencies, for example where the inputs necessary for an alternative methodology are not available at all for the relevant currency, or not available on appropriate terms to the LIBOR administrator.

Fourth, even if the inputs are available and the consumer and market tests are met, parties who rely on regulatory action enabled by this legislation, will be giving up their control over the economics of their contracts. The LIBOR transition process has already shown that some markets, notably derivatives markets, but also bond and large parts of cash markets, prefer transition to overnight interest rates compounded in arrears at the end of a relevant interest period. And we think that preference is sensible. But LIBOR is a forward-looking benchmark. Tough legacy contracts using term LIBOR benchmarks use a forward-looking measure of expected interest rates. Methodology changes that replicate the forward-looking nature of these contracts would not therefore deliver the first-best outcome for many LIBOR users, including the majority of derivative and bond contracts. Industry-agreed fallback arrangements – for example through the ISDA protocol – or bilaterally or multilaterally agreed conversions before end-2021 will be preferable for a wide range of contracts.

In short, if you rely on regulatory action you will have neither certainty nor control, and you may not get what you want. The only way for contractual counterparties to have that certainty and control over the future of their obligations is to convert them by mutual agreement.

So the likely existence of these powers does not mean you don’t need the protocol. Indeed, we may not be comfortable using these powers unless there has been wide take up of the protocol. That’s because we don’t view a synthetic LIBOR as a suitable foundation for derivatives markets. In fact, as we said in our statement of 23 June, wide adoption of ISDA’s protocol, will actually increase the prospects that the FCA will be able to use these proposed powers to address tough legacy needs in cash markets.

And the powers could reduce one concern that some protocol signatories might have had. Previous discussions about the important pre-cessation triggers in derivatives contracts have noted the discomfort that could arise for some if a non-representative panel bank LIBOR continued to be published. This is because panel bank LIBOR’s value could diverge from that of an RFR-based fallback with a fixed spread. We don’t think those risks should be overstated – parties that have adopted the fallback would have done so voluntarily, while LIBOR would in this scenario officially have been found no longer representative of the underlying market. But we have been sensitive to the risk. Again as we noted in our 23 June statement, the new powers would give us an option of requiring methodology changes that aligned the retiring and now non-representative LIBOR rate with market consensus on how to calculate fair fallback values for LIBOR during a pre-cessation period – by using a term-adjusted RFR plus the same fixed credit spread around which market consensus has formed. There would be no mandated LIBOR methodology change before the point of non-representativeness, but, if all the conditions were met, it might even be possible to mandate a change to coincide with the conversion of contracts that have pre-cessation fallbacks based on non-representativeness. In other words, these new powers can potentially reduce this downside risk that some prospective protocol signatories had identified. 

Conversion ahead of the protocol

I have focused my remarks on ISDA’s protocol – a key tool for helping markets safely through the bumpy road of the LIBOR end-game. But I should not end my keynote without reminding you of the obvious point that the safer way still is to move away from LIBOR before those bumps are hit. For new business, this is essential. And the smaller your legacy books, the smoother the journey through the end-game will be.

Many are already well advanced in the move away from LIBOR. Trading in swaps and futures based on the new RFRs is up and running, and is a growing share of both new flow and outstanding stock.

Liquidity is most developed in sterling, where we had a head start with active SONIA swap markets at shorter maturities. There is now plentiful liquidity at the long-end too. Liquidity needs to build in US dollar too, and I certainly hope to see that in the months ahead, as we approach the important landmark of switching discount rates to SOFR at the major CCPs.

ISDA’s protocol is necessary but not sufficient. And in our supervisory capacity, FCA will be expecting firms to be able to show not only that they have robust fallback documentation in place before LIBOR ceases or becomes unrepresentative, but also that they have completed transition for all new business, and have plans that make use of opportunities to reduce legacy LIBOR books before the end comes.

Conclusion

I have concentrated on the need to make time for the essential transition tasks in the months ahead. Change involves time and effort. But we should remember that this is a change for the good. The new near RFR benchmarks are not only a more robust, but also a better measure of the economic factors that most derivatives are trying to capture and hedge. They were chosen by the market for this task. They will make markets stronger and make them work better. The factor that has sustained my own motivation through this massive transition is the strong common interest between private and public sectors, and the enormous energy and insight that has been provided by firms from all sectors, by trade associations such as ISDA, and by countless individuals at those firms and associations. So let me finish by thanking you all, and looking forward to working with you in the months ahead.