Welcome to our July 2021 issue of the Risk-Free Rates (RFR) Regulatory Round-up  - LIBOR. With less than six months to go until the end of non-USD LIBORs, regulators are emphasising the urgent need for firms to actively transition their LIBOR referencing portfolios. However, there is a recognition that not all products can be transitioned and regulators are also finalising the details of `tough legacy' solutions.

International developments

International bodies urge action to complete the transition away from LIBOR by end-2021

The Financial Stability Board (FSB), IOSCO and the International Association of Insurance Supervisors (IAIS) all published statements urging market participants to cease new use of LIBOR in all currencies as soon as possible, complying with national working group timelines and supervisory guidance, and no later than the end of 2021. The FSB emphasised that the tools necessary to complete the transition are available and have been for some time. Market participants should not wait for the development of additional tools. It highlighted loan markets as an area of concern, with much new lending still linked to LIBOR, increasing the stock of contracts affected by its discontinuation. The FSB also updated its global transition roadmap of LIBOR, helpfully summarising the transition timetable across jurisdictions.

The role for RFR-derived term rates

An FSB paper outlines why it is important the that the transition is to the new overnight RFRs.  However, the FSB has recognised that in some cases there may be a role for RFR-derived term rates and sets out the circumstances where their limited use would be compatible with financial stability.

ISDA consultation on fallbacks for GBP LIBOR ICE Swap Rate and USD LIBOR ICE Swap Rate

Given the imminent LIBOR cessation, ICE Benchmark Administration (IBA) is consulting on its intention to cease publication of the sterling LIBOR ICE Swap Rate for all tenors (from one to 30 years) immediately after publication on 31 December 2021.  It is likely that the IBA will also cease publication of the USD LIBOR ICE Swap Rate at end June 2023.

In order to address the potential cessation of these ICE swap rates, ISDA is consulting on the implementation of:

  • Fallbacks for the sterling LIBOR ICE Swap Rate suggested in a paper published by the Non-Linear Task Force of the Working Group on Sterling Risk-Free Reference Rates in the UK; and
  • Fallbacks for the US dollar LIBOR ICE Swap Rate proposed in a paper published by a Subcommittee of the Alternative Reference Rates Committee (ARRC) in the US.

Sterling market developments 

Speeches from Andrew Bailey, Governor of the Bank of England (BoE), and Edwin Schooling Latter, Director of Markets & Wholesale Policy, FCA, emphasised that firms must have active transition plans in place in the next three months. They also warned of the risks of transitioning USD contracts to `credit sensitive rates' which they redefined as `liquidity sensitive'. The regulators have asked that any regulated UK market participants looking to use rates in UK-based business consider the risks carefully and raise with their FCA supervisors before doing so.

Developing the FCA framework for synthetic LIBOR

On 20 May, the FCA issued a consultation paper asking for feedback on proposed criteria it would use to decide which `tough legacy' products would be allowed to use synthetic LIBOR. The criteria are very broad, such as harm to retail consumers, risks to financial stability and ease of amendment. The FCA is also consulting on when it might use its powers to prohibit new use of critical benchmarks during the wind-down period​, for example, prohibiting new referencing of USD LIBORs that are ceasing in June 2023 (but will be representative until then)​.

On 24 June, the FCA issued a further consultation paper on its proposed methodology for synthetic LIBOR GBP and JPY settings:

  • Calculated using a forward-looking term version of the relevant risk-free rate and the fixed ISDA spread adjustment
  • For sterling— the IBA term SONIA reference rate
  • For yen— Tokyo Term Risk Free Rate (TORF) provided by QUICK Benchmarks Inc (QBS)

These consultations do not yet clearly define which products will be able to use the synthetic GBP and JPY LIBOR settings. This puts pressure on firms to actively transition as much of their portfolios as possible rather than rely on synthetic LIBOR. The FCA aims to consult further in Q3 on precisely what legacy use to allow for any synthetic LIBOR, confirming final decisions as soon as it can in Q4 2021.

Adapting the regulatory framework for the LIBOR transition

Parts of the financial services regulatory framework reference LIBOR and need to be updated to take account of cessation. 

The derivative clearing obligation (CO) in UK EMIR requires standardised OTC derivatives contracts to be cleared through central counterparties (CCPs). The BoE’s overall aim is to remove contracts that reference benchmarks that are being discontinued and replace them with Overnight Indexed Swaps (OIS), with the same range of maturities, which reference the replacement RFRs selected for each currency. Specifically it proposes at this time:

  • To remove contracts referencing EONIA and replace them with contracts referencing €STR
  • To remove contracts referencing GBP LIBOR and replace them with contracts referencing SONIA
  • To remove contracts referencing JPY LIBOR

The BoE has no proposals to amend for USD contracts at this time.

Similarly, the derivative trading obligation (DTO) in UK MiFIR requires that certain transactions in standardised and liquid OTC derivatives take place only on regulated trading venues. Currently, the classes of derivatives that are subject to DTO are swaps referencing to USD LIBOR, GBP LIBOR and the EURIBOR, and index Credit Default Swaps (CDS) for contracts with standardised terms. The FCA is proposing that LIBOR OTC derivatives, in settings that are being ceased, need to be excluded from the DTO. Instead the DTO should extend to derivatives based on relevant RFRs, provided they are sufficiently liquid or are likely to become sufficiently liquid as transition plans approach or reach completion. 

The FCA liquidity analysis concludes that OIS referencing the SONIA as a class of OTC derivatives is sufficiently liquid to impose a DTO. It proposes to remove derivatives referencing GBP LIBOR under the current DTO and replace them with OIS referencing SONIA. SOFR and €STR OIS markets are not sufficiently liquid yet to make any changes.

Euro market developments

The European Commission (EC) and EU regulators have also issued a statement encouraging market participants to actively reduce their exposure and not wait for the EC to exercise its new powers, via the Benchmark Regulation, to designate a replacement for LIBOR.

Recommendations for EURIBOR fallback rates

To help EURIBOR users comply with EU Benchmarks Regulation fallback obligations, the Working Group on euro risk-free rates published recommendations addressing:

  • events that would trigger fallbacks in EURIBOR-related contracts
  • €STR-based EURIBOR fallback rates (i.e. rates that could be used if a fallback is triggered)

The document recommends different €STR-based term structure methodologies for specific types of financial products and also has recommendations for the credit spread adjustment.

Although there are no EURIBOR discontinuation plans currently, the development of more robust fallback language addresses the risk of a potential permanent discontinuation.

Adapting the regulatory framework for the LIBOR transition

The European Securities and Markets Authority (ESMA) is also looking to amend the scope of both the CO and the DTO to reflect the benchmark transition for OTC derivatives. In line with the UK regulators, ESMA is proposing to: 

  • For the CO:
    • to remove contracts referencing EONIA and replace them with contracts referencing €STR
    • to remove contracts referencing GBP Libor and replace them with contracts referencing SONIA; and
    • to remove contracts referencing JPY Libor
    • consider introducing contracts referencing SOFR
  • For the DTO, it proposes to remove the GBP LIBOR class

ESMA is seeking views on when USD LIBOR should be removed given its transition table.

US dollar market developments

In the US the timetable for LIBOR transition is just as urgent with the main US LIBOR settings continuing to end June 2023. However, the US regulators, in tandem with their UK counterparts, have highlighted their concerns that firms are choosing to transition to alternative rates, known as `credit-sensitive rates', that do not have sufficient underlying transaction volumes. Using these rates could lead to some of the conduct and stability risks that emerged with LIBOR rates. This ARRC press release clearly shows the US regulators' support of robust alternative rates such as SOFR.

Interdealer trading conventions switch to SOFR

To facilitate a shift in market liquidity towards SOFR, CFTC's Market Risk Advisory Committee's Interest Rate Benchmark Reform Subcommittee (MRAC Subcommittee) voted to recommend 26 July 2021 for switching interdealer trading conventions for USD linear interest rate swaps from USD LIBOR to SOFR— a strategy known as the `SOFR First' switch. The BoE and FCA also issued a statement in support of this switch.

ARRC updates

The ARRC has released the Guide to Published SOFR Averages to provide market participants— and nonfinancial corporates in particular— with key information on the LIBOR transition, including how the published SOFR Averages can be used and what factors market participants should consider before selecting the alternative rate they use.

The ARRC has selected CME Group as the administrator that it plans to recommend for a forward-looking SOFR term rate, once market indicators for the term rate are met. The ARRC will also recommend best practices for the use of the term rate. It will be limited in scope of use as set out in the ARRC key principles for a forward-looking term rate.

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