DerivSource LIBOR Transition Podcast Series – Episode 2 Transcript (Listen now)
Julia Schieffer:
Hello and welcome to this DerivSource podcast. I’m Julia Schieffer the founder and editor of derivsource.com. You’re listening to episode two of our podcast series on the LIBOR transition. In our previous episode, we offered a high-level view of some of the remaining market wide challenges the industry faces with a LIBOR transition. And in this episode, we are taking a deeper look at the challenges firms face with legacy trades, as they prepare for the transition away from LIBOR and to alternative benchmarks. To share his expertise with us on this topic I have with me, Deepak Sitlani, Partner in the derivatives practice at Linklaters in London. Welcome to the podcast, Deepak.
Deepak Sitlani:
Thanks for having me on.
Julia Schieffer:
So, Deepak, before we begin, can you share a little bit about yourself with our audience?
Deepak Sitlani:
Yeah, sure. As you say, I’m a partner in the law firm, Linklaters in London. And so, I focus on derivatives and specifically on this topic, I’ve been helping a number of both buy and sell-side institutions on LIBOR reform and also have led on the work for ISDA on the fallbacks protocol.
Julia Schieffer:
Great. Well, you’re in an excellent position to give us a deep dive into this topic. Starting very generally, what are the things that firms need to think about to adhere to the ISDA protocol? How does it work?
Deepak Sitlani:
Yeah, it’s a good question. And actually, there’s a bit more complexity to it than people might imagine. At a super high level, the way it works is firstly it allows all of your contracts with other adhering parties to be updated. And what it contemplates is once a LIBOR falls away, you end up with a compounded risk-free rate plus spread. The first thing is that you end up with a backward-looking rate. So unlike LIBOR where you know your rate at the beginning of the period, it is only at the end of the period that you will know your fallback rate. Another thing is that by adhering to the protocol, what you’re doing is just changing the floating rate options. A question I get asked frequently is do I have to change my confirmation after I’ve adhere to the protocol? And the answer is no, you don’t have to do that. So that at a super high level is how it works. Lots more detail there, but I think that’s probably the key points.
Julia Schieffer:
And you mentioned confirmations. What are some of the issues that firms come across with the protocol?
Deepak Sitlani:
It’s not necessarily a slam dunk and it’s not necessarily the right thing for everyone. So, the types of things that we talk to clients a lot about are firstly scope. It’s quite a broad protocol. It covers more than just ISDA documents. So, one thing is just to think about are you comfortable with the protocol amending all of the documents that you have within its scope? Generally people are, but you just need to go through the thought process. There is a bucket of trade types that people call non-linear derivatives. These include things like range accrual swaps, forward rate agreements, caps, floors and cross-currency swaps, and for various and different reasons, the protocol works less well for those product types. So they are within scope but I think if you have those trade types within your portfolio, you probably just need to understand where some of the friction is and whether or not they are trades that you should actively remediate rather than relying on the fallbacks to the protocol.
Other areas are loan-linked swaps. So, these are generally swaps that have been entered into specifically to hedge a position under loan. And by adopting the protocol, you may have a couple of issues that crop up. One, if you’ve got a broad financing, it may be that you need the consent of the other finance parties to amend your swap. And by adhering to the protocol, you’re effectively amending your swap. So, you need to make sure you’ve got the consent if you need it. And the other one is just making sure that you’re comfortable with the way in which the swap will operate versus the way in which the loan will operate because ultimately if you are a borrower, you’re looking for that swap to match your loan, and you just need to have a look at, or keep an eye on both sides – the loan and the swap. So, those are the kinds of things that come up.
Julia Schieffer:
Beyond the legal issues, are there any issues that firms are raising with you outside of this?
Deepak Sitlani:
Yeah, there are a couple issues and one is operations. So, as I mentioned, with an IBOR rate people are used to seeing the rate and knowing the rate at the beginning of the period, whereas now whether it’s through fallbacks or with the new world of compounding, you’ll only know the rate towards the end of the period. So operationally there’s a big lift to deal with that.
And then the other issue is with valuation. People have talked about what is the impact of having the fallback rate, which is made up of a compounded overnight rate and a spread that is based on an historic median, does that impact the value of my position and in turn, does that have knock-on accounting or tax implications? So, those are the types of non-legal topics that I most often hear about.
Julia Schieffer:
Thank you, Deepak. And we’re actually going to be covering that in some detail in episode three as well. And we’ll definitely cover the issues that you’re already getting flagged by your clients there.
Deepak Sitlani:
That’s good. I’ll look forward to listening to it.
Julia Schieffer:
So, you mentioned scope, are there any particular rates that are not covered by the protocol such as the ICE Swap?
Deepak Sitlani:
That’s a good question. There are two buckets of product types or two rate types that aren’t included within the scope of the protocol. One, as you say, one is the ICE Swap Rate. The other one is overnight rates for use in CSAs. So, firstly with the ICE Swap Rate we see that used in the 2006 ISDA Definitions and it’s most relevant when it comes to cash settling swaptions. So, one of the problems is that the ICE Swap Rate is ultimately a rate that is determined by looking at the price for a fixed floating LIBOR swap. So, to the extent you haven’t got LIBOR, you basically haven’t got a LIBOR swap rate. And so, what we are going to see, and in some places already do see, is a swap rate based on the overnight rates.
That’s all well and good going forward, but you have a number of existing positions that ultimately continue to refer to the LIBOR swap rate for a particular currency. So, what we expect to see over the coming months is provisions that allow you to update those references so that they capture the overnight swap rate adjusted with the Bloomberg spread with a further convexity adjustment. So that I think is a topic that is going to be quite live over the next few months.
And then I also mentioned CSAs. So, another area is we’re seeing for US dollars, we’re seeing the overnight rate in CSAs move away from Fed funds to SOFR. And similarly, for Euro cash collateral, we’re seeing the overnight rate move away from EONIA to €STR because EONIA will cease to be published in January 2022. And so there is a repapering exercise that is due to come, but people often incorrectly feel that that process is covered by the protocol. So just to be abundantly clear, it is not; it’s a standalone process that people need to go through to remediate their CSAs.
Julia Schieffer:
Excellent point to clarify. Cause I think there is quite a bit of confusion about that last point. Now we haven’t talked about legislation, what are the legislative options? And can we rely on them for difficult products or areas of complexity?
Deepak Sitlani:
This is another area of focus, I think, for the coming months. And so it’s easy for people to think that they don’t need to worry about any of this because there are legislative options out there or solutions out there. And I would definitely urge your listeners not to do that and actively engage with transitioning.
So, when we look at legislation that’s coming down the track, under New York law, for New York law governed contracts that reference USD LIBOR, if a contract is silent as to fallbacks or the fallback is to a LIBOR base rate, then effectively there’s going to be a mandatory override. Now that shouldn’t be relevant for derivative contracts because we have the protocol and really people should ideally be adopting the terms of that protocol, but it may well be that it’s relevant for other products or in instances where people haven’t adopted the protocol. But that’s only helpful if you have USD LIBOR and a New York law governedcontract and clearly there’s a much bigger universe out there.
If we look at the UK, there’s a prospective piece of legislation coming through, which is an amendment to the UK Benchmark Regulation. And basically, what that will allow the FCA to do is to designate a critical benchmark, such as LIBOR as being at risk of being not representative with its representativeness not being capable of being restored. And we’ve actually already seen the FCA make it’s statement on March 5th that basically contemplated or laid a path for some of the tenors for GBP, USD and JPY LIBOR to go down this road. And so, once a rate is non representative, then the idea is that it won’t be capable of being used in new contracts and could only be used in legacy contracts in line with the parameters that the FCA sets out.
This is where people talk about ‘synthetic’ LIBOR because the idea is ultimately that the LIBOR rate would be continued to be published on the LIBOR screen, but it would be made up of a term rate plus a spread. So, the challenge is what trade types will be permitted to benefit from this synthetic LIBOR? And so this is the idea of ‘tough legacy’. And so, the kinds of products that people have in mind here are widely-held bonds, for example, that it’s very difficult to get the requisite consent to amend. In the context of derivatives, I think that default presumption is we have the protocol, that should allow us to update the swaps and so we shouldn’t really have derivatives benefiting from this tough legacy protection and the application of synthetic LIBOR. You then have questions that arise around, well, what happens if my counterparty to my derivative won’t adhere the protocol, or what happens if I’ve got a non-linear derivative for which the protocol may not be appropriate, or what if my derivative hedges a cash product that benefits from tough legacy treatment?
There are some very much open questions as to the scope of use for synthetic LIBOR and we will see some consultations come out to define the way in which synthetic LIBOR can be used. But what I would say is I would bank on it being a relatively limited scope, certainly in the context of derivatives and therefore the overarching message is to make sure that parties deal with their LIBOR references either through adoption of fallbacks or through consensual transition. Those are the two main pieces of legislation. There is a piece of legislation in the EU as well, which without going into a huge amount of detail is basically similar to the New York approach.
Julia Schieffer:
Great. Excellent. So a lot, a lot going on globally there. Now, one thing that we haven’t covered is the cleared space. So, what is going on in the cleared space with CCPs?
Deepak Sitlani:
Yeah, and the cleared space is obviously quite a fundamental and a big portion of the derivatives markets so it’s absolutely right to ask about that, Julia. So, the first thing is you may wind back time and remember the LCH, and CME came out saying that they would adopt the fallbacks that ISDA has put together as part of the protocol, which is what they’ve done as part of their rule books. But focusing on LCH, one of the things that they’ve said is actually what they’ll try to do is, in advance of the fallbacks kicking in, they’ll look to switch or convert their LIBOR-based swaps into compounded overnight rate swaps. So that’s something that we will see happen later on in the year. It then raises the question as to how do you deal with the difference between an overnight rate and a LIBOR rate.
And there, I think we will see a spread added similar to the approach that we have in the fallbacks world. So that’s certainly what we’re seeing on the cleared side. We are also coming across questions around swaptions, for example what if I have entered into a swaption that is due to be, when exercised, cleared and actually what if we get to the point in time when it should be cleared and there is no LIBOR clearing that’s available? That then takes you back to that ICE Swap Rate conversation that we’re having earlier. So those are the two things that are topical at the moment in the context of cleared trades.
Julia Schieffer:
Excellent. We get a lot of questions on that. So thank you for clarifying the, the status quo there. My final question for you, Deepak, is given the challenges that you’ve outlined overall in this conversation, what is the one piece of advice that you would give our listeners as to what they need to do now or next, depending of course, on their own level of readiness?
Deepak Sitlani:
I think the main thing is just to embrace the new world. The new world is working on compounded overnight rates. One of the things that we’ve come across, is there are a vast range of ways of compounding, so understand how all of those work and just make sure that you prepare yourself for it, because that is the way of the future.
Julia Schieffer:
Well, that’s an excellent point to end on. Thank you very much. And thank you Deepak for sharing your expert insight with us today.
Deepak Sitlani:
Not at all. And thanks again for having me on.
Julia Schieffer:
You’ve just listened to episode two of our podcast series on the LIBOR transition, stay tuned for our final installment of the series coming soon. And in the meantime, you can find information on this topic on our show notes page. Thank you for listening. Join us next time.
