LIBOR to RFR Transition

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

Since our last Round-up and as the end of 2021 gets nearer, we are continuing to see a number of important 'building blocks' being 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 two months including: FCA, PRA, ECB, ARRC and ISDA.

The UK Government, through HM Treasury, made an important announcement on 23 June on the legislation it intends to enact to help address the problems caused by 'tough legacy contracts' as identified by Sterling RFR Working Group in its May paper (PDF 103 KB). The UK Government plans to amend the UK version of the EU Benchmarks Regulation. This is to give the FCA enhanced powers to be able to direct the administrator of LIBOR to change the methodology used to calculate the benchmark if doing so would protect consumers and market integrity. This may provide a mechanism for publishing a 'LIBOR rate' if the panel banks fall away. This concept of a synthetic LIBOR calculation could then be applied post 2021 to avoid existing LIBOR contracts becoming frustrated. It is intended that this approach would not be relevant to new contracts and primarily aimed at the hard to transition portfolios as outlined in the 'tough legacy' paper. 

However, in their announcements, both HM Treasury and the FCA make it clear that regulatory action to change the LIBOR methodology may not be feasible in all circumstances, for example, where the inputs necessary for an alternative methodology are not available in the relevant currency. Further, even if regulatory action to change the methodology enabled by the legislation is feasible, the economic terms of the action may not be the most beneficial to the parties involved.

The legislation will be amended, later this year, as part the Financial Services Bill. The FCA will also publish statements of policy on how it might use its new powers and consult on the possible new methodology.

In theory, this action by the UK Government may reduce the pressure for legislative action such as the ARRC proposal (PDF 567 KB) for New York State legislation for USD LIBOR contracts. However, much will depend on timings, products involved and any future replacement methodology selected.

Given that there is still uncertainty on timeframes, the exact form this solution will take and to which products it can be applied, firms continue to be encouraged to focus on pro-active transition of as many of their existing LIBOR contracts as possible. This should be through substituting existing LIBOR references, or adopting robust fallbacks, either contract by contract or through market standard transition approaches such as the ISDA derivative protocols.

In May, the PRA and the FCA confirmed that they would be resuming full supervisory engagement on the LIBOR transition plans for dual-regulated firms from 1 June 2020. This followed the publishing of the Bank of England (BoE) interim financial stability report (PDF 4.9 MB), highlighting that during the market volatility prompted by the COVID-19 pandemic, LIBOR rates rose as central bank policy rates fell, reinforcing for the BoE, the importance keeping to the LIBOR transition end date at end-2021.

As covered in our last update, at the end of April the FCA, BoE and Sterling RFR Working Group lengthened the interim deadlines for the ceasing of new issuance of GBP LIBOR-linked loans, specifically that new issuance of LIBOR-linked loans should cease by end of Q1 2021. In line with these new dates, on 7 May, the BoE put out a market notice changing the dates for haircuts and eligibility of LIBOR linked collateral in the BoE's Sterling Monetary Framework. In summary, the 10% haircut date has been pushed back to 1 April 2021 (previously 1 October 2020) and the 40% to 1 September 2021 (previously 1 June 2021). Finally, LIBOR linked loans issued before 1 April 2021 are eligible for the facility (was previously 1 October 2020).

To assist market participants in their transition to SONIA, the BoE confirmed on 11 June that it will publish a daily SONIA Compounded Index from early August 2020. This followed, near universal, support from respondents to the February 2020 discussion paper. However, there was a lack of consensus on the usefulness of SONIA 'period averages' and so the BoE has no plans to publish these rates.

To help firms with active transition, KPMG professionals have (RC) contributed to the 'Case studies for navigating conduct risks' paper published by the FICC Markets Standards Board on 11 June. Focusing on practical examples of selling new RFR-linked products or, on the buy-side, switching performance benchmarks, the paper considers how firms can manage risks to market fairness or effectiveness in line with regulatory expectations.

The switch by central counterparties clearing houses from EONIA to €STR discounting regime will take place on 27 July 2020. To help firms prepare for this, on 16 June, and following the results of a consultation in March, the Euro RFR Steering Group recommended voluntary compensation for legacy swaption contracts impacted by the switch. It is similar to the ARRC recommendations for the SOFR discounting switch in October (see below).

In this period, the key announcement from the US Alternative Reference Rates Committee (ARRC) is its recommended best practices (PDF 584 KB). These set dates for detailed intermediate transition steps that firms should aim to take across the range of different financial products that reference USD LIBOR, including dates after which no new USD LIBOR activity should be conducted. The core guidance from the ARRC is that:

• new USD LIBOR cash products should include fallback language as soon as possible 
• third party technology and operation vendors should complete all necessary enhancements to support SOFR by the end of this year by following the vendor best practices (PDF 195 KB) released by the ARRC on 7 May and
• the new use of USD LIBOR should stop according to the timetable (PDF 900 KB) specified for each product in the best practices (PDF 584 KB) paper

It is important that firms incorporate these milestones and deadlines in their LIBOR transition planning. Some of the timelines in the US are now more aggressive than those in the UK.

On 6 May, the ARRC issued (PDF 604 KB) a supplemental consultation (PDF 284 KB) on spread adjustment methodologies for cash products referencing USD LIBOR. It seeks views on another potential option for calculating the five-year median spread that had not been included in the initial consultation. It outlines the option to use the same spread adjustment values that will be used by ISDA across all of the different fallback rates, rather than using the historical difference between LIBOR and the SOFR fallback rate for each product. The supplemental consultation also seeks views on a second issue: recognising that ISDA will now include a pre-cessation trigger, the supplemental consultation seeks views on whether the timing of the calculation of the ARRC's spread adjustment should match ISDA's timing if a pre-cessation event is operative.

In line with the Euro RFR Working Group, the ARRC on 14 May, also recommended (PDF 142 KB) voluntary compensation for swaptions impacted by the CCP discounting transition to SOFR in October 2020. 

The exchange of voluntary compensation or amendment of terms could be subject to regulatory requirements. Consequently, on 17 June, the ARRC requested (PDF 94 KB) the CFTC to extend their existing IBOR relief letter (CFTC Letter 19-26 (PDF 332 KB)) to cover amendment of a swaptions terms or exchange of voluntary compensation due to the CCP discounting transition to SOFR.

Alongside the ARRC, other regulatory bodies in the US have also been issuing guidance and timetables to help with the transition.

On 4 June, The Consumer Financial Protection Bureau released an updated Consumer Handbook on Adjustable Rate Mortgages (CHARM) to help consumers better understand adjustable rate mortgage loan products. Firms should be using this booklet or similar suitable substitute in client communications. The Bureau also released a Notice of Proposed Rulemaking (NPRM) concerning the anticipated discontinuation of LIBOR, including proposing examples of replacement indices that meet Regulation Z standards and LIBOR transition FAQs (PDF 224 KB).

Fannie Mae and Freddie Mac (the government sponsored enterprises of the Federal Housing Agency) released a LIBOR transition playbook (PDF 1.19 MB) that also has detailed timelines and guidance for the LIBOR transition for the various products that they purchase and guarantee.

The pre-cessation triggers debate has finally concluded for derivatives with ISDA publishing on 14 May, a summary of the responses to its second consultation on the implementation of pre-cessation fallbacks for derivatives referencing LIBOR. Given these responses ISDA will now amend the 2006 ISDA definitions for LIBOR to include pre-cessation and permanent cessation fallbacks without optionality or flexibility. Alongside the publication of amendments in July, ISDA will also publish a protocol that allow participants to incorporate the revisions into legacy trades if they choose to.

It is likely that both the amendments and protocols will come into effect before the end of the year. Firms will then be able to have confidence that most derivatives trades will not be referencing a benchmark that is unrepresentative, keeping them within the obligations of the EU Benchmark Regulation.

However, in the cash market there is no similar mechanism to the ISDA definitions to amend trades 'en masse', each cash contract is unique and therefore needs to be amended individually and no consensus has been reached on pre-cessation triggers.

This could bring a possible dislocation between the cash markets and derivatives markets if pre-cessation triggers were met. Raising challenges where derivatives are used to hedge cash products or where complex structured products that include both cash and derivative structures.

Please contact James Lewis, Peter Rothwell, Karim Haji, Lucie Alexander-Orr, Graham Stride or Kate Dawson for further information. To find out more on how to manage the transition from LIBOR to RFR, visit our Evolving LIBOR insights hub.

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• KPMG EMA Financial Services Risk & Regulatory Insight Centre
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