LIBOR to RFR Transition

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Welcome to our May 2021 issue of the Risk-Free Rates (RFR) Regulatory Round-up – LIBOR. The end-2021 cessation date for non-USD LIBORs is nearing. Regulators are strongly emphasising the need for active transition in the next few months and, alongside national working groups, are issuing guidance and putting in place measures to help with transition.

Joint PRA/FCA 'Dear CEO' letter

The PRA and FCA have written jointly to firms on preparations that should be made for the cessation of LIBOR. The letter highlights areas where there is a lack of progress, particularly in the syndicated loans market and non-sterling currencies, and announces an intensifying of supervisory focus.
Specifically:

• Meeting Sterling Working Group milestones – All firms are expected to meet the milestones of the Working Group on Sterling RFRs (RFRWG). A detailed annex to the letter lists priority areas where further action by firms is necessary to prepare for the cessation of LIBOR. The letter puts the onus on firms, along with the Senior Manager Function (SMF) holder(s), to determine the specific actions necessary to mitigate the risks to safety and soundness arising from their firm’s exposures to LIBOR, to ensure good client outcomes and to preserve market integrity.
• Letters to LIBOR SMFs – The UK regulators have also written separately to the each firms' responsible SMF, to outline the steps they expect them to take in the remaining time available. The responsible SMFs should satisfy themselves that all appropriate actions are being taken to ensure an orderly transition.
• Increased supervisory oversight – UK Regulators are assessing transition progress, with a range of supervisory tools under review and available for use where they see either insufficient progress, or incidents of poor risk management or governance of transition, including relative to the expectations set out in the annex to the letter.
• Formal models – The PRA will also write shortly to firms setting out its expectations for market risk models (Internal Model Approach (IMA)) and for counterparty credit risk models (Internal Model Method (IMM)).The PRA expects all formal model change applications to be submitted by end-September 2021.

Risk Free Rate Working Group - Assistance in transitioning

Following the 'Dear CEO' letter, the RFRWG published a statement (PDF 437 KB) setting out a range of considerations to help market participants, across GBP bond, loan and derivative markets, assess and prioritise the active transition of legacy GBP LIBOR contracts to SONIA.

For derivative market participants which may rely on ISDA's IBOR fallbacks, the RFRWG has published (PDF 600 KB) a paper providing infrastructure and operational considerations to inform their planning and preparation for the operationalisation of fallbacks in non-cleared linear GBP LIBOR derivatives.

The RFRWG has also published a paper considering how a sterling structured products market could be designed using compounded-in-arrears SONIA. It should help support issuers, manufacturers, distributors and investors in these structured products that are often pre-packaged structured finance investments with a derivative component.

FMSB Spotlight Review - Conduct Risk

The FICC Markets Standards Board (FMSB) published a new Spotlight Review on LIBOR transition, looking at how market participants may manage potential conduct risks arising in back book transition. Using case studies, the review provides practical guidance and key considerations for banks and end users when looking at different transition options, as well as good practice observations to help promote a fair and effective transition.

The Review focuses on proactively transitioning LIBOR-based contracts to alternative benchmark rates in advance of LIBOR cessation at end-2021, given that this should reduce uncertainty and operational risks. However, the review also considers high-level issues around the other three broad options: proactively amending legacy fallback language; relying on legacy fallback terms; or relying on a legislative solution for tough legacy contracts.

Use of forward-looking term SONIA rates

The UK regulators and the RFRWG expect the use of forward-looking term SONIA reference rates to be relatively limited. Instead, the expectation is that markets should predominantly transition to SONIA compounded in arrears, as part of the move away from LIBOR, to preserve the most robust overall market structure.

As there will be circumstances where the use of a rate compounded in arrears is not appropriate or operationally achievable, the FMSB has published a Transparency Draft of a new standard on use of term rates with the aim of identifying where there may be robust rationales for using term SONIA and setting out certain expected behaviours of market participants.

The Standard contains eight core principles, which collectively cover:

• Across lending products, derivative products and bonds, market participants should assess whether there is a robust rationale when deciding to use term SONIA.
• Banks/dealers should track and retain appropriate records of the volume of products used or issued that reference term SONIA.
• Banks/dealers should ensure they have adequate policies, procedures, systems and controls in place to identify and mitigate any conflicts of interest which may arise.
• Comprehensive risk disclosures should be provided by banks / dealers to end users to highlight any relevant risks associated with the use of term SONIA.
• Corporates and buy-side firms should assess whether there is a robust rationale for any requests made to dealers to provide products referencing term SONIA.
• Where market participants do use products referencing term SONIA, they should ensure that such products have robust fallback arrangements included within the contractual terms to allow orderly transition if term SONIA were to be discontinued or declared non-representative.

LIBOR-linked collateral in Sterling Monetary Framework

The Bank of England (BoE) has updated its approach to collateral referencing all LIBOR rates for use in the Sterling Monetary Framework. The updates reflect the different deadlines that are now in the LIBOR transition timetable. For LIBOR-linked collateral referencing those tenors that are ceasing end-2021 - specifically, GBP LIBOR, 1-week and 2-month USD LIBOR tenors, EUR LIBOR, JPY LIBOR and CHF LIBOR - the Market Notice indicates that a haircut add-on of 10 percentage points will be applied from 1 April 2021, 40 percentage points from 1 September 2021 and 100 percentage points from 31 December 2021.

However, in an additional update, the notice sets out that the BoE now reserves the right to waive the LIBOR-linked haircut add-ons applicable to collateral where it is satisfied (in its sole discretion) that such collateral benefits from a robust fallback or a future rate switch mechanism that meets certain specified conditions. Therefore, at the BoE's discretion, some firms may have less collateral subject to the haircuts than originally calculated.

Any new LIBOR-linked collateral issued after 1 April 2021 and maturing after 31 December 2021 will be ineligible for use regardless of whether it contains a robust fallback or a future rate switch.

The BoE is considering how to treat the remaining USD tenors given the now later cessation date. In the meantime, collateral referencing the remaining USD LIBOR tenors will not be subject to the scheduled haircut add-ons set out in the notice. However, the BoE will not accept any collateral referencing the remaining USD LIBOR tenors that is issued on or after 1 January 2022. Also, collateral referencing the remaining USD LIBOR tenors that is issued on or after 1 April 2021 and before 1 January 2022 will not be eligible unless the BoE is satisfied (in its sole discretion) that such collateral benefits from a robust fallback or a future rate switch mechanism that meets certain specified conditions.

SONIA switch in sterling non-linear and exchange traded derivatives market

The FCA and the BoE are encouraging liquidity providers in the sterling non-linear derivatives market to adopt new quoting conventions for inter-dealer trading based on SONIA, instead of LIBOR, from 11 May 2021. They are also encouraging liquidity providers in the sterling exchange traded derivatives market to switch the default traded instrument to SONIA instead of LIBOR from 17 June 2021. This is an extension of the successful similar change to the interdealer quoting convention for linear sterling swaps during Q4 2020, which supported a substantial move in trading volumes from GBP LIBOR to SONIA over subsequent months. Extending this to other derivatives is intended to increase alignment in sterling markets and help accelerate a reduction in new LIBOR exposures.

This change will also help meet the RFRWG deadline to cease any initiation of new GBP LIBOR-linked derivatives expiring after 2021 by end-Q2 2021, except of risk management of existing positions.

Statutory replacement rate for CHF LIBOR

The European Commission is proposing to use its new powers, under the amended EU Benchmark Regulation (BMR), to designate a statutory replacement rate for CHF LIBOR in mortgages and small business loans. The FCA is not planning to require the LIBOR administrator to publish CHF LIBOR on a synthetic basis after end-2021. Banking sector participants in a number of member states, particularly Poland and Austria, have raised concerns to the Commission that they have a stock of mortgage credit agreements entered into prior to 1 January 2018 - date of entry into application of the BMR - that have no contractual fallback arrangements. They are concerned that a private contractual conversion from CHF LIBOR to Swiss Average Rate Overnight (SARON) compounded will be subject to litigation and may be deemed inappropriate or illegal by a court decision - impacting financial stability and contractual continuity in their respective jurisdictions. The Commission is consulting on designating 3M SARON compound with the adjustment spread, as recommended by the Swiss National Working Group, as a replacement rate for 3M CHF LIBOR, the most commonly used setting in this particular market.

New York State LIBOR legislation

In New York State, LIBOR legislation has been signed into law, thereby providing a solution for the 'tough legacy' New York State contracts that mature after mid-2023 and do not have effective fallbacks or other ways to transition off LIBOR. It will minimise legal uncertainty and adverse economic impacts. The Alternative Reference Rates Committee (ARRC) welcomed the signing of the law, which it had initially presented to the legislators.

ARRC considers forward-looking SOFR term rate

The ARRC is continuing to consider a SOFR-based forward-looking term rate. However, to provide greater clarity to allow market participants to judge the likelihood and potential timing of a recommended term rate for certain uses, the ARRC published a set of key principles (PDF 146 KB) for forward-looking SOFR term rates. They should:

1. Meet the ARRC's criteria for alternative reference rates, similar to SOFR itself.
2. Be rooted in a robust and sustainable base of derivatives transactions over time.
3. Have a limited scope of use - to avoid (i) use that is not in proportion to the depth and transactions in the underlying derivatives market or (ii) use that materially detracts from volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct a term rate, making the term rate itself unstable over time.

Building on these principles, the ARRC has also published the market indicators it will consider in recommending a term rate:

1. Continued growth in overnight SOFR-linked derivatives volumes.
2. Visible progress to deepen SOFR derivatives liquidity, consistent with ARRC best practices:
   1. Offering electronic market-making and execution in SOFR swaps and swap spreads.
   2. Changing the market convention for quoting USD derivative contracts from LIBOR to SOFR.
   3. Making markets in SOFR-linked interest rate volatility products (including swaptions, caps and floors).
3. Visible growth in offerings of cash products, including loans, linked to averages of SOFR, either in advance or in arrears.

Suggested Fallback Formula for the USD LIBOR ICE Swap Rate

The ARRC published a white paper (PDF 119 KB) that describes a formula to calculate a fallback from the USD LIBOR ICE Swap Rate to a spread-adjusted Secured Overnight Financing Rate (SOFR) Swap Rate. Contracts indirectly linked to USD LIBOR through reference to USD ICE Swap Rates are not covered by existing fallback provisions. This white paper should facilitate conversations within industry bodies and between counterparties on incorporating robust fallbacks in both legacy and new contracts referencing the USD LIBOR ICE Swap Rate. The paper's formula complements a similar approach adopted by the RFRWG in designing a fallback for the GBP LIBOR ICE Swap Rate.

In Japan, the cross-industry committee updated the roadmap to prepare for the discontinuation of JPY LIBOR to include interest rate swaps.

Also in Japan, the administrator of yen TIBOR and euroyen TIBOR is consulting on its intention to retain yen TIBOR and discontinue euroyen TIBOR at the end of December 2024, with the specifics of the reform and the timing to be finalised after the consultation process. ISDA confirmed that the statement does not constitute an index cessation event under the IBOR Fallbacks Supplement or the ISDA 2020 IBOR Fallbacks Protocol.

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