Treliant Industry Insights
Graham Broyd and David Wagner
Note: This update is part of a continuing series on the transition away from the London Interbank Offered Rate (LIBOR), one of the world’s most widely used interest rate benchmarks. You can read Part I, Part II, and Part III of the series, and take our LIBOR Risk Assessment online.
Seemingly every public mention of LIBOR refers to December 31, 2021, as “the date LIBOR goes away.” However, private conversations we have acknowledge a different truth: there is no way financial markets will wait for that single day to convert the $300 trillion of contracts that need to transition to a new interest rate benchmark. Given recent developments and announcements from the International Swaps and Derivatives Association (ISDA), we would advise companies to expect the transition to actively commence in Q2 2020—not January 2022.
Your preparations should be accelerated to meet this date, which is when the markets will demand that legacy LIBOR-linked books be moved to new risk-free reference rates such as the Secured Overnight Financing Rate (SOFR) for US Dollars (USD).
How the Calendar Has Changed
A key driver of LIBOR acceleration kicked in on May 16, when ISDA announced two new consultations on benchmarks:
•One aims to set the pricing and spread adjustments that will apply to the selected, relevant risk-free rates, once fallbacks are triggered; and
•The other aims to define potential pre-cessation triggers for LIBOR and certain other IBORs.
The consultations are open until July 12. ISDA will review that feedback and respond publically to the market. The results of this consultation will be the latest steps in a process that ISDA has been working on effectively since the Financial Stability Board’s mandate in 2013 to repair interest rate benchmarks.
ISDA has advised that a new ISDA supplement and protocols will be published in Q3 2019 and will become effective in Q1 2020. With the new clarity on product, pricing, and protocols, we expect significant levels of market activity in transitioning legacy LIBOR risks to the new SOFR rates by major market participants soon after that ISDA effective date.
At a recent LIBOR Roundtable hosted by Treliant, ISDA also reminded us of the effective date in Q2 2020 for companies that signed up for the 2006 update to its master agreement (ISDA 2006), which is the great majority of all users of derivatives. ISDA’s position is that these companies are, by default, accepting the forthcoming supplement, fallback language, and reference rate product definitions.
In other words, no one has to opt in or sign a new agreement; this is considered a supplement to what participants have already agreed to and will just become automatically effective to all contracted participants on that date. With the new protocols, each counterparty has the component parts to remedy existing derivatives contracts. (That is, recognizing that each party will have to agree to enter into these transactions that clean up legacy LIBOR-linked exposures.)
The Outlook is in the Details
The forthcoming ISDA supplement will amend the 2006 ISDA product definitions for all five currency LIBORs, plus EURIBOR, JPY TIBOR, Euroyen TIBOR, Australia BBSW, Hong Kong’s HIBOR, and Canada’s CDOR.
The amended product definition for US Dollar LIBOR (found in Section 7.1 of the 2006 ISDA definitions) will point to SOFR as its replacement reference rate, and only SOFR. For those hoping for a fallback to a more LIBOR-like benchmark (AMERIBOR, LIBOR-plus, etc.), this looks exceptionally unlikely for derivatives contracts.
A key question is whether that SOFR rate will mean “compounded in arrears,” or SOFR with a “forward-looking term rate.” For clarity, the SOFR rate currently established is an overnight rate, and a 3-month SOFR rate will be the 3-month average of overnight rates, compounded in arrears (i.e., one will not know the final 3-month rate until the last iteration of three months’ worth of overnight rates has been completed.)
Unsurprisingly this formula has been deemed a radical change by some who want to know their 3-month borrowing rate at inception, and many in the industry have called for the addition of a forward-looking SOFR rate. The Alternative Reference Rates Committee’s (ARRC) loan-related working groups are particularly eager to achieve this forward-looking outcome, and it appears as the first step in their fallback from LIBOR waterfall. ISDA’s stance however appears to be clear: SOFR compounded in arrears will satisfy the derivatives market.
Specifically, ISDA already completed a consultation for most of the other non-US Dollar fallback language and reference rates, the results of which were announced on December 20, 2018. The report highlighted that the overwhelming majority of respondents preferred the “compounded, setting in arrears rate” for use after LIBOR cessation. Additionally, many contributors to that consultation volunteered feedback on the US Dollar as well, and the responses were consistent—compounding in arrears is fine.
Most interesting to us, is that before ISDA entered into the recent USD consultation, the Federal Reserve’s ARRC representative wrote and requested that ISDA consider a forward-looking rate in its consultation. ISDA did not. This does not rule out that there could be an overwhelming final push in the feedback to the consultation and that ISDA might feel obliged to respond. But there already was an opportunity to highlight this issue, and ISDA chose not to.
Our interpretation is that interest rate derivatives are getting SOFR compounded in arrears as the LIBOR replacement. This is significant for all the loan-related working groups, because we expect the derivatives transition will start to happen as soon as companies have all the language and protocols effective, and so SOFR will become customary in use in 2020. Trying to land a new version of SOFR after that date will become confusing and redundant. Practice will drive reality.
The ISDA supplement will only alter the agreements for new trades, it does not deal directly with the massive outstanding deal log—some $200 trillion of derivatives alone. But the ISDA protocols will clarify exactly what one has to do in order to transition a legacy book from LIBOR-linked to SOFR or another risk-free reference rate IBOR replacement.
The key and most problematic issue here is the term rate premium. 3-month and 12-month LIBOR looks very different than the 3-month average or 12-month average of overnight-based SOFR. That’s a lot of basis points. In Q1 it was 45 bps for the 3-month spread difference and 76bps for the 12-month difference. The protocols announced in Q3 2019 and effective Q1 2020 will include language that will point to that rate spread differential. To cite ISDA: Amendments will generally include a description of the fallback that would apply upon the occurrence of that trigger event (the permanent or pre-cessation trigger), which will be the adjusted reference rate (SOFR)—plus the spread adjustment.
A Cascade of Activity
The term spread adjustment will be published by a third-party vendor approved by ISDA (and by ARRC, as well). It will be transparent and consistent. Two parties wanting to transition a series of legacy LIBOR-linked transactions to a new SOFR benchmark can point to the old LIBOR rate, and then to SOFR, then add the spread adjustment that will be available on a known screen on a trader’s terminal, and then execute.
The daily publication of term rate premiums creates risk and opportunity for traders to manage as they monitor intra-day live pricing. But the publication will be a plus for many of the other LIBOR transition stakeholders, since it will provide clarity to clients across functions including communications, legal, systems, operations, risk management, financial reporting, and controls.
This will significantly enable participants in the derivatives market to accelerate their transition away from LIBOR risk. We expect a cascade of activity to follow, starting with the major participants in derivatives markets, and driving all the way through to cash products for the buy-side.
Avoiding the LIBOR Cliff
With the tools available to transfer legacy LIBOR derivative booked trades to the new accepted reference rate, we believe the larger companies will proceed immediately. In discussing LIBOR transition, the U.K. Financial Conduct Authority likes to talk about putting on a seat belt but still driving 100mph towards the cliff’s edge. They are referring to recognizing that LIBOR is going away, understanding there are $200 trillion of outstanding derivatives, but only doing the preparations for the eventual permanent cessation of LIBOR post the end of 2021.
A better plan would be to get rid of as much of that $200 trillion exposure as quickly as you can before that end date, and thus reduce, mitigate, or eliminate that cliff-event risk at the end of 2021. We expect the largest derivatives banks to be active in that transition starting in Q2 2020.
There is an enormous concentration of the derivatives market in the largest 20 banks and largest 10 funds in the world. If they need to move those legacy LIBOR-linked books, there will be a lot of pressure for everyone else to move books, too. When the market in USD and British pound (GBP) derivatives becomes predominantly SOFR- and SONIA-based, then being an outlier will be difficult. Access to pricing, liquidity, and support will all become strained. Clients will call second-tier banks to move books, because they will have been asked to change their deals with one of the largest banks, and so they will now call their other banks. We expect this to evolve rapidly.
In addition, once derivatives have moved to SOFR, then cash products have to follow, otherwise accounting, hedging, tax, and risk management and its respective reporting will only get more and more complicated. It is an illogical chronology that the underlying cash (loans, mortgages, floating rate notes) products are forced to transition because the derivative hedge has already changed—but this will be reality because of the scale and needs of that derivatives market and its state of readiness.
To follow the metaphor of the seat belt and cliff edge: The sports cars of the derivatives traders will put their brakes on and swerve off in another direction before they get to the cliff edge, even though their brethren in other vehicles are still watching storm clouds gather on the horizon as they continue to drive toward them.
To recap, we anticipate that companies of all types and sizes will end up having to transfer their legacy LIBOR-linked books, in USD and GBP to start, and in derivatives to start, in 2020, shortly after the ISDA effective date. In many cases, this will happen before companies are properly prepared for such activities.
We recognize that it won’t be a simple task to update contracts, systems, technology, risk, modeling, financial reporting, accounting, client communications, etc. Nonetheless we suggest people shift their target readiness dates for LIBOR transition from January 2, 2022, to the end of Q2 2020.