Buried in the depths of the Communiqué from the G20 Finance Ministers & Central Bank Governors Meeting on the 23rd of February was a stark call to arms regarding LIBOR transition. Building on the comments from National Competent Authorities (NCA) came a clear G20 statement:
“We emphasise that markets need to transition away from LIBOR to alternative reference rates before end-2021. Therefore, urgent work is needed by the private sector, supported by the public sector, to manage this transition, given the risks that may arise if parties are insufficiently prepared for the expected discontinuation of widely used LIBOR benchmarks. Given the short time remaining for this transition to take place, substantial progress is needed in 2020 to address the potential financial stability risks. We ask the FSB to identify remaining challenges to benchmark transition by July 2020 and to explore ways to address them.”
The transition away from LIBOR to Risk Free Rates (RFR) has polarised the industry. It is a huge undertaking with multiple touch-points throughout an organisation, and with multiple risks including significant legal challenge – see my previous blog on ‘the 4 themes to get right in 2020’. This set out the UK position that firms need to adopt SONIA in both lending and derivative markets and to reduce the stock of legacy LIBOR referencing contracts. It called on the market to change the convention for sterling interest rate swaps from LIBOR to SONIA at the beginning of this month!
The Bank of England turned on the afterburners, in Millennium Falcon style, when declaring that their new initiatives “are aimed at turbocharging sterling transition”. Key amongst the measures are progressively increasing “haircuts” on LIBOR-linked collateral and not accepting it from October this year. However, changing to LIBOR for new activities is the easier side of a dual problem. The real problems arise with respect to legacy contracts that do not contain fallback provisions in the advent of LIBOR rates not being published. Here, legal litigation is a very real possibility with the attendant risks.
The battle lines in the United States are starker than those in the UK. The US Alternative Reference Rate Committee (ARRC) chose the Fed’s Secured Overnight Financing Rate (SOFR) as LIBOR’s replacement. The ARRC’s bank representation is predominately investment banks alongside large foreign banks, and the decision on the chosen alternative has alarmed ten large and unrepresented regional banks that account for a large percentage of the domestic loan markets. While supporting SOFR for derivatives they question the value for bank loans. This centres on the core difference between RFR and LIBOR, one referencing a secured rate backed by treasury collateral calculated in arrears (you get the rate at the end of the term rather a forward-looking one at the start); and the other being an unsecured rate and, therefore, has a larger element of credit risk priced into the rate.
This is what the regional banks are objecting to; that in times of stress it could push the borrowers rates lower while bank funding rates are rising! They contend that the consequence of this would either be “a reduction in the willingness of lenders to provide credit in a SOFR-only environment…or an increase in credit pricing through the cycle.” Similar arguments have been heard elsewhere around the globe. Alongside questioning the imbalance between RFR and LIBOR when it comes to secured and unsecured rates, moving to rates sent in arrears comes with a colossal bill to replace or upgrade lending and borrowing systems with the attendant changes to the processes behind them.
Another issue with RFR is the volatility of a short-term overnight rate when liquidity conditions change. This was well illustrated in the US when on the 17th of September 2019 the rate spiked to 5.25% from 2.43% the day before. This has led to the Federal Reserve intervening in the market to “smooth” the repo rate. Some see this as replacing a LIBOR rate that was allegedly manipulated by banks which lead to calls for its abolition and transition to a RFR manipulated by a Central Bank. If LIBOR is being replaced because it was “unrepresentative” by SOFR, it could be argued to be unrepresentative and guided by a single central bank without any market input. The war over what is a good benchmark in the US continues with AMERIBOR, the Bank Yield Index and Commercial Paper Rates battling with the ARRC anointed SOFR especially for markets better suited to a rate that has a dynamic credit spread imputed.
Meanwhile, in Asia, some NCA’s are urging preparation for LIBOR transition but the region is seen to be well behind the US and UK with regards to market preparedness. While in the European Union the RFR rate will be ESTER administered by the ECB and will replace EONIA. However, there has been no suggestion that EURIBOR will be discontinued and, in fact, was successful in receiving authorisation under the BMR in July 2019 and has transitioned panel banks to the hybrid methodology! Other important financial centres have also got transition plans such as Australia (AONIA), Canada (CORRA), Switzerland (SARON), Hong Kong (HONIA) and Japan (TONA).
With ISDA re-consulting on pre-cessation and permanent cessation fallbacks having failed to reach a consensus the first time, and the markets waiting on indicative spread calculations in the first half of this year to help facilitate operational readiness for fallback implementation, much work remains to be done. As stated by ISDA; it is important we arrive at a solution that has broad industry support. Expect the LIBOR wars to be a recurring theme coming to your screens for some time to come.