Market fragmentation – The impacts of multiple rates and conventions

A forum of industry leaders discusses key developments in benchmark reform, and the strategic, operational and technological challenges involved in Libor transition

With Libor cessation dates now fixed, what does this mean for transition? How are market participants responding?

Philip Whitehurst, LCH

Philip Whitehurst, LCH: The announcements on March 5, 2021 by the UK Financial Conduct Authority, the ICE Benchmark Administration and the International Swaps and Derivatives Association (Isda) have had a real impact. First and foremost, it has given the market certainty about two very important inputs into the transition planning: the Index Cessation Effective Date and the Spread Adjustment Fixing Date – versus the risk-free rate (RFR) – for each Libor.

This is vital information for making the transition actionable. By crystallising the timing and the spread, we lock in the relationship with RFR swaps – since a Libor swap quote now embeds a great deal of implicit RFR projection – and this has provided an upward driver on actual trading volume. LCH has now cleared more than $5 trillion nominal of secured overnight financing rate (SOFR)-linked swaps in 2021, which is more than was cleared in the whole of 2020. 

It also makes the reality of the transition much more tangible and acts as a catalyst to firms at all levels as they intensify their preparations. LCH, for example, has been able to announce definite dates of December 4 (CHF/JPY/EUR Libor) and December 18 (GBP) for its conversion processes, and we have been able to specify increasing levels of detail around other aspects of the transition. 

Max Verheijen, Cardano: The end of Libor has long been announced – as early as 2017 – and we have been preparing towards an end date for alternatives in 2021 ever since. For Cardano, the most important one was GBP Libor. We switched to (reformed) Sonia early for new contracts and let GBP Libor contracts expire. The cessation event did not really change anything in our strategy.

Marc Meyer, HSBC: We see a two-track market developing. For the four currencies ceasing at the end of 2021, we see market participants rapidly transitioning to alternatives. The move away from Libor is accelerating, especially for GBP Libor. However, the continued publication of USD Libor until June 20, 2023 seems to have resulted in a slowdown – even a reversal – in the transition away from USD Libor, with market participants reducing the priority of transition presuming they have considerably more time. 

 

How will the extended timeline for US Libor influence adoption of SOFR and alternative rates?

Max Verheijen, Cardano

Max Verheijen: The most important USD Libor rates in the derivatives markets are those with an end date – when the Isda fallbacks kick in – of June 30, 2023. Currently, there is no liquid alternative for derivatives contracts referencing US Libors, hence the continued use of derivatives referencing US Libor expiring before the 2023 date. Setting an earlier end date would have increased the adoption of SOFR and alternative rates. However, market participants indicated the need for an extended implementation time, which was adhered to. It is apparent this extension has not yet led to increased trading in SOFR or alternative reference rates.

Marc Meyer: This seems to have slowed the transition to alternatives to USD Libor quite significantly and has resulted in market participants delaying their readiness for SOFR and other options. This seems fairly consistent across markets, including in the US, despite the Alternative Reference Rates Committee’s SOFR Best Practices recommending that USD Libor be removed from sale in less than two months.    

Philip Whitehurst: This is an interesting question. Arguably, uncertainty has shifted from the Index Cessation Effective Date and Spread Adjustment Fixing Date to the likely timing of material changes in liquidity. Many market participants continue to express their views on USD rates via USD Libor swaps, but we know this cannot continue on an open-ended basis. 

There is likely to be a tipping point in liquidity and, for a central counterparty (CCP), this is critical. On the one hand, we need to maintain eligibility in support of market participants for as long as possible, since ongoing efforts to transition risk across to RFRs can temporarily boost Libor volumes. On the other, we need to attend to our own risk and default management responsibilities. 

Official sector announcements have stated that trades conducted as part of a CCP default management process are permitted, and this provides a useful safe harbour. However, we need to assess this protection in the context of other exceptions, since CCP default management processes are insufficiently frequent to enable a truly vibrant marketplace. 

 

What further clarity is needed on regulators’ solutions for transitioning tough legacy products?

Marc Meyer, HSBC

Marc Meyer: HSBC is not overly concerned that further clarity is necessary. For the portfolios and/or products with Libor exposure, there are relatively few contracts that actually qualify for tough legacy and for which it will not be possible to agree a contractual amendment to a successor rate. We are comfortable the proposed solutions for the small number of problematic contracts will be satisfactory. 

Philip Whitehurst: While tough legacy is an enormously important question in some quarters, cleared swaps are not tough legacy. However, there’s still a big role for derivatives in the wider context. We must align outcomes in cleared swaps (and also those for uncleared derivatives) with potential outcomes elsewhere – a point that stood out in the feedback from our January Libor consultation.

Focusing briefly on sterling, if the synthetic Libor on which certain tough legacy products will be allowed to rely is, as has been suggested, a function of the forward-looking term Sonia reference rates (TSRRs), and given the reliance of these TSRRs on short-end sterling overnight index average (Sonia) swaps, this would align closely enough with both ‘fallen-back’ Libor trades – at least, to the extent we can predict their value today – and also with the conversion output in cleared processes.

Max Verheijen: If forward-looking alternatives are to be used based on RFRs, they must be structured in a way that circumvents all the issues with Libor fixings, ruling out the possibility of rigging them. Clarity and uniformity on the governance of forward-looking alternatives is needed. 

 

To what extent will market participants rely on fallbacks rather than a proactive transition strategy?

Philip Whitehurst: LCH is not allowing fallbacks to become operational. Allowing them to do so may be the right approach for some products, but we believe it is best avoided for cleared swaps. Our motive is to eliminate the mismatch between the labelling – which we would argue becomes a mislabelling – of Libor swaps when their economics have switched as a result of the cessation events already announced to being driven by RFRs. 

We need to perform the conversion to restore the right level of transparency to our risk and default management processes. In doing so, we are, to some extent, a standard-bearer for proactive conversion, and we hope this creates a template for how this proactive transition can be achieved.

Max Verheijen: In the derivatives markets, the experience has been that participants are proactively transitioning away from Libor. This was most eminent in the GBP market, where the use of Sonia swaps increased. Only in the case of illiquid legacy contracts that cannot be replaced at a fair market price would we expect participants to rely on the fallbacks. 

Marc Meyer: The majority of our customers are aiming to actively transition, especially in the loan market. Some customers will choose a transition effective date set to the Libor cessation date; however, in general, we see customers actively transitioning ahead of Libor’s cessation. This seems to be the same for linear derivatives – in effect, interest rate swaps, especially those hedging loan contracts for corporate customers. Clearly those professional counterparts that have signed up to Isda’s fallback protocol intend to rely on the provisions of the protocol. The one exception seems to be non-linear derivatives, where relying on fallbacks is likely to result in the cheapest transition option because this avoids any transaction costs. 

 

Will the existence of multiple rates and compounding conventions lead to market fragmentation?

Max Verheijen: A fair question to ask is: “What tenor determines a rate to be truly floating?” Is a 12-month rate a floating rate because it resets every 12 months? One could argue the only floating rate is an overnight rate. All other rates are fixed for a certain period. If that was the market convention, then all liquidity around floating rate instruments would concentrate around the overnight rate. All derivatives and loan contracts that exchange a floating rate would reference the overnight rate, which would bring together all supply and demand, thereby hugely increasing liquidity. 

As long as there are multiple rates and conventions, there is bound to be some bifurcation and fragmentation in the market, which would serve no real purpose if everyone agrees on a single narrow definition of a floating rate – in effect, the overnight rate.

Marc Meyer: Yes, we are very concerned about fragmentation, especially for USD. Clearly, for Sonia, one set of conventions was recommended and the entire market has adopted common conventions – although, even in this case, small but important terms such as market disruption continue to cause friction in the syndicated market – which is a positive outcome. The multiple potential SOFR settings, including recent discussion and some borrower preference for SOFR in advance and the continued desire for term SOFR, mean market participants are reluctant to be first movers, which has created a sense of inertia, and almost paralysis. Add the various credit-sensitive benchmarks to the mix (such as Ameribor or the Bloomberg short-term bank yield index) and this increases the challenge. 

We are less concerned about these credit-sensitive benchmarks, but they are adding to the noise. All the while, participants continue to insist on using Libor. This creates significant issues for multicurrency contracts – which are quite prevalent. Clearly it has delayed and will delay [further] the transition of derivatives to SOFR, plus the potential for that market to fragment, reducing liquidity and increasing costs.

Philip Whitehurst: We do not think this will lead to market fragmentation. There is no debate and no question from anyone we speak to that the recommended RFRs will perform the central role for the derivatives markets as a pricing spine, for use in discounting and as the reference point for basis to other indexes. 

But term RFRs have been slow to emerge, in some cases with good reason. And this has allowed the sustained interest from certain pockets of the industry in benchmarks that plug the gaps associated with RFRs – the absence of credit sensitivity and the fact that they don’t look sufficiently forward – to find a foothold. That certain jurisdictions have always entertained, if not targeted, a multi-rate end-state is the best evidence for the idea that this is a sustainable future market structure.

Regarding different conventions, the most important thing is to develop consistent terminology. If we all use ‘lookback’ or ‘observation period shift’ with a common meaning, then the industry can focus its efforts on propagating the capability through different products and processing technologies. This will take some work, of course, but it will enable a functional marketplace that avoids fragmentation.

The panellists’ responses to our questionnaire are in a personal capacity, and the views expressed herein do not necessarily reflect or represent the views of their employing institutions

Libor Risk – Quarterly report Q2 2021
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