Finance industry faces tricky transition away from the tarnished interbank offered rates (Ibors) to alternative risk free rates.
An important set of protocols to help the transition away from the tarnished interbank offered rates (Ibors) to alternative interest rate benchmarks have been given the green light by the US Department of Justice (DoJ), but industry still faces struggle to be ready on time.
Despite DoJ ruling that certain fallback protocols drafted by the International Swaps and Derivatives Association (ISDA) do not breach antitrust rules, the financial sector still faces a tough task in transitioning to alternative risk free rates.
“I think it was a very important step,” said Subadra Rajappa, head of US rates strategy at Société Générale in a podcast organised by The Banker’s sister title Global Risk Regulator (GRR) on October 13 about the regulator mandated move away from Ibors to alternative interest rate benchmarks. She said the protocols should reduce the chance of legal challenges.
On October 1, the DoJ stated that the ISDA fallbacks protocol and associated supplement are “unlikely to produce anticompetitive effects …. has the potential to offer substantial benefits to the financial services industry” and therefore has “no present intention to challenge ISDA’s proposal to amend its standard documentation”.
ISDA responded on October 9 that the protocols will be launched on October 23 to give industry a chance to digest the contents before coming into effect on January 25, 2021.
The protocols are important because they enable derivatives contracts that are priced off Ibors, which became discredited following manipulation scandals, a legal process to move to alternative interest rate benchmarks, such as the US dollar Secured Overnight Financing Rate (SOFR).
The Financial Conduct Authority (FCA) will stop compelling panel banks to publish the London Ibors (Libor) after the end of 2021 making it likely that the rate will cease to exist after that. This is forcing industry to transition to alternative rates, which is creating an operational headache.
Widespread adoption urged
On October 9, the Financial Stability Board “strongly” urged widespread and early adherence to the protocol by all affected financial and non-financial firms. “Libor transition is a G20 priority and remains an essential task that will strengthen the global financial system,” the FSB said.
On October 13, the Australian Securities and Investments Commission said adherence is an important step towards the orderly transition of Libor-referenced derivatives contracts. It said it is critical to the mitigation of both individual entity risks and systemic risks associated with the discontinuation of Libor.
“The global financial market has long sought a clear and efficient method to transition away from Ibors,” says Abram Ellis at law firm Simpson Thacher & Bartlett. “The proposed amendment and supplement to ISDA’s standard documentation offer that option for derivatives transactions, and the DoJ’s issuance of a favourable business review letter is a critical step in bringing these documents to the market.”
Mr Ellis explains that the favourable judgement was likely aided by the way ISDA developed the protocols, its transparency, robust safeguards and that it reflected market-wide consensus.
The global financial market has long sought a clear and efficient method to transition away from Ibors
He noted that although most competition authorities outside of the US do not have a formal process akin to the DOJ’s business review, ISDA has kept the authorities in multiple jurisdictions (Australia, Canada and EU) apprised of its process and intentions related to the supplement and protocol and does not expect any adverse actions by these authorities.
“We expect that market participants will look to avail themselves of the safety net that the protocol provides with respect to managing the risks of Libor’s cessation,” PwC wrote in a note, warning that there are bound to be cases where participants won’t or can’t sign the protocols necessitating bilateral negotiations to remedy any disagreements.
For example, some contracts depend on the Ibors’ forward curve while the replacement rates, such as SOFR and the sterling overnight index average (Sonia) are backward compounding rates. Efforts are being made to develop a forward curve for these replacement rates.
“The automatic adoption of the protocol is slightly more problematic for corporates,” said Sarah Boyce, associate director, policy and technical at the Association of Corporate Treasurers and a participant in GRR’s podcast.
She explained that this revolves around hedging and hedge effectiveness. This boils down to the different structures of the rates. Also, Libor has a credit component built into its pricing whilst SOFR and Sonia are risk free rates.
Unintended consequences
Ms Boyce worries that these differing structures could lead to unintended consequences for corporate hedges effectively either making them less effective or more costly.
Despite the importance of the ISDA fallbacks, Fitch Ratings warned that the transition to the alternative rates remains challenging, particularly for US dollars where US efforts are lagging their UK counterparts. For one, some transition milestones have been missed due to the Covid-19 pandemic. It noted that liquidity in the SOFR derivatives market is thin compared to dollar Libor and that some market participants will struggle to transition in time.
The rating agency said the clearing of the protocols should reduce the risk of the US dollar derivatives market not transitioning to SOFR ahead of Libor cessation at year-end 2021, which would be very disruptive.
It explained that the switch to SOFR from the Federal funds rate for US interest rate swap discounting should provide momentum behind SOFR adoption in the derivatives market and continue to improve liquidity in the primary market.
However, the rating agency worries that delays in creating a robust SOFR-based derivatives market could have the knock on effect of the SOFR term rate not developing in time for the demise of Libor.
“This would materially increase various risks facing US financial institutions, including operational, reputational, economic, and legal risks,” it said, adding that it views the advent of a SOFR term rate as unlikely before mid-2021, despite the ISDA fallback announcement.
Fitch Ratings said the situation has arisen partly because some market participants took a ‘wait and see approach’ rather than trying to find workable solutions and that there is less room now for further unexpected delays.
This article first appeared in The Banker's sister publication Global Risk Regulator.
