LIBOR to RFR Transition

Welcome to our February 2021 issue of the Risk-Free Rates (RFR) Regulatory Round-up - LIBOR. As the end-2021 deadline for non-USD LIBOR becomes closer, the practical challenges of the transition are becoming clearer and regulators and working group are continuing to refine possible solutions to these challenges. This issue summarises the latest updates from across the main markets.

On 25 January, the ISDA IBOR fallbacks came into effect helping to manage the risks of disruption to derivatives market if IBORs become permanently unavailable. The fallbacks will be now be incorporated into all new derivatives contracts that reference ISDA's standard interest rate derivatives definitions. They are also included in legacy non-cleared derivatives if the counterparties have bilaterally agreed to include them or both have adhered to the IBOR Fallbacks Protocol. Over 13,000 parties across nearly 80 jurisdictions have now signed up to the protocol.

Updated transition deadlines

The Working Group on Sterling Risk-Free Reference Rates (RFRWG) has updated its priorities and roadmap for the final year of transition helping firms with the last phase of their transition planning. Updates included a more specific end Q2 deadline for the ceasing of issuing of new GBP LIBOR non-linear derivatives and a specific end Q3 target for completing active conversion of all legacy GBP LIBOR contracts, where viable, and if not viable ensure robust fallbacks are adopted where possible. The RFRWG also published a short paper which also outlines the limited circumstances where it may be appropriate to enter into GBP LIBOR linked derivatives after the deadlines. The RFRWG also launched a consultation (PDF 520 KB) on a successor rate for GBP LIBOR for bond market fallbacks.

A key, and unaltered, milestone at the end of this quarter, Q1, is to cease new LIBOR linked lending. The Bank of England will start applying a 10% hair-cut to all LIBOR-linked collateral eligible for its lending operations from 1 April 2021.

UK Regulators continue to emphasise the importance of active transition away from LIBOR in 2021, with the FCA and PRA issuing a joint statement alongside the update RFRWG priorities.

At the end of December, the PRA outlined its supervision priorities to UK deposit takers and international banks. In both cases, it expects intensive efforts by firms on the transition from LIBOR and early progress in 2021. The regulator will monitor firms' progress against the targets of the RFRWG and targets for non-GBP exposures as relevant. It will also closely monitor how firms are managing transition risks and where it sees insufficient progress, poor risk management or transition governance, it will consider a range of supervisory tools.

Looking forward

In January, Edwin Schooling Latter of the FCA outlined some of the next crucial steps in the LIBOR transition in the UK. The results of the IBA consultation (PDF 606 KB)  on cessation dates for the 35 LIBOR currency tenor settings are expected shortly, which will give clarity to the future timetable for cessation. The FCA has also been consulting on the framework under which, and the circumstances in which, it might consider it desirable and feasible to require continued publication of any LIBOR currency tenors on the basis of a changed methodology i.e. synthetic LIBOR.

Given the interaction of these three consultations, it should be clearer over the next few weeks which of the two scenarios each tenor will follow:

• tenors could be subject to a cessation announcement, where the tenor will cease and there will be no 'synthetic' methodology for that tenor
• tenors that the FCA envisage requiring synthetic publication or will continue to assess whether to do so, then there will be a 'pre-cessation announcement' in terms of ISDA documentation.

The FCA has also said, that the next step after any pre-cessation announcement, would be further consultation and decisions on the specific settings for publication on a synthetic basis. It will also consult on the restrictions around legacy use of the synthetic LIBOR, where it needs to strike a careful balance between incentivising active transition away from LIBOR and managing the disruption that could come from frustrated contracts.

Use of term rates

UK regulators would prefer the majority of sterling market to be based on SONIA compounded in arrears but recognise there may be specific parts of the market that need the less robust term SONIA reference rates (TSRRs). In the next few weeks, we expect the FICC Market Standards Boards (FMSB) to publish a proposed standard for appropriately limited use of TSRRs developed closely with the RFRWG.

Legal safe harbour proposal

HM Treasury is consulting until 15 March on stakeholders' suggestion that legal safe harbour would act as a helpful contingency in reducing the potential risk of contractual uncertainty in the LIBOR transition. The legal safe harbour would reduce the action, liability or grounds for litigation between parties to LIBOR contracts. For example, reducing the risk that designation of LIBOR as unrepresentative and/or a methodology change could have the effect of giving any party the right unilaterally to terminate or suspend performance under any contract or could constitute a breach of contract

The consultation is seeking views on what should be included in a legal safe harbour, the scope of the safe harbour i.e. apply only to contracts covered under UK Benchmarks Regulation (BMR), and how safe harbour provisions could interact with contractual fallbacks. It also considers whether there should be legal immunity for the benchmark administrator if it is acting under the direction of the FCA.

HMT would look to incorporate results of the consultation into the Financial Services Bill amendments to the UK BMR.

Impact on insurers

The PRA is consulting until end-March 2021 on the transition away from LIBOR as regards the rates and spreads used by insurers in calculating the matching adjustment and volatility adjustment. Since end-2020 (post-Transition), the PRA has been required to publish technical information (TI) that includes the risk-free rates for each currency. Those rates must be based on financial instruments that are traded on a deep, liquid and transparent market.

The PRA proposes to transition to SONIA swap rates for the GBP TI references, from end-July 2021, and to transition the JPY and USD TI references to an Overnight Indexed Swap rate (OIS), on dates yet to be determined. Given that GBP LIBORs are currently higher than the equivalent SONIA rates, the transition could lead to increased technical provisions for insurers. The PRA therefore proposes some mitigating measures, including in relation to transitional relief and the calculation of long-term average spread.

The two most widely used benchmarks for euro are EONIA and EURIBOR. Since October 2019 EONIA has been calculated as the €STR plus a spread and will be formally discontinued on 3 January 2022. EURIBOR is now calculated using a hybrid approach but its long-term sustainability is not guaranteed. Therefore, there is now a focus on ensuring robust fallback mechanisms for EURIBOR. Steven Maijoor, Chair of ESMA, emphasised this in a speech (PDF 136 KB) '…As EURIBOR plays such a central role in EU financial markets, any issue related to the continuity of EURIBOR can become a risk to investor protection, market integrity and financial stability at once. For this reason, we do not think that financial firms can afford to take any risk of contract frustration vis-à-vis EURIBOR products. The implementation of fallback provisions in all EURIBOR contracts, including legacy contracts, is therefore a regulatory and supervisory priority for ESMA.'

On 15 February 2021, the Working Group on euro risk free rates published a summary (PDF 474 KB) of responses to the consultation (PDF 1.65 MB) on €STR-based EURIBOR fallback rates and a summary (PDF 312 KB) of responses to the consultation (PDF 770 KB) on EURIBOR trigger events. Generally, respondents agreed with the proposals that:

• Backward-looking lookback period methodology would be the most appropriate for building a €STR-based term structure that could function as a fallback for most wholesale products such as corporate lending and debt securities.
• Forward looking methodology would be most appropriate for retail mortgages, consumer & SME loans and trade finance. 
• Historical mean/median spread adjustment methodology would be the preferred approach for cash products. 
• An announcement on the discontinuation of EURIBOR made by the supervisor of the benchmark and/or the administrator should constitute a fallback trigger, as this is in line with established practice and will increase global consistency across products and jurisdictions.

The Working Group will use this feedback to publish final recommendations on both topics in H1 2021.

Although the deadlines for the major USD LIBOR tenors are likely to be moved to June 2023, the regulators are still focused on active transition.

On 10 February 2021, the OCC published a self-assessment tool for banks to evaluate their preparedness for the cessation of LIBOR. The self-assessment tool can be used to assess:

• the appropriateness of a bank's Libor transition plan;
• bank management's execution of the bank's transition plan;
• related oversight and reporting.

The tool is aimed at community banks but will have wider applicability.

On 29 January 2021, the Alternative Reference Rates Committee (ARRC) published recommendations (PDF 249 KB) for intercompany loans based on SOFR recommending that the new SOFR-based intercompany loans use the 30-day or 90-day Average SOFR set in advance, with a monthly, quarterly, semi-annual, annual, or other reset period as is determined appropriate by firms. These conventions supply non-financial corporations with another tool to help smoothly transition away from LIBOR.

As more of the market transitions to SOFR, indexes or credit spread adjustments are emerging to help address market participants concern that SOFR does not have the embedded bank credit component that is included in LIBOR. In January, Bloomberg launched the Bloomberg Short Term Bank Yield Index (BSBY) which is based on commercial paper, certificates of deposits, USD bank deposits and bank bond trades. IHS Markit also announced that it expects to publish a daily USD credit spread adjustment for SOFR from Q2 of this year which will also be based on similar transaction data.