Welcome to our September 2020 issue of the Risk-Free Rates (RFR) Regulatory Round-up - LIBOR transition.
As the initial impacts of the pandemic subside, the regulators and RFR Working groups are fully focused on the end-2021 deadline for LIBOR transition. Over the last six weeks we have seen a continuous stream of updates that will assist market participants in the transition from LIBOR, which we summarise below.
Updated RFRWG priorities and targets
On 28 July, the Sterling Risk-Free Reference Rates Working Group (RFRWG), published a statement (PDF 213 KB) on LIBOR transition with a range of materials designed to assist firms in implementing their transition plans. These included: a) a set of updated priorities for 2020-21, including an updated roadmap (PDF 389 KB); b) Q&A (PDF 537 KB) on RFRWG's revised end-Q3 milestones for loan markets; and c) a series of educational videos providing background on the key issues in the LIBOR transition.
The roadmap (PDF 389 KB) has become more detailed and now also includes a helpful product-by-product view of intermediate steps and milestones. However, across all products, the working group's targets are to cease initiation of new Sterling LIBOR products maturing after 2021, by end Q1 2021, and complete active conversion where viable by end Q3 2021.
In the very near term, RFRWG deliverables for Q3 2020 are:
In terms of market developments and external dependencies, RFRWG targets for Q3 2020 are:
SONIA Loan Market Conventions
To support the transition to SONIA in the sterling loan market, the RFRWG published, on 1 September, a recommendation (PDF 487 KB) on standard market conventions for sterling loans based on compounded in arrears SONIA. The recommendations cover a number of aspects in relation to calculation of interest to support new lending on a SONIA-linked basis, and on the treatment of interest rate 'floors' in existing LIBOR-linked contracts moving to SONIA. The standard approach recommended is the 'five banking days lookback without observation shift', which aligns with the approach recommended by ARRC for the US dollar loan market. The RFRWG has published explanatory slides (PDF 1.01 MB) and worked examples (Excel 790 KB) to help lenders be able to offer non-LIBOR alternatives to customers by the RFRWG end-September target.
Tough legacy products
Following on from the UK Government's June proposal to amend the UK version of the EU Benchmarks Regulation (BMR) to help manage the risk of 'tough legacy' products (see issue 12), on 24 July, the European Commission issued its own proposal to amend the EU BMR to help prevent disruption caused by the cessation of LIBOR. The proposal is open for consultation until 6 October. In a slightly different methodology to the UK, the amendments proposed to the EU BMR would empower the Commission to designate a replacement benchmark to cover all references to a critical benchmark, such as LIBOR, when such a benchmark ceases to be published and could result in significant disruption to EU financial markets. The statutory replacement rate will be available only for financial contracts that reference the critical benchmark at the time it ceases to be published.
With the ARRC proposal on New York State legislation, there are now three proposals to address the 'tough legacy' issue. However, pending further information from the authorities, it is not yet clear, for any of these solutions, exactly how they will apply or the economic impact they may have on individual contracts. All these solutions also require legislative approvals at a time when legislators are likely to be occupied with measures to combat the pandemic or other national developments. Therefore, it is crucial that individual firms focus on transitioning as many of their LIBOR-referencing exposures as possible. Firms should expect steadily increasing scrutiny from supervisors as the end of 2021 draws nearer.
ECB assessment of banks' preparedness for benchmark reform
On 23 July, the European Central Bank (ECB) published (PDF 88.8 KB) an assessment of the preparedness of banks it supervises for benchmark reforms. The assessment, carried out in H2 2019, found that while banks are generally well-aware of the complexity of the reforms and the challenges involved, their level of preparation leaves room for improvement: their action plans were generally behind schedule. Banks had focussed more on the transition from EONIA to the euro short-term rate (€STR) than on the risks associated with the reform of the euro interbank offered rate (EURIBOR). This is despite the fact that EURIBOR is currently the most frequently used benchmark rate for contracts in the euro area. Therefore, alongside the assessment, the ECB published good practice examples outlining how banks can best structure their benchmark-rate related governance, identify benchmark-rate related risks, and create action plans and documentation in relation to the reforms.
€STR compounded term rates
On 24 July, the ECB launched a consultation on the publication of compounded term rates based on the euro short-term rate (€STR). The publication would take place daily, shortly after the €STR publication. Published maturities could range from one week up to one year. A daily index, making it possible to compute compounded rates over non-standard periods, is also envisaged as part of the publication. The consultation closed on 11 September. For comparison, the Bank of England has published, since 3 August, a daily SONIA compounded index but has decided not to publish SONIA 'period averages' given lack of consensus on usefulness and methodology. And the New York Federal Reserve has published daily SOFR averages and index since 2 March.
CFTC no-action letters
On 31 August the Commodities Futures Trading Commission (CFTC) issued three revised no-action letters, which will allow market participants to qualify for relief when amending swaps to update provisions references LIBOR or others IBORS. The letters provide relief from, amongst other things, uncleared swap margin rules, business conduct requirements, uncleared swap margin rules, and time limited relief from the trade execution requirement and the swap clearing requirement. This should help reduce the operational implications of LIBOR contract transition for market participants.
The Alternative Reference Rates Committee (ARRC) continues to publish guidance, recommendations and supporting material across market sectors to assist with LIBOR transition. Key ARRC targets for end-September 2020 are:
On 10 September, the ARRC requested (PDF 121 KB) proposals for an administrator for a forward-looking term rate for SOFR. The aim is to publish in the first half of 2021, if liquidity in the SOFR derivatives market has developed sufficiently. Regulators have questioned the need for forward-looking term rates for the RFRs, but market participants have continued to request them. The announcement stresses that it does not guarantee that any SOFR term rate or administrator will ultimately be recommended by the ARRC.
On 27 August, the ARRC published (PDF 603 KB) updated recommended hardwired fallback language for newly-originated USD LIBOR bilateral business loans. ARRC's 'Best Practices' (PDF 221 KB) state that new bilateral loans should incorporate hardwired or hedged fallback language by 31 October 2020. The changes are similar to the recent revisions made by the ARRC to its recommended fallback language for newly-originated syndicated loans.
The ARRC also released a technical reference document (PDF 553 KB) for syndicated loan conventions, which includes example calculations of the different methodologies.
On 18 August, the ARRC published the LIBOR ARM Transition Resource Guide, which (PDF 1.34 MB) focuses on LIBOR-based adjustable rate mortgages, including home equity products, and the Legacy LIBOR-Based Private Student Loan Transition Resource Guide, which (PDF 1.06 MB) focuses on LIBOR-based variable rate private student loans. Developed by the ARRC's Consumer Products Working Group, both resources offer guidance for all stakeholders throughout the LIBOR transition process, with consideration of the potential consumer impacts.
Second Consultation on Japanese Benchmark Reform
On 7 August, the Bank of Japan's Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks published a second consultation (PDF 831 KB) on interest rate benchmark reform, gathering views on specific outcomes from fallbacks triggered in cash products referencing JPY LIBOR. It also presents the Committee's recommendations for enhancing the robustness of Term Reference Rates and a transition plan for cash products referencing JPY LIBOR and maturing beyond end-2021; specifically, a deadline of end-Q2 2021 of ceasing issuance of new cash products referencing LIBOR.
Bank of Japan review of financial institutions' preparedness for LIBOR cessation
On 11 August, the Bank of Japan published a review of the preparedness of financial institutions for the cessation of LIBOR. This highlighted the results of a survey (PDF 570 KB) jointly conducted with the Japanese Financial Services Agency from October to December 2019 covering a total of 278 entities across financial services. Similar to the ECB survey detailed above, the Japanese survey suggests that “although there has been progress in financial institutions' preparations overall, such as in terms of their awareness of challenges posed by LIBOR cessation and their identification of contracts referencing LIBOR, there remains some room for further efforts on their part.”
IBOR fallback protocol
At the time of writing, the market is expecting the publication of the ISDA IBOR fallback protocol. ISDA is awaiting a positive business review letter from the US Department of Justice, giving approval, and similar feedback from competition authorities in other jurisdictions. The IBOR fallback protocol is the most efficient way for firms in most non-cleared linear derivatives markets to mitigate against risks associated with the discontinuation of a key IBOR. It forms a critical part of addressing the systemic risks related to the expected discontinuation and/or non-representativeness of LIBOR, in particular. Central counterparties clearing derivatives that reference key IBORs have already confirmed that they will use the powers in their respective rule books to implement the new fallbacks across all new and legacy over-the-counter transactions.
On 22 July, ISDA sent a letter (PDF 231 KB) to all the chairs of the RFRs working groups asking them to encourage regulated entities and other key market participants to sign up to the protocol 'in escrow' in the two weeks prior to the official launch date. ISDA will then be able to publish a comprehensive list of adherents when the protocol is launched. The hope is that this will indicate to the market an expectation of widespread usage and therefore encourage further adherence.
On 29 July, the ISDA Board of Directors published a statement signalling its strong support for broad adherence to the protocol.
On 19 August, ARRC updated (PDF 560 KB) its recommended Best Practices, encouraging dealers and other firms with significant derivatives exposures to adhere to the protocol during the escrow period. As Tom Wipf, the ARRC chairman said, “The IBOR fallback protocol is crucial to ensuring that the derivatives market continues to function and that LIBOR derivatives contracts continue to perform through the transition away from LIBOR.”