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Following end-2021, publication of 24 LIBOR settings has ceased and 6 LIBOR settings have become non-representative. Looking ahead, we consider what is next for LIBOR transition.
In brief
- Going forward, market participants should not delay in USD LIBOR transition and should actively convert remaining legacy contracts wherever possible.
- After initial focus on LIBOR, the industry starts planning for possible transition and cessation of other IBORs.
The transition from Interbank Offered Rates (IBOR) to Alternative Risk-Free Rates (RFRs) has an impact on all financial and non-financial institutions operating with the impacted floating reference rates. It affects a wide range of financial instruments on the derivatives and cash markets.
The New Year 2022 marks a long-awaited market event following which, the publication of 24 out of the 35 CHF, EUR, GBP, USD and JPY LIBOR settings has ceased, and the 6 most widely used GBP and JPY settings will be published using a changed methodology (“synthetic LIBOR”). The remaining 5 USD LIBOR settings will continue to be calculated using panel bank submissions until mid-2023. However, new use of USD LIBOR is banned by regulators, with limited exceptions.
In our article, we reflect on the key takeaways from the end-2021 transition as well as consider what is next for LIBOR transition in the context of the most recent market developments. We explore the remaining USD LIBOR transition, synthetic LIBOR, statutory replacement rates and what this means for market participants going forward, as well as we look beyond 2022 to the industry approach for the potential transition and cessation of other IBORs.
1. Key takeaways from the end-2021 non-USD LIBOR transition
While the LIBOR transition is unprecedented in scale, the first days of trading without non-USD LIBOR in 2022 did not result in any significant market disruptions – recognizing the magnitude of market participants’ efforts and the level of attention from the regulators and industry bodies to support the transition to the RFRs.
This does not mean that the transition efforts are now over.
Although regulators and industry working groups had been vocal about favoring an active transition where possible, many trillions of dollars’ worth of legacy financial contracts transitioned through fallbacks upon the cessation event at the year 2021 end. The fallbacks have been perceived by certain market participants as an ‘easy fix’. Indeed, when asked about the status of their non-USD LIBOR legacy transition, only about 39 percent of the LIBOR users participating to our Global EY webcast on December 17th, 2021 were planning to transition actively ahead of the year 2021 end.
However, as highlighted by Scott O’Malia, the International Swap and Derivatives Association’s (ISDA) Chief Executive, in recent commentary “Get Ready for Fallbacks”, reliance on fallbacks does not mean that there is not a reason to prepare. Importantly, the differences in conventions mean there will inevitably be variations between cleared trades and non-cleared trades that have relied on fallbacks, as well as between cash instruments that may have applied different methodologies. Modifications to systems and processes may be required as a result to account for these differences. Although, market participants may also choose to bilaterally negotiate changes to their reference rates over time to reduce discrepancies.
The market participants who favored the fallbacks as the primary transition mean must focus on the operational completion of legacy portfolio transition for fall-backed trades in the first months of 2022.
When transitioning through the contractual or statutory fallbacks, a LIBOR contract does not change upon cessation of the LIBOR rate as the fallback rate that will be triggered is part of the contract itself. However, regulators across global jurisdictions have stated it is essential for them to have transparency of the trade economics and therefore are requiring market participants to report updated trade details when a fallback rate is triggered. Regulators also require voluntary transfers to a RFR to be reported. Regulators have published guidance in various formats for how they expect market participants to report fallback rates / RFRs. To assist market participants in understanding their reporting obligations, ISDA published in December 2021 a summary document which aims to consolidate the regulatory guidance published by regulators along with the additional impacts to reporting requirements discussed within ISDA working groups that market participants may want to consider to meet the obligations for reporting fallbacks and transfers to RFRs.
Beyond reporting, the LIBOR cessation has also impact on the uncleared OTC derivatives clearing obligation (CO) and trading obligation (DTO). Indeed, the authorities worldwide have started proposing to modify the scope of contracts subject to these obligations, to reflect ongoing reforms to interest rate benchmarks and to introduce new mandates for RFR based derivatives. For instance, ESMA is proposing to remove interest rate derivative classes referencing GBP and USD LIBOR from both the CO and DTO, those referencing EONIA and JPY LIBOR from the CO, and to introduce interest rate derivatives classes referencing €STER, SONIA and SOFR to the CO. The latter with a longer phase-in. in the US, the Commodity Futures Trading Commission (CFTC) issued a request for comments and information on potential changes to the Part 50 of the CFTC’s regulations regarding the LIBOR transition and adoption of RFRs.
Market participants should follow closely these developments prepare for clearing of derivative classes that will be included in the scope of the CO in the future.
2. Remaining USD LIBOR transition
The main challenge ahead is the USD LIBOR transition. As the phase II of the LIBOR transition journey, the market participants will now need to get ready for the USD LIBOR cessation on 30th June 2023 and complete the legacy USD LIBOR transition by that date through active transition or operation of robust fallbacks.
Moreover, market participants must now be ready for new trading in RFRs only. As we approached end-2021, regulators and industry working groups became increasingly critical about the increased USD LIBOR trading and notably banned all new use of USD LIBOR, except for certain limited and justified exceptions.
Despite a ban on new use of USD LIBOR from 1 January 2022, the data suggests that contracts referencing USD LIBOR have continued to trade in the first days of 2022, however in significantly lower volumes. Indeed, the data reported to the Depository Trust & Clearing Corporation showed that a third of traded USD swaps notional ($74 billion) still referenced LIBOR on 3 January 2022, SOFR accounted for 30% ($66 billion) and the remainder largely reference the effective Fed Funds rate. Also, the activity in Eurodollar contracts, referencing three-month LIBOR, showed little sign of decline in the early days of January 2021. SOFR liquidity could remain an issue if there is potential for ongoing LIBOR activity.
Therefore, the regulators, including FINMA, previously announced that they will continue to monitor LIBOR transition on a risk basis after end-2021 and it is likely that any new use of USD LIBOR will be closely monitored. In December 2021, the Financial Conduct Authority (FCA) clarified the framework for the ban on the new USD LIBOR use:
- The market making exception applies only where market making is undertaken in response to a request by a client seeking to reduce or hedge their USD LIBOR exposure on contracts entered into before January 1, 2022;
- The prohibition does not prohibit new single currency USD LIBOR basis swaps entered into in the interdealer broker market (to the extent they would constitute new use); and
- Where relevant, FCA expects a market maker to make all reasonable efforts to ensure that the client knows about the prohibition set out in the notice and to engage with them on the extent to which they have taken it into account.
The supervised institutions who may have new recourse to LIBOR within the limits of the authorized exceptions (e.g., portfolio maintenance and hedging of legacy positions) should implement robust exception policy frameworks, internal controls, and appropriate documentation to justify any new LIBOR use going forward.
Smaller banks have shown a preference for credit-sensitive benchmarks such as BSBY or Ameribor, as many worry that SOFR’s lack of credit sensitivity would see them lose out in a stressed market. Regional banks are also concerned that borrowers won't understand SOFR. However, the regulators have been warning that the use of credit sensitive rates without appropriate checks against IOSCO principles could result in similar issues to using LIBOR. To address these concerns, the risks around using credit-sensitive rates should also be considered very carefully and the compliance gap assessments conducted to demonstrate the suitability of the alternative rate to SOFR.
3. Synthetic LIBOR
As initially announced by the FCA in September 2021 in its statement on the orderly wind-down of LIBOR, 6 GBP and JPY settings will continue for the duration of 2022 and will be published using a changed methodology (“synthetic LIBOR”). New use of the synthetic LIBOR rates is not allowed, but the FCA decided to permit the use of synthetic GBP and JPY LIBOR in all legacy contracts, except for cleared derivatives.
The FCA has also been vocal about encouraging users of LIBOR to continue to focus on active transition and move their contracts away from LIBOR wherever possible, rather than relying on synthetic LIBOR, which will not be published indefinitely and is not guaranteed beyond end-2022.
There is no sign of a wide reliance of synthetic LIBOR by the market participants. During our December 17th, 2021 EY Global webcast on LIBOR transition, just over 6% of participants indicated that they would rely on synthetic LIBOR or statutory replacement where available for certain legacy contracts that they were not able to transition before year-end.
Use of synthetic LIBOR or statutory replacement
of webcast participants* expected to rely on synthetic LIBOR or statutory replacement where available for certain legacy contracts
To the extent that the market participants do rely on synthetic LIBOR, their efforts to transition should continue. It is also important that market participants understand if and how the FCA exercising its use restriction power will affect them and take any necessary steps to prepare themselves.
4. Statutory replacement rates
As a result of the statutory replacement of CHF LIBOR and EONIA enacted by the EU legislator, certain contracts and financial instruments linked to CHF LIBOR and EONIA were automatically replaced with references to SARON plus the adjustment spread and €STR plus 8.5 bp on 1 January, 2022 and 3 January, 2022 respectively.
In December 2021, we saw continued activity from regulators and working groups to support an orderly transition away from LIBOR by providing market participants with further tools, notably in relation to statutory replacement rates for additional LIBORs.
- GBP and JPY LIBOR
On 24 December 2021, the European Commission (EC) announced that it will be issuing implementing acts to designate replacement rates for certain GBP LIBOR and JPY LIBOR in Q1 2022. This comes in response to the FCA announcement to allow all contracts (except cleared derivatives) to use synthetic versions of GBP and JPY LIBOR until the end of 2022. It also takes into consideration the demands expressed by the Working Grouping on Euro Risk Free Rates (EUR RFR WG) asking to designate replacement rates for GBP LIBOR and JPY LIBOR to ensure legal certainty beyond 2022 and consistency with the EU Benchmark Regulation (BMR).
However, it can be expected that like for the previous statutory replacement rate enacted in 2021, the statutory designation will not provide a universal solution. Indeed, article 23a of the BMR limits the effect of designation of a statutory replacement to i) any contract, or any financial instrument that references a benchmark and is subject to the law of one of the Member States; and ii) any contract, the parties to which are all established in the Union, that references a benchmark and that is subject to the law of a third country and where that law does not provide for the orderly wind-down of a benchmark. It is therefore important that market participants continue to focus on the active transition of legacy contracts wherever possible without relying on the statutory replacement solution.
- USD LIBOR
The Alternative Reference Rates Committee (ARRC) also published at the beginning of December 2021 statutory fallback recommendations for 1-week and 2-month USD LIBOR contracts affected by the State LIBOR Legislation. Those LIBOR tenors are not published after 31 December 2021.
The ARRC highlighted in its recommendations that references to 1-week and 2-month USD LIBOR are uncommon, and therefore the recommendations apply only to the narrow set of LIBOR-based contracts that are affected by the State LIBOR Legislation, generally contracts with no fallbacks or fallbacks that reference LIBOR. Further, it is worth highlighting that the State LIBOR Legislation will only apply to in-scope New York-law-governed contracts. For contracts with fallbacks that give a party (such as the lender or noteholder) discretion to choose a replacement rate, the State LIBOR Legislation also provides a safe-harbor if that party chooses the SOFR-based rate and conforming changes recommended by the ARRC.
The State LIBOR Legislation may therefore have allowed a narrow set of LIBOR-based contracts to successfully move off LIBOR. However, market participants should continue to focus converting remaining USD LIBOR contracts by mid-2023.
5. Possible transition and cessation of other IBORs
As the industry approached the end-2021 deadline, we witnessed increased focus from the industry on the transition of other IBORs.
Notably, ISDA published a new set of fallbacks for derivatives referenced to certain IBORs not covered by ISDA’s initial fallback rollout earlier in 2021. The new fallbacks cover IBORs in India (MIFOR), Malaysia (KLIBOR), New Zealand (BKBM), Norway (NIBOR), the Philippines (PHIREF) and Sweden (STIBOR), ensuring a robust replacement based on RFRs would automatically take effect if any of those benchmarks permanently ceases to exist.
ISDA also published a supplement to the 2006 ISDA Definitions plus a new version of the 2021 ISDA Interest Rate Derivatives Definitions to enable parties to include the fallbacks into new derivatives transactions from 16 December 2021. The December 2021 Benchmark Module of the ISDA 2021 Fallbacks Protocol has also been published to allow firms to incorporate the fallbacks into all legacy derivatives contracts with counterparties that also adhere to the protocol. That module is also effective from 16 December 2021, and other modules covering additional IBORs may be published in future.
Going forward, market participants should monitor their exposure to potentially impacted IBORs and consider adhering to the ISDA protocol module where applicable, which would ensure robust fallbacks were in place if any of the impacted IBOR ceased to exist.
The Canadian Alternative Reference Rate Working Group (CARR) also published a White Paper on the recommended future of CDOR. The White Paper recommends that Refinitiv, the administrator of CDOR, cease publication of all of CDOR’s remaining tenors after 30 June 2024. The CARR’s recommendation is therefore to align with regulators globally moving financial markets away from credit-sensitive benchmarks to RFRs. Market participants may potentially wish to anticipate any new use of CDOR, however, it is worth noting that the White Paper is a recommendation only; the decision to cease CDOR ultimately lies solely with Refinitiv.
Finally, the discussion around EURIBOR is open and regulators will wait until LIBOR cessation is completed. Nevertheless, as part of their BMR compliance, the institutions need to make sure to have robust fallbacks (€STR based) in place legally and operationally in case of disruption or cessation of EURIBOR in the future.
Summary
It is not yet the end of the road for LIBOR transition. Going forward market participants should continue to actively transition away from any remaining LIBOR contracts and continue to look ahead and prepare for the possible transition of other IBORs.
Many thanks to Rebeca Slade for her valuable contribution to this article.