With the US LIBOR cessation deadline rapidly approaching, market participants must urgently tackle remaining challenges. Gill Wadsworth reports on the final hurdles, the results of dress rehearsals and what firms need to focus on next as they look to Canada next.
The US Securities and Exchange Commission (SEC) has issued a warning alert just weeks before the deadline for US LIBOR cessation, noting “several challenges exist to a smooth and orderly transition” to alternative reference rates (ARRs).
US Dollar LIBOR is scheduled to be discontinued after June 30, 2023 and while the regulator says firms have made “significant efforts to prepare for the transition away from LIBOR, implementing a variety of practices depending on their business models and client base”, there is still work to do.
The SEC focuses on transitioning complex LIBOR-linked contracts, particularly where no fallback exists to ensure existing products can continue to operate post-USD LIBOR cessation.
The regulator’s alert follows that made by the Financial Standards Board this April which said, “it is critical that market participants act expeditiously to ensure that their legacy contracts are prepared to transition by end-June 2023”.
The timings of such warnings are pertinent as clearinghouse LCH gears up to complete the second tranche conversion on 20May. This major operation covers about US$45 trillion of swaps and includes USD-LIBOR vs Fixed Interest Rate Swaps and USD-SOFR-Overnight Index Swap Compound basis swaps.
This second tranche follows the earlier – and thus far – successful tranche that completed on 22 April which covered USD-LIBOR vs USD-Federal Funds basis swaps; amortizing; and zero-coupon swaps.
Phil Whitehurst, head of Service Development, Rates at LCH, says: “The first tranche went through smoothly which sets us up well for the second tranche on the 22 May.”
Whitehurst says that while the imminent conversion of $45 trillion worth of swaps “is a headline grabbing figure”, he adds that focus should instead be on the number and complexity of the contracts involved.
“More important is the number of contracts which is north of half a million swaps with their own terms to respect . There is a lot to get through and we’ve got probably got 85-90% of the notional still to do in that second tranche.”
Practice makes perfect
A dress rehearsal on 1 April uncovered relatively few pitfalls ahead of the May event, but Whitehurst is far from complacent about the potential challenges ahead.
“No dress rehearsal goes without learnings, but I am pleased to say, in one sense, that we didn’t learn too much. But there is still a lot of hard work going on ahead of the live event.”
Meanwhile clearinghouse CME Group completed its transition in a single tranche on April 21, which saw the conversion of 7.5 million contracts in Eurodollar OI and $4 trillion in cleared USD LIBOR swaps to SOFR.
Agha Mirza, CME Group global head of Rates and OTC Products, says: “The path ahead for short-term interest rate risk management is stronger than ever, as open interest for SOFR derivatives is now 48 million contracts, and clients are significantly benefitting from our portfolio margining solution between cleared OTC interest rate swaps and listed futures.”
That the conversions have proved success is, according to Matthew Slen, Interest Rates Derivatives consultant at Murex, testament to participation in the dress rehearsals.
“The good news is we have had very few issues to deal with. We tried to encourage our clients to participate in dress rehearsals which were really beneficial because we were able to identify a handful issues and correct them in a timely manner before the actual conversions,” Slen says.
A reliance on fallbacks
Despite the success of the US transitions, there has been a considerable reliance on fallbacks which act as a stop gap when there is no immediate rate to replace LIBOR.
The International Swaps and Derivatives Association (ISDA) fallback protocol says benchmark rates will “fall back” to a new benchmark in contracts that are governed by Master ISDA agreements and existed before the effective date, provided that the counterparties have both agreed to adhere to the protocol.
Consultancy PwC describes the protocol as a seatbelt: “It can prevent serious injuries in case of a crash, but it’s much wiser to avoid the crash in the first place.”
Meanwhile, according to PwC, ISDA says companies should sign the protocol and then close out affected positions and voluntarily convert to instruments that reference ARRs where possible, before LIBOR becomes unavailable.
Given the prevalence of fallbacks, Vikash Rughani, senior director, business management at OSTTRA, says, ISDA’s protocol has been invaluable.
“Everything that ISDA has done to work with the industry and implement the fallback procedures under the protocol as well as devising language that people can embed into their contracts has been extremely successful,,” Rughani said..
No time to rest – Canada next
All this success is fortuitous given that once the June deadline passes for US Dollar Libor cessation, derivatives participants will barely have time to catch their breath before moving on to the next major market: Canada.
On June 28, 2024, the Canadian Dollar Offered Rate (CDOR) will cease publication leaving just 12 months to effect transition to the Canadian Overnight Repo Rate Average (CORRA), which has been identified as the recommended alternative benchmark rate.
The transition will take place in a two-phased approach with the first phase coming quickly, demanding the majority of all new derivative products shift from CDOR to CORRA by June 30, this year.
Rughani says that a large number of participants can draw on their experience of earlier transitions in the US, UK, Japan and Switzerland, but those without prior participation have a lot to come to terms with and have relatively little time to do so.
Rughani says: “There are likely to be some new market participants impacted, particularly given the construct of the Canadian market. You’ve got the kind of the pension funds, energy distributors and mining companies, which means working with different participants that may not be aware of what needs to be done.”
LCH’s Whitehurst notes that the success of previous transitions in major markets will have trodden a path for new jurisdictions including not just Canada but also Poland and Mexico.
“I would hope that the industry will find these transitions increasingly easy, not just because of familiarity but people have built the kit already and we can reuse that in future transitions.”
However, he adds: “There are always idiosyncrasies and specifics to every market, and we will adapt the process in line with what our market participants want.”
Slen recommends taking part in dress rehearsals and he encourages testing existing processes to ensure they cater to the nuances of the Canadian market.
He also says Murex invested heavily in “performance optimisation” to ensure “clients don’t experience degradation in performance as they transition their LIBOR positions to ARRs”.
Monumental task
Ever since the frailties of LIBOR became apparent, the need to move to alternative rates was clear, but it has been what Rughani calls a “monumental task” for the regulators and market participants to make the change.
To date the cessation of LIBOR has been a success and as more jurisdictions make the switch so the process looks set to become smoother, but we can expect a few bumps along the way.
Risk alert, overcoming obstacles to achieve a smooth US Dollar LIBOR transition
This May the SEC released a risk warning noting the “ongoing and new challenges” to a smooth US Dollar LIBOR transition. These included:
- Transitioning Bank Loans in Advance of June 30, 2023. The Alternative Refence Rates Committee (ARRC) has encouraged market participants to remediate as many outstanding LIBOR-linked bank loans as practicable before the Cessation Date, to avoid a flood of contracts requiring individually negotiated amendments in mid-2023.
- Complex Contracts and Synthetic LIBOR. A few complexes identified highly complex LIBOR-linked contracts that: (i) are issued overseas and not subject to the Adjustable Interest Rate (LIBOR) Act of 2021, and (ii) where no fallback language exists and/or transition via an amendment process is impracticable. It is likely that many of these contracts will now transition to a synthetic LIBOR.
- Operational Challenges Associated with June 30, 2023 Cessation Date. Firms noted significant operational complexities associated with the conversion of LIBOR-linked contracts that will be transitioning, whether by hardwired fallback provisions, an amendment process, or the LIBOR Act for legacy contracts with no or impracticable fallback provisions (“tough legacy”). Firms recommended continued monitoring of the ARRC and other industry resources for guidance and tools in addressing these complexities.
Related Reading: Want more info on the LIBOR cessation?
USD LIBOR Cessation: 2021 Blueprint Paves the Way but Requires Actions Now – Derivsource
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