Welcome to our October 2019 issue of the RFR Regulatory Round-up. Post the summer holidays, the RFR working groups and industry bodies have been pushing forward initiatives on the transition to alternative RFRs. The September 2019 PRA/FCA letters to UK financial institutions is the latest regulatory initiative to encourage firms to push forward their transition efforts.
Below you will find the latest regulatory summary of activities and output from key parties including: PRA, FCA, ECB, ARRC and ISDA.
Sterling market developments
PRA and FCA joint request
In September 2019, the PRA and FCA issued a new joint request to firms, following on from the 2018 Dear CEO letter. This new request requires more detailed information on firms’ transition approach and was sent to a far broader set of firms than the 2018 request. With global regulators increasing their supervisory oversight around the transition, firms will need to ensure that they have good exposure data and are executing their transition strategies.
Regulatory dependencies taskforce
The Working Group on Sterling Risk-Free Rates has set up a regulatory dependencies task force to identify regulatory barriers and dependencies involved in the LIBOR to RFR transition. The group is focussed on conduct and prudential topics and has written to UK and International authorities as listed below:
- Letter to Basel Committee on Banking Standards: Regulatory capital impediments to transition from ‘IBOR’ to new Risk-Free Rate ('RFR') Framework.
- Letter to European Commission: Removal of pan-European regulatory barriers to transition away from LIBOR and other IBORs.
- Letter to PRA: Regulatory capital impediments to transition from ‘IBOR’ to new Risk-Free Rate (“RFR”) Framework.
- Letter to FCA: Regulatory barriers and enablers to LIBOR transition.
Legacy bond transitions
In September, Santander and Lloyds publically signalled their intentions to transition a number of historic fixed income positions from GBP LIBOR to SONIA. Lloyds announced two solicitations, one for £1bn of covered bonds and a second for £300mm ABS. Santander announced that it was exploring the possibility of transitioning GBP LIBOR notes issued by Homes Master Issuer PLC to SONIA. NatWest Markets are assisting Santander with this exercise.
The transition of these legacy positions will be a good test case for the market. It will calibrate how easily these types of contract can be transitioned with clients. Market participants should follow the outcomes and approach taken closely when considering their own portfolios.
Euro market developments
On 2 October 2019, the ECB published the euro short-term rate (€STR) for the first time reflecting the O/N deposit activity on 1 October 2019. The inaugural fixing was -0.549 % based on €36bn of underlying deposits. Firms have already conducted some initial transactions to test system capabilities with HSBC and JP Morgan undertaking a €100mm swap with 1 week maturity. The European Investment Bank (EIB) was the first institution with issuance against the new benchmark with a €1bn, 3 year bond priced as €STR + 200bps. The next two years are critical for €STR in the run-up to the discontinuation of EONIA in January 2022. Firms need to start reducing their reliance on EONIA and update their systems to transact in €STR.
EONIA methodology change
On 2 October 2019, the EONIA methodology was changed by EMMI to coincide with €STR’s release. EONIA is now calculated as €STR +8.5bps and has had its publication time moved from T0 to T+1. This change will affect the payments and the settlement of many EONIA linked positions. Firms will need to make sure they have taken this into account for any legacy as well as new EONIA positions.
US dollar market developments
ARRC practical implementation checklist
On 19 September, the US Alternative Reference Rates Committee (ARRC) released a practical implementation checklist for SOFR adoption. The checklist documents the 10 key areas firms should consider for their transition to SOFR, setting out the actions required to help ensure a smoother transition. The checklist is focused on banking institutions but provides a useful reference point for all firms transitioning away from LIBOR.
SOFR floating rate note conventions
In August, the ARRC published the SOFR Floating Rate Notes Conventions Matrix along with the SOFR Floating Rate Notes Comparison Chart. These documents set out the considerations for market participants interested in using SOFR issuances along with examples of issuance conventions used this year. These documents show that a single convention for SOFR FRNs has not yet emerged. Given the USD FRN market is a major source of funding for firms and government agencies across the world, market participants should watch closely which conventions are preferred by investors.
Term SOFR linked preferred stock
In late July, JP Morgan became the first institution to issue preferred stock linked to term SOFR. JP Morgan issued a $2.25bn preferred stock deal which pays 5% fixed until August 2024 before switching to three month term SOFR +3.38%. With a term SOFR rate currently being developed under sponsorship of the ARRC, it will be interesting to see whether more products start to include reference to a future term rate.
Fallback consultations update
There have been a number of ISDA consultations over the last 18 months covering the ISDA fallbacks and triggers.
The consultation in July 2018 covered the LIBOR (GBP, CHF, JPY); TIBOR; Euroyen TIBOR and BBSW benchmarks with the purpose of determining the adjustments that will apply to the alternative RFRs if the fallbacks are triggered for any IBOR. The result of the consultation was that the Compounded Setting in Arrears Rate with Historical Mean/Median Approach would be used for the IBORs covered in this consultation. The exact parameters of the Historical Mean/Median approach were not defined from this consultation.
In May 2019, ISDA published two consultations. The first covered pre-cessation triggers for LIBOR and other IBORs. There was no clear majority in the responses to this consultation on which approach should be taken on pre-cessation triggers. The second consultation in May was a supplementary consultation to the July 2018 consultation and covered USD LIBOR, HIBOR and CDOR. A majority of respondents to the consultation were in favour of using the same fallback methodology (Compounded Setting in Arrears Rate with Historical Mean/Median Approach) as the July 2018 consultation.
In September 2019, ISDA published the Consultation on Final Parameters. This consultation provides two primary options for the historical mean/median approach to the spread adjustment for market participants to consider. Option I is a median over five year lookback period. Option II is a trimmed mean over ten year lookback period. Firms with ISDA derivative exposure should follow the outcome of the consultation closely to see how it could impact their portfolio.
Supervisory oversight and pressure is growing and is set to further increase as we head towards 2021. The next year will be key for firms to ensure they are well positioned for the transition and the different scenarios which could emerge.
Co-Head, EMA FS Regulatory Insight Centre
KPMG in the UK