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RFR Regulation Round-up Issue 3

RFR Regulation Round-up Issue 3

Welcome to our third issue of the RFR Regulatory Round up. We have entered a new year and a key one for firms in the transition from inter-bank offered rates (IBORs) to risk free rates (RFRs). Since our last update it’s been a busy period in the RFR space with UK firms submitting their PRA/FCA Dear CEO responses as well as a number of key updates from across each major jurisdiction.

As further feedback is received from the recent industry consultations and the Dear CEO letter, there should be additional clarity from across the global jurisdictions over the coming months. H1 2019 will be a key time for firms to understand the key impacts and risks of this transition to their overall business.

In this round-up, we summarise key activities including:

  • ISDA updates – results of benchmark fallback consultation
  • Working Group on Euro Risk Free Rates – updates on EONIA transition pathways and ESTER term rate consultation (feedback required by 1 February 2019)
  • Sterling RFR working group – considerations for loan market participants and identification of key systems and infrastructure
  • Alternative reference rate committee – Consultations on Bilateral Business Loans and Securitisations (feedback required by 5 February 2019)
  • Building Liquidity – update on RFR issuance

ISDA Updates

Results of Benchmark Fallback Consultation

On 20 December 2018, the International Swaps and Derivatives Association (ISDA) published a report summarising the results of the benchmark fallback consultation. The consultation asked market participants to submit responses on the proposed fallbacks for GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW.

  • The consultation considered responses from 147 entities including banks, asset managers, insurers, pension funds and corporates.
  • A majority of respondents favoured the compounded setting in arrears rate term adjustment combined with the historical mean/median spread adjustment approach.
  • ISDA is now set to start developing fallbacks for inclusion in its standard definitions based on the favoured approach.

It is expected that ISDA will launch a subsequent consultation in the next few months on the final parameters of the historical mean/median approach as well as a consultation covering benchmarks which were excluded from the initial consultation (e.g. USD LIBOR).

Firms should follow further developments to the ISDA fallbacks closely, particularly when determining whether they will sign up to the ISDA protocol for legacy positions. The compounded setting in arrears rate term adjustment combined with the historical mean/median spread adjustment fallback approach is likely to cause economic transfer, in some cases, if the fallback is triggered. The economic transfer will be caused by the difference between the product and ISDA determined credit spreads.

Working Group on Euro Risk Free Rates

EONIA – ESTER transition

On 19 December 2018 the EONIA transition subgroup provided an update (PDF 304KB) to the Working Group on Euro Risk Free Rates on transition paths. The subgroup proposed a number of recommendations to both EMMI and the wider market. One of the key recommendations to EMMI is for a modification of its EONIA methodology to become ESTER plus a spread. The adoption of such a recommendation by EMMI would reduce the risk of a cliff edge EONIA discontinuation, allow a period for both rates to run in parallel, and ensure an easier glide path for future transition.

Within the update, the subgroup listed eight questions, covering the proposed transition path and EONIA methodology changes, to market participants in relation to the proposed recommendations. Firms should review the questions and look to feedback views to the subgroup prior to the February working group meeting.

ESTER based term structure methodology

In December 2018 the ECB launched a consultation (PDF 372KB) on determining an ESTER-based term structure methodology as a fallback for EURIBOR-linked contracts. The purpose of the consultation is first to determine for which use cases market participants consider a forward-looking term structure is necessary or desirable. Secondly, the consultation aims to receive feedback on the preferred methodology for a forward-looking ESTER based term structure.

  • The paper acknowledges that certain products (e.g. loans) are currently dependent on forward looking rate determinations and users are likely to prefer a forward looking fallback.
  • However, based on the responses to the ISDA fallback consultation, we expect that EUR derivatives will use a backward looking rate determination.
  • Any difference in fallback approach will cause difficulties from a systems, risk management and hedging perspective in a scenario where the fallback is triggered.

Market participants have until 1 February 2019 to respond to the consultation, which the ECB will anonymise and summarise ready for the 27 February working group meeting.

Sterling RFR working group

New and legacy loan transactions referencing Sterling LIBOR

In late December, the Sterling RFR working group published a paper (PDF 52.5KB) to raise awareness regarding potential considerations for loan market participants relating to the RFR transition. The paper sets out some of the measures that can be taken to mitigate the risks for both new and legacy transactions.

For new transactions, it is noted that there is still work to be done to align SONIA to the requirements of the loan market. However there are still actions that firms can take now, such as including disclaimers in marketing material and incorporating the ‘Replacement of Screen Rate Clause’ into loan documentation.

  • For legacy contracts, firms should assess their loans book with maturity post 2021, as well as any associated hedging arrangements.
  • Steps can be taken to make clients aware of the uncertainty around LIBOR’s future and what it means for their positions.

As market conventions and infrastructure for LIBOR alternatives are developed, firms should move to mitigate the risks surrounding the transition of their loan book.

Infrastructure and Systems preliminary priority list

The Bank of England working group has identified (PDF 39.7KB) a list of key required infrastructure developments related to RFR transition. Whilst not an exhaustive list, it identifies key areas that need to be examined to ensure a smooth transition.

  • While most of the list compromises primary impacts of the transition – such as the ability to process RFR linked products, provide analytics and back office operations – it is very important to highlight the impact on risk management and valuations.
  • Changes within risk models are likely to have far reaching impacts across institutions, such as curve construction, discount curves and pricing implications for RFR-related products.

Firms should review the list and consider each of these change elements within their impact assessments.

Alternative Reference Rates Committee

Consultations on Bilateral Business Loans and Securitisations

In December 2018 the Alternative Reference Rates Committee (ARCC) released (PDF 329KB)consultations on fallback language for USD LIBOR bilateral business loans and securitisations. The consultations propose language which could be used in new contracts as a fallback in case of LIBOR cessation or discontinuation.

The consultation on bilateral business loans contains two potential approaches:

  • The first is a ‘Hardwired Approach’, which sets a defined waterfall in case of fallback.
  • The second is an ‘Amended Approach’, which provides flexibility for the two parties to negotiate a replacement benchmark and rate if the fallback is triggered.

The consultation also makes an important inclusion for proposed wording for hedged loans.

The ARCC is cognisant that a large number of business loans are hedged and that any difference in approaches between the fallbacks of loans and derivatives could create basis risk.

The consultation on securitisations proposes one ‘Hardwired Approach’ setting out the triggering events and waterfall to be used within the fallback. Within the proposed triggers, the consultation includes an ‘Asset Replacement Percentage’ trigger specifically tailored to the securitisations market. This would trigger the fallback should a set percentage of the underlying assets have converted to the replacement rate. This provision could help negate some of the basis risk to securitisations through the transition.

Feedback to the consultations is required by 5 February 2019. We would encourage firms exposed to these markets to review and respond to these two consultations.

Building Liquidity

RFR Issuance

Debt issuers are already anticipating the end of LIBOR and began issuing instruments linked to the RFR Alternatives in the second half of 2018. This is setting a standard for other issuers to follow and also enables counterparties and service providers to gain operational experience in the mechanics of the new benchmarks and to test internal systems. As more issuers come to market it will also increase the liquidity across other RFR referencing products.

The recent issues have been linked to Sterling Overnight Index Average (SONIA) in sterling and to the Secured Overnight Financing Rate (SOFR) in dollars, respectively.

  • Lloyds was the first financial issuer to issue a SONIA-linked FRN
  • Credit Suisse was the first bank to issue debt linked to the SOFR.
  • Wells Fargo issued the first non-government bond linked to SOFR.
  • Other institutions that have issued SOFR-linked debt include Toyota Motor Credit Corp, African Development Bank, Metlife and the New York Metropolitan Transportation Authority.

Whilst RFR issuance is growing, the volumes are small compared to LIBOR-based issuance. Firms looking to issue products maturing post 2021 should actively consider alternative reference rates, and in doing so, ensure their systems are able to handle products referencing RFRs.

To find out more on how to manage the transition from LIBOR to RFR, visit our Evolving LIBOR insights hub here.

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