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Welcome to our December 2019 issue of the RFR Regulatory Round-up – LIBOR Transition. The Regulators continue to emphasise the need for firms to take action as the December 2021 deadline grows closer. Industry bodies are now beginning to produce standards to help firms implement their transition. This was highlighted in the Financial Stability Board’s annual progress report on the LIBOR transition which states that the continued reliance of global financial markets on LIBOR poses risks to financial stability and calls for significant and sustained efforts by the official sector and by financial and non-financial firms across jurisdictions to transition away from LIBOR by end-2021.

Below you will find the latest regulatory summary of activities and output from key parties including: FCA, PRA, ECB, ARRC and ISDA.

Growing global consensus on regulatory relief for amendments to replace IBORs

Over the last month the European Supervisory Authorities (PDF 80.4 KB) (ESAs), the US CFTC and the UK PRA have all announced that they consider amendments of legacy derivatives contracts for the sole purpose of referencing new RFRs or fallbacks will not introduce new obligations for these legacy contracts e.g. clearing obligations and margin requirements. This should take away another uncertainty that may have been causing firms to delay in transferring to RFRs.

Sterling market developments

FCA guidance on Conduct Risk

On the 19 November, the FCA published clear expectations and guidance for firms on managing the prudential, operational and conduct risks arising from the transition away from LIBOR. The scale and the complexity of the transition process, and therefore the conducts risks that can arise, have become apparent to both industry and the regulators as the end of 2021 deadline becomes nearer. This guidance is a critical building block for firms in defining their transition plans, timelines and paths. A summary of the guidance can be found here.

PRA Letter on the prudential regulatory framework and LIBOR transition

In response to a letter (PDF 247 KB) from the Chair of the Working Group on Sterling RFRs, the PRA have covered a number of issues, including:

  • Amendments to either capital instruments or non-cleared derivatives to replace an LIBOR rate do not require reassessment of eligibility of instruments or reassessment of margin.
  • PRA Supervisors will discuss with major firms how they will address the modelling challenges that the LIBOR transition poses to counterparty credit risk, market risk and interest rate risk in the banking book (IRRBB) and will expect analysis to be included in future Internal Capital Adequacy Assessment Process (ICAAP).
  • PRA Supervisors will request feedback on models to determine scope for re-approval. There is an expectation that pre-approval may need to be granted.

Working Group on Sterling Risk-Free Reference Rates establishes three new task forces

As the likely cessation of LIBOR becomes closer, the working groups are focusing on specific transition issues. The Sterling Working Group has set up the following task forces to support this.

  • The Tough Legacy Task Force will build upon the of the work of the Regulatory Dependencies Task Force to provide market input regarding the ‘tough legacy’ of products that may prove unable to be converted or amended to include robust fallbacks.
  • The Cash Market Legacy Transition Task Force will produce a discussion paper to support awareness of potential approaches to either actively convert existing contracts to alternative rates or update those contracts to include robust fallback language.
  • The Loan Flow Enablers Task Force will focus on enablers to moving new loans issuance away from GBP LIBOR.

Alongside these new task forces, the Working Group has recently published a consultation (PDF 987 KB) on credit adjustment spread methodologies for fallbacks in cash products (loans, bonds and securitisations) referencing GBP LIBOR. The consultation closes on 6 February 2020.

Bank of England Financial Stability Report

In March 2017, the Bank of England (BoE) Financial Policy Committee judged that continued reliance of financial markets on long term LIBOR benchmarks created a risk to financial stability and so has monitored the transition ever since. In its latest Financial Stability Report, the BoE reports that sterling markets show encouraging signs in the development of new products linked to SONIA, and the transition of some legacy products. But the BoE emphasises that important gaps remain, so efforts will need to continue to accelerate in the first half of 2020. The report also notes that the transition remains further behind in US dollars, the largest LIBOR market.

Transitioning legacy cash positions

Lloyds and Nationwide have confirmed noteholder support to replace LIBOR with SONIA in some of their legacy cash positions. Lloyds amended a £300mm asset backed floating rate on 18 November. Nationwide amended a £550mm securitisation with the new margin and new step-up margin calculated via a Forward Start Adjustment plus a LIBOR vs SONIA Interpolated Basis.

Euro market developments

Working Group on Euro Risk Free Rates recommendations

The Euro RFR Working Group has published a number of recommendations in the last few months to help firms with their transitions to Euro RFR:

  • Recommendations to address impact of euro risk-free rates transition on risk management. This report focuses mainly on the risk management implications for banks but also touches on additional challenges facing the asset management and insurance sectors.
  • Recommendations for fallback provisions in contracts referencing EURIBOR.
  • Recommendations to address accounting impact of euro risk-free rates transition, focusing on the implications for IFRS and IAS standards.
  • Recommendations around fallback arrangements for users of €STR (required by the BMR).

European Commission consultation on the functioning of the Benchmarks Regime

As required by the regulation, the European Commission consulted on the functioning of the Benchmarks Regime two years after the implementation of the Regulation – this paper addresses a number of issues. In terms of IBOR reform, it consults on the powers of national competent authorities (NCAs) over critical benchmarks particularly around their cessation. The consultation closed on 6 December and the next steps will be for the EC to prepare a report, based upon the responses received to the European Parliament and Council.

Clearing of euro-denominated swaps benchmarked to €STR

The London Clearing House (LCH) announced it cleared the first euro interest swaps referencing €STR on 21 October. LBBW and Morgan Stanley were among the first participants to clear derivatives using the new rate.

US dollar market developments

ARRC Chair Tom Wipf’s Opinion-Editorial on Transitioning to SOFR

Wipf’s Opinion-Editorial stressed the importance of moving away from LIBOR, and while recognising that many important milestones have been reached, emphasised that “two years is a short period to close out the remaining tasks. The strength of institutions individually, and the architecture of the financial system broadly, relies on everyone doing their part to ensure a smooth transition to SOFR.”

Federal Reserve Bank of New York consultation on proposed publication of SOFR averages and a SOFR index

In order to support a successful transition away from USD LIBOR, and as administrator of the SOFR, the New York Fed, in cooperation with the Treasury Department’s Office of Financial Research (OFR), is proposing to publish daily three compounded averages of the SOFR with tenors of 30-, 90-, and 180-calendar days. The New York Fed plans to initiate publication of these averages in the first half of 2020 and the consultation on the method and publication arrangements is open until 10 January 2020.

Bilateral SOFR-linked loan

J.P. Morgan executed its first bilateral SOFR-linked loan with Brazilian bank Itau BBA. It will be interesting to see whether the issuance of SOFR-linked loans begins to gain momentum.

ISDA updates

Consultations on Final Parameters for Benchmark Fallback Adjustments

Three consultations by ISDA on fallback rates have identified a broad consensus for calculating a fair replacement rate in LIBOR derivatives. ISDA’s latest report outlines the methodology for calculating the two types of adjustments needed: the ‘historical mean/median approach’ to deal with differences in credit risk and other factors and the ‘compounded setting in arrears rate’ to address differences in tenor between IBORs and overnight risk-free rates. ISDA expects to implement a historical median spread adjustment over a five-year lookback period without including a transitional period, without excluding outliers and without excluding negative spreads. The spread adjustment will be applied to a compounded in arrears rate with the applicable calendar to be determined and announced by Bloomberg prior to implementation. The consensus supported a two-Banking Day backward shift adjustment period, which is anticipated to apply absent fundamental conflict with the suitability and implementation of the adjusted fallback rates.

By the end of the year, ISDA expects it will make the relevant adjustments to the 2006 ISDA definitions to incorporate fallbacks with these definitions for the new IBOR trades and publish a protocol to enable market participants to include fallbacks within legacy IBOR contracts if they choose. Bloomberg expects to publish these adjustments and ‘all-in’ fallback rates at the beginning of 2020.

Following on from the above consultations, ISDA have also just launched a supplemental consultation on the spread and term adjustments that would apply to fallbacks for derivatives referencing Euro LIBOR and EURIBOR. The consultation also covers technical issues related to the adjustment methodology, and seeks feedback on whether the adjustments would be appropriate for lesser-used interbank offered rates (IBORs) if ISDA implements fallbacks for those benchmarks in the future. The new consultation closes on 21 January 2020.

Pre-Cessation Triggers for Derivatives Fallbacks.

The Financial Stability Board’s Official Sector Steering Group (FSB OSSG) is concerned about the systemic risk that could occur if, a pre-cessation event, such as 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 that this 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.

The FSB OSSG asked ISDA in November (PDF 120 KB) to include a pre-cessation trigger alongside the cessation trigger as standard language in the definitions for new derivatives and in a single protocol, without embedded optionality, for outstanding derivative contracts.
ISDA responded in December (PDF 491 KB) outlining that there is no market consensus on how to respond to a statement of ‘non-representativeness’ in the context of fallbacks for derivatives contracts and that it would need to re-consult on this issue. However, ISDA thinks that there needs to be clarity on the following issues before re-consulting:

  • statement from the UK FCA and the ICE Benchmark Administration (IBA) that the “reasonable period” during which a “non-representative” LIBOR would be published would be minimal (i.e., a number of months not years) after the FCA announces that LIBOR is no longer representative.
  • A public and definitive confirmation directly from CCPs clearing LIBOR derivatives or its regulatory supervisor that the CCP has implemented appropriate rule changes or will use discretionary powers provided by its rules, that upon an announcement by the FCA that LIBOR is “non-representative”, the CCP will amend its entire portfolio of cleared LIBOR derivatives so these derivatives reference the relevant adjusted RFR instead.

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