As the global drive to replace Libor with alternative benchmarks enters a crucial period, a number of challenges remain.

The demise of the world’s most-referenced benchmark may have been expected for some time, but phasing it out has been far from straightforward. The London interbank offered rate (Libor) has been ubiquitous in financial contracts including derivatives, bonds and loans for decades, with an estimated $260tn-worth of Libor-referencing contracts outstanding.

The benchmark’s problems — notably the 2012 rigging scandal that irreparably tarnished its reputation — are well documented. But its fate was sealed in July 2017 when Andrew Bailey, then chief executive of the UK’s Financial Conduct Authority (FCA; the body that supervises Libor’s administrator), announced that from the end of 2021 it would remove any obligation for Libor panel banks to submit data — effectively setting Libor on course to being wound down. Since then, markets have been grappling with shifting issuance to alternative benchmarks, which work very differently to Libor, and huge swathes of legacy contracts.

Libor is published in five currencies — pound sterling, US dollar, euro, yen and Swiss franc — and for seven different time periods. In addition, several ‘hybrid’ benchmarks, such as Singapore’s swap offer rate (Sor) and Thailand’s Thai baht interest rate fixing, are based on US dollar Libor, making the transition a genuinely global issue.

At the time of press, the results of a crucial consultation by Libor’s administrator, ICE Benchmark Administration (IBA) are eagerly awaited. If they are as expected, these will confirm Libor publication for most settings will cease at the end of 2021, and the five most-used US dollar Libor tenors on June 30, 2023. The announcement is regarded as a significant market event as it would create a hard deadline, and the race to achieve wind-down would truly be on. The obvious question is: can it all be done in time?

Derivatives action

Transition efforts are generally being managed within local regulatory jurisdictions. But one of these took a global leap forward on January 25 when the International Swaps and Derivatives Association’s (ISDA’s) updated Ibor fallbacks came into effect. The fallbacks define what reference rate would apply instead of Libor, or another relevant benchmark, should it cease being available.

I think most people in the market will keep going with the remediation of contracts and not hold out for [a synthetic Libor rate]

David Wakeling, Allen & Overy

Derivatives account for the significant majority of Libor-referencing contracts — almost 90% by FCA estimates. Going forward, all new derivatives contracts that reference ISDA’s standard interest rate derivatives definitions will include the fallback language. And for legacy non-cleared derivatives, if both counterparties have signed up to ISDA’S Ibor protocol it will apply retrospectively. Clearing houses have also signed up in relation to cleared derivatives.

As ISDA head of benchmark reform Ann Battle observes: “The significance of January 25 — and specifically the significance of so many counterparties, as well as the major clearing houses, agreeing to use these new fallbacks — is now if, or when, Libor ceases or becomes non-representative, counterparties will have certainty and clarity regarding the precise value of their contracts.”

In a January 26 speech, Edwin Schooling Latter, the FCA’s director of markets and wholesale policy, suggested as of that date, 12,500 firms had signed up to the protocol (it has since increased to more than 13,000). He estimated that high levels of protocol adherence (and some contracts expiring before Libor cessation) meant $245tn-worth of Libor-referencing contracts, out of a total $260tn, were now covered.

The standardised nature of derivatives contracts makes such an industry-wide approach possible. In other product areas, the same route is not available and a more bilateral approach is needed.

For instance, in the bond markets some consent solicitation processes have begun to obtain agreement to amend contracts to reference the sterling overnight index average (Sonia), the alternative reference rate for sterling markets. Catherine Wade, counsel, capital markets, at Linklaters, has worked on several of these meetings in the past year or so. She says: “The activity has been mostly in the UK, so in English law governed bonds, because although the thresholds for consent to get those amendments through are quite high — usually two-thirds or 75% — it is still possible to get that approval through.”

This contrasts with other jurisdictions, such as the US, where 100% bondholder approval would be necessary. In the majority of cases so far, she says, bondholder approval has been achieved.

Sterling progress

Sterling markets are acknowledged to be one of the furthest progressed of the five currency areas on transition. Although the context in euro markets is rather different, as euro Libor is used less frequently than benchmarks such as Euribor, so separate reform and replacement efforts around these benchmarks will have a far greater impact.

For Swiss franc Libor too, although nonetheless a substantive issue, affected volumes are much smaller than sterling or US dollar Libor. Guidance has been provided for new issuance using the Swiss average rate overnight (Saron) and the Swiss Financial Market Supervisory Authority reports the volume of tough legacy Swiss franc Libor contracts (that is, contracts that would be very difficult to amend to a new rate) “appears to be small and not an existential problem”.

There is a near unanimous view, across the industry, that getting the New York legislation passed would be very helpful

Bradley Ziff, Sia Partners

Sterling markets had a relative advantage with the chosen alternative reference rate as Sonia had already existed in some form since 1997 — although this is not to downplay the challenges of adapting to overnight rates, which fundamentally differ from Libor in several respects. From a pricing perspective, these so-called ‘risk-free’ rates have a completely different risk profile. Libor is also available in forward-looking terms, such as three or sixth months. With backward-looking overnight rates, the interest due on a product is not knowable at the outset; the established method of using overnight rates is compounded in arrears — that is, interest is calculated at the end of the interest period.

For derivatives, most of which trade overnight, these features are not so problematic; however, for loans, securitisations and floating-rate bonds, which had typically relied on forward-looking term rates, it is a significant shift. Nonetheless, in a January 2020 paper, the Working Group on Sterling Risk-Free Reference Rates said: “Overnight Sonia compounded in arrears has become the market norm for floating-rate sterling bonds, and there is strong liquidity developing for securitisations that reference overnight Sonia compounding in arrears.”

Since January 11, Refinitiv and IBA have been publishing term Sonia rates for one, three, six and 12 months (following a six-month beta period). However, UK authorities, such as the FCA have stated that term Sonia should only be used in “limited” circumstances by a “niche” of market users, particularly within loan markets; therefore, it is not a mainstream option.


Tom Wipf, ARRC

The UK regulatory authorities have set a clear expectation that there should be no new sterling Libor issuance after March 2021. There is optimism this target can be hit, although nonetheless it will mark a significant shift. The FCA has also mooted publishing a so-called “synthetic Libor” rate, even after proposed cessation dates, to be used for remediating any outstanding contracts. Its provisional view is that such a rate could be based on a forward-looking term Sonia plus an appropriate fixed spread.

There is a risk that creating a synthetic Libor for contracts to lapse onto could dissuade market participants from addressing legacy issues. However, as David Wakeling, partner and head of Allen and Overy’s markets innovation group, comments: “I think most people in the market will keep going with the remediation of contracts and not hold out for it. Because you don’t know for certain if it’s going to arrive or if it will come in time. So, it would be an unreliable solution, and could be a risky business decision.”

US sets out programme

In the US, the Alternative Reference Rates Committee (ARRC) in 2017 designated the secured overnight financing rate (Sofr) as its recommended Libor alternative. Sofr began being published by the New York Fed in 2018. The focus is on ending new Libor issuance by the end of 2021, a deadline that arguably was slightly blurred by the IBA consultation pushing the expected cessation deadline back by 18 months for most US dollar Libor settings.

However, ARRC chair Tom Wipf says it is important to view the consultation in the context of a wider “package” of communications, including from US Prudential Regulators on November 30, 2020 that said they expected banks to transition away from Libor “as soon as practicable” and any new Libor issuance after 2021 would “create safety and soundness risks”.

Mr Wipf says: “What we’ve tried to do is focus the market on the fact that this is not a reprieve, it’s a rolldown corridor, which is being created for legacy positions.” Indeed, the aim of the 2023 date is to allow a significant number of US dollar Libor contracts to lapse, therefore considerably shrinking the tough legacy issues.

A legislative mechanism that would mandate that any outstanding dollar Libor contracts switch to an approved alternative rate is the favoured solution for addressing any remaining outstanding contracts. In January, New York governor Andrew Cuomo included proposals for such legislation, which had been initially drafted by the ARRC, in his state budget for 2022 — an important step towards them becoming law. New York law governs the majority of impacted contracts, so such legislation would have a significant impact.

Bradley Ziff, operating partner at Sia Partners, a management consultancy that has been heavily engaged in the issue of Libor transition, says: “There is a near unanimous view, across the industry, that getting the New York legislation passed would be very helpful, due to the legislative clarity that it would provide.” There is also hope that similar legislation would be replicated federally, or by other states.

In terms of new issuance, there remains a distance to travel to phase out Libor. However, as some industry participants point out, new Libor issuance will typically have fallback language included within it. Jason Granet, head of Libor transition efforts at Goldman Sachs, says: “If you look at current Libor production, it has decreased considerably. It is possible to point to derivatives, but much of that market is now covered by the ISDA fallbacks. So, if you strip out the derivatives market, the amount of other issuance, such as floating rate notes, linked to Libor is not that significant. I don’t see any evidence pointing towards it not being possible to phase Libor issuance out by the end of the year.”

For Mr Wipf, the important thing is for firms to get on with the transition. “At this stage, it really comes down to having the commitment to getting it done. I think the last piece of the puzzle will be the announcement confirming cessation dates. After that, there’s not much more anyone’s going to need to know.”

Mr Ziff believes the true test in the coming months will not be faced by larger banks, which are generally already well engaged in this process — it will be smaller and mid-size banks that “have less volume individually, but collectively their exposure is meaningful and needs redress”, as well as how corporate and other financial end users engage.

Asian markets are also working through their own transition efforts. Here the picture is complicated by the fact that not only is much issuance linked to US dollar Libor in particular, but also local benchmarks that are also undergoing reform.

Asian markets complexity

As Jean Woo, a partner at Ashurst, says, this situation is likely to create disruption for banks in the coming years, as they grapple not only with Libor transition, but also with local benchmarks.

Woo Jean 4925-M

Jean Woo, Ashurst

“Unlike with Libor, there is no single administrator that can cut across and regulate all the local benchmarks,” Ms Woo adds. “For financial institutions, it is worrying because the back office will have to cater for different conventions for calculating rates for different countries, while this transition process is taking place. So that is something that they will have to grapple with for the next few years, and it will create quite a workload for them.”

Philippe Dirckx, head of fixed income at the Asia Securities Industry and Financial Markets Association, says he is hopeful that “the proposed extension of US dollar Libor will provide the relevant regulators with the room to take the necessary decisions and provide guidance for the transition of their hybrid reference rates”.

Within the region, Hong Kong and Singapore have been the leading regulatory voices corralling progress on Libor transition efforts. In addition, Singapore is also managing the transition from its Sor to Sora (the Singapore overnight rate average).

Japan’s particular risks

Japan also has its own specific complications. Yen Libor is planned to be phased out at the end of 2021 and the Tokyo overnight average rate (Tonar) has been selected as an alternative reference rate. Additionally, the Tokyo interbank offered rate (Tibor) is another benchmark used domestically, and at present there are no plans to phase it out, which some argue is potentially complicating the switch to Tonar.

Fitch Ratings recently published a paper suggesting the transition risks falling behind schedule, with issues such as the slow development of Tonar markets and market inertia. It suggests a more concerted push and greater clarity from regulators or local industry groups may be needed. Fitch analyst Willie Tanoto says: “The current plan to implement the transition still requires quite a bit of faith that things will come together in time. And we will be waiting until the second half of 2021 for several elements to be finalised, which — if they don’t come through then — may too late for market participants to act.”

In response to the concerns raised by the Fitch paper, the Japanese Financial Services Agency said: “Financial institutions, non-financial corporate investors and other relevant market participants are required to take actions in line with the [Libor transition] roadmap” published in August 2020, and it “will continue to appropriately monitor financial institutions that are considered likely to be significantly affected by the discontinuation of Libor”.

It is clear across all jurisdictions that there remains work to do. And as Chris Zachodzki, a manager at Sia Partners, observes: “I think what becomes clear the more work you do in this space is just how much needs to get done, like peeling back the layers of an onion.”

The question of whether an orderly global wind-down can be achieved may only be possible to answer much closer to the deadline.


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