To say that the LIBOR and Risk Free Rate (RFR) transition is complex is an understatement. There is no shortage of activity – or acronyms – in the market. This transition will affect all market participants and the updates below show that the pace of change is accelerating. We would encourage firms to start considering how this shift will affect their organisation and the steps required to ensure a smooth transition.
Over the coming months, KPMG will be bringing you regular updates on LIBOR and RFR to help keep you apprised of the goings-on; here you will find a regulatory summary of the latest and greatest from key parties including ISDA, the ECB, CME and the Bank of England.
ISDA Consultation on Benchmark Fallbacks
On 12 July 2018, the International Swaps and Derivatives Association (ISDA) launched a market wide consultation on benchmark fallbacks for derivative contracts. This consultation covers the GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW rates and the fallbacks which will be used in a cessation event.
The consultation focusses on the different terms and credit adjustment methods that could be used in case of invoking a fallback from an Inter-bank offer rate (IBOR) to an alternative RFR. The output of the consultation will determine how the 2006 ISDA definitions will be amended to account for a benchmark cessation type event.
The consultation is open until 12 October. It is important that as many participants and sectors as possible respond to the consultation. ISDA need to ensure that the chosen fallback approach for each IBOR will work for the majority of participants in the market.
ECB RFR working group – 11 July 2018
EONIA and EURIBOR timeline issues were a significant topic at the July ECB working group (PDF 85KB) on the euro risk-free rates. The EURIBOR benchmark is currently going through a process of reform. The completion of the reform and outcome on compliance with the EU Benchmark Regulation (EU BMR) is expected by the end of 2019. Both the EURIBOR administrator (EMMI) and Belgian Regulator (FSMA) have indicated that the timeline for reform cannot be accelerated. This leaves a potential scenario where both EONIA and EURIBOR are non-compliant with EU BMR on 1 January 2020. There is significant concern in the market that there is insufficient time to transition onto the chosen euro RFR, reinforced by the ECB announcement that publication of ESTER will commence in H2 2019 at the earliest and this timeline is unable to be accelerated.
The ECB has set up a sub-working group on EONIA transition to help address the potential cliff edge event. The group will focus on the following overall deliverables:
The first item the sub-working group will aim to produce is a high level transition plan for all potential EURIBOR/EONIA scenarios. Until clearer regulatory guidance is provided, firms will need to review the transition plans carefully and incorporate flexibility into their RFR programmes to be able to adapt quickly to the different EONIA scenarios.
Decision on the euro RFR
The working group provided an update on the timelines for the euro RFR decision process. Market feedback on the euro RFR consultation was published mid-August and will be reviewed by working group members. Each of the 21 voting members (firms) of the ECB euro RFR working group will have an anonymous vote at the next working group meeting (13 September). A two thirds majority will be required for the selection of the euro RFR. In our view, ESTER appears to be the most likely rate to be selected given its similarity to reformed SONIA and EONIA.
Term structure developments
The ECB’s term structure subgroup are in the process of defining different methodology options for creating a term structure, including the pros and cons of each option. The complete list of options will be presented to the RFR working group in September along with steps for narrowing down the list. It has been noted that a liquid derivatives market based on the new RFR rate will be required for deriving term structures. The subgroup reported that from the date the euro RFR is chosen, it is expected to take 18-24 months preparation time followed by 12-14 months liquidity growth to establish liquidity in the OIS and centrally cleared derivatives market. Given the lengthy timeline, firms will need to prepare for a scenario where there is no available EUR term rate.
SONIA term rate consultation
The Bank of England (BoE) working group on Sterling Risk Free Rates launched a consultation on term SONIA reference rates in July 2018. The consultation paper sets out eight overarching methodologies for calculating a SONIA term rate in the 1m, 3m, 6m and 12m tenors.
The BoE working group has concluded that the most feasible approach is using firm spot starting OIS quotes on central limit order books (CLOBs) due to data sufficiency and transparency. For this approach to work, SONIA based OIS would need to move from voice OTC markets to regulated trading platforms running CLOBs. This shift is likely to require impetus from the Financial Conduct Authority to obligate firms to trade on CLOBs, otherwise there is going to be little incentive for firms to do so.
Building Liquidity in SONIA & SOFR
CME SOFR Futures
On 20 July 2018, CME announced that the total trade volume for SOFR futures contracts had surpassed 100,000 contracts with open interest surpassing 20,000 contracts. Volumes are still small compared to Fed funds and Eurodollar futures. However SOFR is supported by more than 12 market makers as part of CME’s liquidity incentive programme and the first block trades took place in July.
World Bank and Fannie Mae SOFR Floating rate notes
On 14 August 2018, the World Bank issued its first Secured Overnight Financing Rate (SOFR) bond. The US$1billion 2 year bond had a coupon of SOFR + 22bps, reset daily and paid quarterly. Citi and TD Securities jointly managed the bond sale which attracted orders from 27 institutions.
Prior to the World Bank’s issuance, Fannie Mae announced that it will issue the first SOFR securities. The US mortgage finance agency three-tranche US$6 billion SOFR debt transaction settled on 30 July 2018.
The floating rate notes were offered in three maturities with TD Securities USA, Barclays Capital Inc and Nomura Securities International Inc as the lead managers of the transaction.
|6-month||$2.5billion||SOFR + 8 bps|
|12-month||$2.0billion||SOFR + 12 bps|
|18-month||$1.5billion||SOFR + 16 bps|
This FRN follows the June announcement by the European Investment Bank (EIB) for their issuance of a £1billion five year bond with a quarterly SONIA based coupon.
The market will require more products such as these to help drive liquidity growth in the SOFR and SONIA derivatives markets.
New issuance of Sterling bonds referencing LIBOR
The Bank of England working group on risk free rates published a paper in July 2018 on the topic of LIBOR referenced sterling bonds. The paper highlights the risks associated with the continued use of long dated LIBOR bonds including:
The paper sets out the main mitigation measures which can be taken to avoid these risks. Primary amongst these is transitioning to using bonds which reference SONIA rather than LIBOR. Where this is not possible or the position has already been entered into, options such as amending the terms of the bond are possible. The difficulty with amending bond terms once entered into is that the contract typically requires a set quorum of bond holders to consent to the change. The concept of negative consent has not been adopted across the vanilla bond market, which would assist in trying to implement such changes. Firms will need to carefully consider the reference rate they are using, and fallback mechanisms, when conducting new issuance.
The pace of change is rapidly accelerating and firms must have a grasp on what the transition means for them and their business.