Welcome to our May 2020 issue of the Risk Free Rates (RFR) Regulatory Round-up - LIBOR Transition.

Although the impact of the COVID-19 pandemic has delayed many deadlines in financial services, the FCA and Bank of England (BoE) emphasised in their announcement of 25 March, that the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet. However, a further joint statement on 29 April announced that a number of interim deadlines in relation to sterling cash markets would be extended to account for the impact that COVID-19 is having on firms.

Since our last Round-up and as the end of 2021 gets nearer, a growing number of important ‘building blocks’ have been put in place by the regulators and working groups to help prepare for LIBOR transition. Below is a summary of these outputs from key parties over the last 3 months including: FCA, PRA, ECB, ARRC and ISDA.

Below you will find the latest regulatory summary of activities and output from key parties over the last three months including: FCA, PRA, ECB, ARRC and ISDA to assist in preparing for the transition.

In this issue, we also include links to KPMG summaries on accounting standards updates related to the LIBOR transition.

Sterling market developments

FCA's & BoE's statement on the impact of COVID-19 to cash market transition

Given the wide ranging impacts COVID-19 is having across financial services and the real economy, the FCA and the BoE have recognised that it will not be feasible to complete transition away from LIBOR across all new sterling loans by the original end-Q3 2020 target. Taking this into account, the Sterling RFR Working Group has recommended (PDF 209 KB) that:

  • By the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers.
  • After the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives.
  • All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.

It should be noted that the extension of these intermediate timelines has not impacted the overall end-2021 deadline for transition. This combined with the BoE's lending haircut timelines (see below) means that firms need to continue their efforts to move their exposures away from LIBOR to risk-free rates.

Sterling RFRs Working Group

The Sterling Working Group will need to revise the intermediate timelines in its 'Path for discontinuation of new sterling LIBOR-linked lending by end-Q3 2020 (PDF 587 KB)', to reflect the new end-Q1 2021 target. But it is likely still to have a staggered transition of lending products starting with bilateral, then club and syndicated, and finishing with multicurrency products. The Working Group also plans to publish material such as a basic guide to compounding.

Another step to help the transition away from LIBOR referencing cash products has been the Working Group's consultation (PDF 987 KB) on credit adjustment spread methodologies for fall-backs in cash products referencing GBP LIBOR. In March 2020, the Working Group issued a summary (PDF 470 KB) of responses, which shows a strong consensus in favour of the historical five-year median approach, in line with the approach adopted by ISDA.

According to the Working Group's roadmap (PDF 345 KB), a paper on the impact of 'tough legacy' products and possible mitigants should be published shortly.

BoE's 'turbo charging'

Before the COVID-19 crisis, the UK regulators were starting to use both 'sticks' and 'carrots', in their own words, to 'turbo-charge' the sterling LIBOR transition.

The 'stick' was the announcement on 26 February of a new policy for the treatment of LIBOR linked collateral in the BoE's Sterling Monetary Framework lending operations. Specifically:

  • From Q3 2020, the BoE will progressively increase the haircuts on LIBOR-linked collateral pre-positioned with it. Haircuts are scheduled to reach 100% (i.e. implying effective ineligibility) at the end of 2021.
  • In line with the Sterling Working Group's 2020 original Q3 target for no new term LIBOR loan issuance, any LIBOR-linked collateral issued after October 2020 will be ineligible for use at the BoE.

However, given the impacts of COVID-19, and regulators' moves to ensure that banks have maximum liquidity to support lending to the real economy, it may be that the deadlines on this policy are delayed. Pressure to delay may also come from the fact that, because of the need to issue new loans quickly under the various government backed emergency lending schemes, there has been an increase of new loan stock referencing LIBOR.

However, alongside the motivation this policy gives to firms to transition away from LIBOR-linked products, firms will also need to think about the secondary consequences of this change in policy, for example around liquidity management. Given the uncertainty of the coming months, firms are likely to have crisis plans that involve boosting liquidity by pledging collateral to the BoE. Firms need to analyse the eligibility of their collateral as this policy rolls out.

The BoE is also consulting on the 'carrot' of their intention to publish SONIA-linked index from July 2020. In addition to the overnight SONIA rate it already publishes, this index will allow market participants to calculate a wide range of compounded SONIA rates to reflect the interest period of their products. It will be consistent with the approach already taken by the Federal Reserve Bank of New York when it started publishing its SOFR index and averages on 2 March.

In tandem the BoE is seeking views on the usefulness of the BoE publishing a simple set of compounded SONIA period averages, which would give users easy access to SONIA interest rates compounded over a range of set time periods. The BoE is trying to establish whether there is market consensus on how to define the relevant time periods. The consultation closed on 9 April.

FCA and BoE's emphasis on the importance of the transition continues

On 10 March, the FCA and BoE jointly issued a letter (PDF 494 KB) to trade associations asking them to raise awareness of the LIBOR transition current deadlines. It links to the factsheet (PDF 334 KB) already published by the Sterling RFRs Working Group. There is also an appendix on protecting the interest of borrowers in transition and emphasising the importance of treating customers fairly throughout the transition.

The FCA continues to emphasise the importance of firms planning on the basis that LIBOR will cease at end-2021. In its annual 'Sector Views' publication, the FCA highlighted that 'good progress has been made on LIBOR transition in some markets, but more progress needs to be made in others' and an 'orderly transition from LIBOR' continues to be one of the key outcomes in the FCA's 2020/21 Business Plan (PDF 1.33 MB). 

The FCA has also been issuing supervisory strategies for various sectors of the financial services. The 'Dear CEO' letters to asset managers (PDF 180 KB) and benchmark administrators (PDF 191 KB) emphasised the importance of managing conduct risks and other risks arising from the LIBOR transition. We expect a supervisory strategy for Wholesale Banks to be issued shortly, which is likely also to emphasise the need to transition away from LIBOR.

As noted in the ISDA section below, the FCA used the letter to ISDA (PDF 100 KB) to further emphasise that it 'would not seek to prolong a non-representative panel bank LIBOR simply to benefit firms which had failed, or continued to fail, to act on opportunities to transition'.

How the FCA will announce LIBOR contractual triggers

On 12 March, the FCA announced the ways it would notify the market if there are LIBOR contractual triggers. The announcements will:

  • be made via the Regulatory News Service (RNS), at the same time as, or very shortly followed by, a posting of a fuller statement on their website
  • be clear that it is being made in the awareness that it will engage certain contractual triggers that are activated by pre-cessation or cessation announcements made by the FCA
  • be clear about the LIBOR currencies and tenors it relates to
  • include the date of cessation, or, if applicable, date from which the relevant LIBOR settings are not going to be representative.

The clarity and transparency of these notices will be very important to ensure that firms understand which of their remaining LIBOR positions will be impacted by each announcement.

Euro market developments

Given the impact of COVID-19 crisis, the Euro RFRs Working Group is considering (PDF 90 KB) whether to delay some of its work on consultations on EURIBOR fallback measures so that final recommendations and guidelines would be published in late 2020 / early 2021 rather than this summer.

Similarly, after pressure from the Euro Working Group, the European Association of CCP Clearing Houses (EACH) announced (PDF 283 KB) a five-week delay of the EONIA to €STR discounting regime switch date from 22 June to 27 July 2020 to give market participants extra time to prepare. However EACH warned that any further delay would severely impact the US dollar discounting switch planned for 16/19 October 2020. Firms should be considering the impact of the delay to their systems and hedging approach.

On 19 February, the Working Group published a report (PDF 409 KB) on the transfer of liquidity from EONIA's cash and derivatives products to the €STR. The report supplements a previous report (PDF 574 KB) from the Working Group (published in August 2019) and provides clarifications around specific topics that have been discussed since then. There are 13 key recommendations/observations, many of which are about encouraging the transition from EONIA to €STR.

US dollar market development

The US regulators are not yet using 'sticks' as comprehensively as the as UK regulators to enable the LIBOR transition. Instead the US dollar market developments are focused around consultations on the technical details of the transition although we are beginning to see 'sticks' used by public agencies such as Fannie Mae and Freddie Mac.1

However an important date in the transition was 2 March when the Federal Reserve Bank of New York started publishing daily SOFR Averages and Index shortly after SOFR is published. These are useful benchmarks to reference in a variety of products such as consumer loans and floating rate notes. In particular they will help accelerate transition for firms struggling to implement the compounding and/or averaging methodologies within their systems.

Alternative Reference Rates Committee (ARRC) Consultations & Recommendations

When announcing its 2020 Key Objectives (PDF 123 KB), the ARRC also noted that it is expecting to release in the coming week some recommended best practices taking into account the potential impacts of COVID-19.

In line with the ARRC's 2020 objective to pursue legislative relief for 'tough' legacy LIBOR-linked contracts, the ARRC released, on 6 March, a proposal for New York State legislation (PDF 350 KB) which intends to minimise legal uncertainty and adverse economic impacts associated with the LIBOR transition. A webinar provides an in-depth overview.

Similar to the Sterling RFR Working Group (see above), the ARRC is recommending (PDF 467 KB) for fallbacks in cash products a spread adjustment methodology based on a historical median over a five-year lookback period. Although it is additionally recommending a one-year transition period for consumer products. This transition would create a slight dislocation between the fallback approaches to USD cash and derivative products. The ARRC will publish a more detailed final recommendation in the coming weeks.

On 27 March, the ARRC released its sixth consultation (PDF 175 KB) on fallback language, seeking views on fallback language for new variable rate private student loans.

On 7 February, the ARRC released a consultation (PDF 1.38 MB) on swaptions based on USD LIBOR that could be affected by the discounting change for cleared derivatives from the use of the Effective Federal Funds Rate (EFFR) to SOFR, which clearing houses are expected to implement at the close of business on 16 October 2020. The consultation closed on 9 March.

On 24 January, ARRC released final recommendations (PDF 245 KB) for new interdealer cross-currency basis swaps that use the SOFR and RFRs recommended by National Working Groups in other jurisdictions. The conventions outlined in the document are for market participants' voluntary use.

Fannie Mae & Freddie Mac no longer to accept LIBOR mortgages

In a more strident move to get banks to transition from LIBOR, on 5 February, the Federal Housing Finance Agency announced that Fannie Mae and Freddie Mac would no longer accept adjustable rate mortgages (ARMs) based on LIBOR by the end of 2020. The agencies will begin accepting ARMs based on SOFR later in 2020.

This was supported in April, when Fannie Mae and Freddie Mac confirmed eligibility, underwriting, and delivery requirements for residential SOFR-based ARMs to provide additional clarity to all stakeholders in the consumer loan market.

ISDA updates

The pre-cessation triggers debate moves forward

As outlined in Regulatory Round-up: Issue 8, the Financial Stability Board's Official Sector Steering Group (FSB OSSG) is concerned about the systemic risk that could occur if there is a pre-cessation event, such as if the FCA, in its capacity as the regulator of LIBOR, found LIBOR no longer to be capable of being representative (“non-representative”), for example because of the departure of panel banks at end-2021. The FSB OSSG is concerned such an event could trigger the main central counterparties (CCPs) to transition cleared contracts away from LIBOR to RFRs. However, without a trigger for this event in outstanding uncleared contracts, there could be fragmentation between the outcomes for cleared and uncleared derivatives.

On 15 April, ISDA announced the initial results of its second consultation on how to implement pre-cessation fallbacks for derivatives. There was a significant majority in favour of including both pre-cessation and permanent cessation fallbacks as standard language in the amended 2006 ISDA Definitions for LIBOR and in a single protocol for including the updated definitions in legacy trades. The updated definitions for other covered interbank offered rates (IBORs) will continue to include permanent cessation fallbacks only. This consultation followed clarification from the FCA (PDF 100 KB) and ICE Benchmark Administration (PDF 130 KB) on how long and in what scenarios a 'non-representative' LIBOR may exist.

ISDA plans to publish the final results and information on next steps in the coming weeks.

The launch of a consultation by LCH on 27 January on proposed rule book changes to implement pre-cessation fallbacks has also provided further clarity to the market on pre-cessation issues.

These are steps towards firms being able to implement fallback language for derivatives contracts that cater for a range of scenarios, and there should not be fragmentation between cleared and uncleared derivatives market. However, due to the bilateral and bespoke nature of cash product contracts, the fallback language for cash products does not currently have pre-cessation triggers included. This could lead to issues with risk management. Firms will need to consider how they manage this dislocation.

Firms should also note that the FCA used its letter to ISDA (PDF 100 KB) to further emphasise that it 'would not seek to prolong a non-representative panel bank LIBOR simply to benefit firms which had failed, or continued to fail, to act on opportunities to transition. Where contracts can practicably be amended to reference alternative rates by bilateral agreement or other arrangements, they should be, before end-2021.…. Tthe FCA has no plans to use its power to sustain panel bank LIBOR beyond end-2021 for the benefit of 'tough legacy' contracts. Those statement[sic] apply regardless of representativeness.'

Bloomberg Rulebook for IBOR Fallback Methodology

On 22 April, for permanent cessation fallbacks, Bloomberg published a rulebook (PDF 760 KB) setting out the methodologies it will use for the adjustments for derivatives contracts. In the coming weeks, Bloomberg will start publishing indicative data on a currency-by-currency basis and will partner with ISDA to help market participants understand the methodologies and their implementation.