As the market prepares for the transition away from the use of LIBOR to alternative benchmarks or risk-free rates (RFRs), financial institutions must closely look at their strategies for tackling legacy trades, which reference this soon to expire interbank lending rate. The trouble with legacy trades is that there is no one way to migrate these transactions to the post LIBOR era. Rather, there are several options a firm can take. And all methods will likely be taken to adjust the entire portfolio in question including the reliance on the ISDA IBOR Fallbacks, direct renegotiation of contracts with counterparties or even reliance on synthetic LIBOR, which is in the works in some jurisdictions. In short, tackling this one element of the LIBOR transition is set to be laborious and a complex task for many firms. In this feature and the related podcast series, we explore the complexities, challenges and opportunities firms have when looking to execute their own strategy to migrate legacy trades away from LIBOR with experts from Murex, Oliver Wyman and Linklaters.
A Mixed Bag and the Impact on Liquidity
Adam Schneider, Partner at Oliver Wyman’s Digital and Banking Practices in the Americas, and co-chair of the Alternative Reference Rates Committee or ARRC, Operations and Infrastructure Working Group.
LIBOR is involved in about $400 trillion of cash assets and notional derivative assets. Cross-currency swaps and cash instruments are common because you could count on LIBOR operating the same across the markets. Within LIBOR are five currencies: the US dollar, the British pound, the Swiss Franc, the Euro, the Japanese yen. Now there will be five rates all sponsored by the respective national regulatory bodies (e.g. the dollar rate is SOFR and the pound rate is SONIA). Liquidity will splinter between the five parties and trading volume is already migrating out of LIBOR into SOFR or SONIA or the other currency-specific rates.
In addition, there are several flavors of each rate. SOFR starts off as a backwards looking overnight rate; if you want to construct a forward rate or a term rate or mortgage related rate (known as SOFR in Advance), those are different flavors with different risk characteristics. All of these are going to split the liquidity of the underlying market into little pieces and the exact relationships between them still have to be worked out because many of these rates or hedges don’t even exist yet. The net of it is less liquidity, plenty of choices and pricing and hedge effects over time.
“All of these [rates] are going to split the liquidity of the underlying market into little pieces and the exact relationships between them still have to be worked out because many of these rates or hedges don’t even exist yet. The net of it is less liquidity, plenty of choices and pricing and hedge effects over time.”Adam Schneider, Partner, Oliver Wyman
Currency facilities which enable users to borrow in the currency they need more or less on demand will likely become individual currency contracts rather than multicurrency facilities because the rates are not comparable. The rates all work differently and there will be no easy translation algorithm to take dollar LIBOR or pound LIBOR into dollar SOFR, pound SONIA and make it all into one contract. The spread between LIBOR and SOFR is fundamentally going to be different between LIBOR and SONIA in the market. There will be a lot of new or single currency contracts, less flexibility around which choice of currency to get, and more energy around the new product side.
The cash market varies by currency and the two biggest markets are the dollar and the pound. In both cases, LIBOR is used as the corporate lending rate. A bank issues a five-year loan using LIBOR and every month or every three months, it resets to the then current rate. The borrower may then want to fix it and hedge it via swaps. Following LIBOR, there is no equivalent rate that everyone can access, and the new country rates behave very differently.
In the US market, there are $8 trillion of loans outstanding that will change when LIBOR ends. The economics of that change are very complicated. For firms that are lending or borrowing, understanding this value implication of the change is critically important. Investors often buy loans, directly or through securities, and those values will change as well.
Derivatives represent about 90% of that $400 trillion outstanding and that market is generally in good shape because it is standardized. Much of the remaining transition issues are in the lending and cash markets. In the US, the cash market products are still being developed—it largely does not exist today—with the SOFR lending market minuscule right now. The UK, Switzerland and other countries are in a better shape. In fact, LIBOR is ending for the other four currencies at the end of 2021, but the US regulators asked for more time to allow loans to be fixed or remediated. In the US market there are millions of contracts with fallbacks that are very difficult to understand and the original 2021 deadline meant a fair amount of financial and operational risk, hence the need for an extension.
The ARRC has aimed to publish term SOFR this year but this is unlikely due to the low volumes of futures trading. We do not believe there will not be an ARRC-approved term SOFR rate published by year end, so market participants will have to decide whether to use the overnight SOFR, which functions differently than current rates or move to other choices. Overnight SOFR is difficult for the lending market because you do not know the rate in advance and that is a key client requirement. Alternatively, the market is seeing other rates being provided by market vendors, which will function more like LIBOR. There are at least four such rates with a term that is known in advance, and they may well become market standard. Come the fourth quarter of the year, many institutions are going to think very hard about lending on a rate that looks a lot like LIBOR, which is any one of these other four rates, versus a term SOFR rate that doesn’t yet exist, or an in-arrears rate. It is hard for the rate that does not exist to win!
Legal Considerations and the ISDA Protocol
Deepak Sitlani, Derivatives Partner and Head of the Derivatives and Structured Products group at Linklaters in London
The ISDA IBOR Fallbacks Protocol allows all of a firm’s contracts with other adhering parties to be updated. Once LIBOR falls away, you end up with a compounded risk-free rate plus spread. However, 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. Operationally, there is a big lift to deal with that.
By adhering to the ISDA Protocol, firms are essentially changing the floating rate options, they do not have to change their confirmations. But the scope of the Protocol is large and covers more than just ISDA documents. The Protocol is not necessarily right for every firm. It works less well for non-linear derivatives (range accrual swaps, forward rate agreements, caps, floors and cross-currency swaps) and loan-linked swaps. These products are within scope but might be better being actively remediated. Firms also need to keep an eye on whether the fallback rate has an impact on valuations, or whether there are knock-on accounting or tax implications.
Two rate types are excluded from the scope of the Protocol: The ICE Swap Rate and overnight rates for use in CSAs. The ICE Swap Rate is most relevant when it comes to cash settling swaptions. The rate is determined by looking at the price for a fixed floating LIBOR swap. Without LIBOR, there is no LIBOR swap rate. This is being replaced by a swap rate based on overnight rates, which is fine going forward, but problematic for existing positions that continue to refer to the LIBOR swap rate for a particular currency. Over the coming months, there will be new provisions that allow firms to update those references to capture the overnight swap rate adjusted with the Bloomberg spread with a further convexity adjustment.
With CSAs, the overnight rate for US dollars is moving away from Fed funds to SOFR, and for Euro cash collateral the rate is moving away from EONIA to €STR because EONIA will cease to be published in January 2022, triggering a repapering process. People often incorrectly feel that that process is covered by the Protocol, but it is a standalone process that firms need to go through to remediate their CSAs.
Legislation is another area of focus for the coming months. 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, there will be a mandatory override. This is especially relevant for products not covered by the ISDA Protocol or firms that have not adopted the Protocol. In the UK, a prospective amendment to the UK Benchmark Regulation will allow the FCA to designate a critical benchmark, such as LIBOR, as being at risk of being not representative, with its ‘representativeness’ incapable of being restored. Once a rate is non representative, then it can’t be used in new contracts and could only be used in legacy contracts in line with the parameters that the FCA sets out.
“There are open questions as to the scope of use for synthetic LIBOR, but it is likely to be limited, so firms need to deal with their LIBOR references either through adoption of fallbacks or through consensual transition.” – Deepak Sitlani, Derivatives Partner at Linklaters
“There are open questions as to the scope of use for synthetic LIBOR, but it is likely to be limited, so firms need to deal with their LIBOR references either through adoption of fallbacks or through consensual transition.”Deepak Sitlani, Derivatives Partner, Linklaters
‘Synthetic’ LIBOR refers to the idea that the LIBOR rate would continue to be published on the LIBOR screen, but it would be made up of a term rate plus a spread. Trade types that might benefit from this synthetic LIBOR are widely-held bonds, for example, where it is very difficult to get the requisite consent to amend. In the context of derivatives, the default presumption is the Protocol should allow firms to update the swaps so derivatives shouldn’t need to benefit from this ‘tough legacy’ protection with the application of synthetic LIBOR. However, questions arise around what happens if a counterparty to a derivative will not adhere to the Protocol, what happens in the case of a non-linear derivative for which the Protocol may not be appropriate, or if a derivative hedges a cash product that benefits from tough legacy treatment? There are open questions as to the scope of use for synthetic LIBOR, but it is likely to be limited, so firms need to deal with their LIBOR references either through adoption of fallbacks or through consensual transition.
Operational and Systems Considerations in a Transition Plan
Alexandre Bon, Head of Marketing in APAC, and Group Co-Head LIBOR and Benchmark Reform at Murex
Managing the transition from LIBOR to an alternative reference rate is like replacing apples with oranges because IBOR benchmarks and the new rates are fundamentally very different. There is no obvious like-for-like replacement but many different options. The recommended alternative reference rate for US dollar LIBOR is SOFR, but firms could also opt to use Fed funds, Prime or Ameribor. Even within SOFR, there are various daily compounding options and fixing conventions which brings a high level of complexity in the choice.
An institution’s transition plans will be dependent on the profile of the firm, the volume of positions that are going to be impacted by the discontinuation of one IBOR index or another, as well as to which IBOR index they are exposed. Firms that are just exposed to US dollar LIBOR have a 2023 deadline, but for those exposed to GBP LIBOR or JPY LIBOR, the deadline is the end of 2021. The type of contracts and positions firms have will also affect transition planning. Linear and vanilla derivatives are clearly easier to deal with than exotics and complex products, as well as securities and cash products. Different fallback options and approaches will be needed for derivatives versus cash, and for cleared versus bilateral derivatives.
The first step in transition planning will be reducing the firm’s LIBOR footprint and the number of contracts that reference a LIBOR index and will mature beyond the deadline. Doing so means fewer renegotiations and fewer operational challenges later. The second step is engaging with counterparties to negotiate the terms of transition. Firms need to understand their counterparties’ constraints and approaches to choose the optimal path for both counterparties. Counterparties may have different views on what the value transfers can be. Finally, firms need to prepare for the switch itself in order to manage the transformation of a large number of contracts on the day an index is deemed unrepresentative and the cessation period kicks in. Firms need to anticipate the impacts this will have across their business processes and be ready to execute a large volume of contract modifications safely and at scale.
ISDA’s fallback Protocol provides a seatbelt mechanism or last-resort insurance to manage the transformation of derivatives contracts when LIBOR ceases to be published, but regulators advise against relying blindly on it. Some institutions may wish to transition the bulk of their contracts that way, but can only do so if their counterparties sign to the Protocol as well. If one counterparty does not inject these fallback terms into their legacy contracts, then the other counterparty needs to negotiate with them how to manage those positions.
Even if firms do stick to fallbacks, they need the ability to execute a large volume of contract fallback transformation on a single day in an operationally controlled and safe way. They will also need to be able to keep track of various exceptions negotiated with counterparties and be able to ensure business continuity across departments and systems. This transformation is more complex and far reaching in terms of business processes and systems impact than the initial margin rollout. And it will not just impact derivatives, but also securities and loans, each of which have their own specificities and challenges.
“This transformation is more complex and far reaching in terms of business processes and systems impact than the initial margin rollout. And it will not just impact derivatives, but also securities and loans, each of which have their own specificities and challenges.”Alexandre Bon, Head of Marketing in APAC, and Group Co-Head LIBOR and Benchmark Reform, Murex
Another added complexity to the LIBOR transition is that it is extensive in its impact on every corner of a financial institution – across multiple departments, business lines, processes and systems. Every single department will be impacted from the front office to back office, risk management and accounting, which also means the technical interactions and system changes that need to take place are complex and require a great deal of collaboration. So, starting early and looking at systems and processes interoperability questions is essential because all moving parts of a firm’s change plan needs to progress in synch for a successful transition.
A final challenge, which is not frequently discussed but also requires early planning, is the technical performance of systems including system stability. The degree of system performance will be evident on both the deadline day for the transition and in the management of new RFR versions of contracts, which will likely be more complex.
On deadline day, a firm will have to manage the fallback mechanisms on a large volume of transactions on a single day, so automation of the supporting operational processes is key to ensure the transition progresses efficiently and in a timely manner.
Following the transition deadline, the new RFR version of the contracts will need to be processed and they are often more complex contracts to evaluate than their IBOR equivalents. This can have significant and adverse impacts on both the systems and hardware a firm uses and thus, affect a firm’s response times when performing other crucial processes such as the computationally intensive XVA pricing and VaR calculations. To address possible performance hiccups, a firm needs to test systems early and plan for a remediation strategy from the beginning.
Firms’ systems need to be able to handle all this complexity, track exceptions and execute transitions to specific contracts seamlessly and across all the impacted business processes. System interoperability will be key.
*Listen to all 3 episodes of our podcast series – “LIBOR Transition: Navigating the Hurdles of Legacy Trades – DerivSource”