Interest rate reform – the transition away from LIBOR

With just under two years remaining to the end of 2021, beyond which the continuation of LIBOR is not guaranteed, the use of risk-free rates (RFRs) is growing across products and work to transition existing LIBOR-based products is picking up pace. However, with the lion’s share of the work yet to be done, and regulatory scrutiny ever-increasing, 2020 will be a critical year in this monumental move away from LIBOR.

A key milestone for the OTC derivatives market is expected in Q1 with the publication of a protocol to amend legacy IBOR derivative contracts. The protocol will apply fallbacks, on the permanent cessation of certain IBORs1, to the term and spread adjusted RFR. These fallbacks will reflect ISDA’s consultations on adjustment methodology. The protocol will take effect three months following publication whereupon a new supplement to the 2006 ISDA Definitions will also go live in order to facilitate the contemporaneous application of the updated fallbacks to both legacy and new transactions. Further ISDA publications during 2020 are expected to include the ISDA Collateral Amendments Definitions, to allow market participants to use standardised definitions of interest rates (including fallbacks) in credit support documentation, and the 2020 ISDA Definitions, the successor to the 2006 ISDA Definitions.

The appropriateness of a pre-cessation fallback trigger, based on a regulatory determination of unrepresentativeness, will likely also be further discussed in 2020. This follows ISDA’s inconclusive 2019 consultation on the point and recent letter to the FSB’s Official Sector Steering Group seeking clarity on key issues with a view to a possible further consultation.

ISDA’s work on fallbacks will enable issuers of structured products, which have generally followed the fallback conventions used in the derivatives market, to progress the transition of their legacy books. For repackagings in particular, where an IBOR cessation could potentially impact the notes, the related hedging swap and/or the underlying collateral across multiple series, the importance of having a consistent and predictable set of fallbacks is key.

A practical concern for both legacy and new contracts is the possibility of increasing basis risk between a product and its hedge, for example by different fallbacks applying or being adopted at different times, or by different approaches to compounding RFRs being applied in different products.

Regulators have emphasised that the best and smoothest approach is to transition to new RFR products before fallback provisions are triggered.

To date, we have seen increased liquidity in RFR derivatives and CCPs are also preparing, where necessary, to move price alignment interest to replacement RFRs. There is promising momentum in the adoption of RFRs in the floating rate note (FRN) and securitisation markets, supported by the development of standard market conventions for SONIA FRNs. The first compounded SONIA loan facilities, based on conventions similar to those seen in the SONIA FRN market, have also been welcome.

Regulators are intensifying scrutiny of market transition and the shift to RFR-based products is central to this. The recent publication by the Bank of England, FCA and Working Group on Sterling Risk-Free Reference Rates of a series of materials intended to catalyse and support transition emphasises the need to pick up the pace. In this coordinated display of resolve, regulators encourage the sterling IRS market to make SONIA the market convention from 2 March 2020, set a target of Q3 2020 to cease issuance of new sterling LIBOR cash products and look to legacy transition to reduce LIBOR-referencing contracts by Q1 2021. The FSB has also highlighted the significant financial and reputational risks facing “firms that have not begun this work in earnest, and do not have plans to complete it by end-2021…”.

For more information visit our Global Interest Rate Reform microsite.

1 Sterling LIBOR, Swiss franc LIBOR, yen LIBOR, yen TIBOR, euroyen TIBOR, the Australian Bank Bill Swap Rate, US dollar LIBOR, Canada’s CDOR and Hong Kong’s HIBOR and, subject to the outcome of ISDA’s ongoing supplemental consultation on the spread and term adjustments that would apply to fallbacks for derivatives referencing euro LIBOR and EURIBOR, fallbacks for these IBORs are also expected to be implemented in the supplement and protocol.

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