The shift from Libor to an alternative risk-free rate will require considerable cost and effort, and the sooner the market takes action the fewer and lesser the risks associated with transition will be. A forum of industry leaders discusses key topics, including the impact of the shift on market pricing and risk management models, the drawbacks with alternative rates and the potential longevity of Libor once a mainstream alternative has been adopted
- Andy Ross, Chief Executive, CurveGlobal
- Roy Choudhury, Partner and Global Ibor Leader, EY Financial Services
- Philippe Vidal, Partner and EMEIA Ibor Leader, EY Financial Services
- Jonathan Rosen, PhD, Product Manager Quantitative Analytics, Fincad
- Christopher Dias, Principal, Advisory, KPMG
- Christian Behm, Partner, LPA
- Geoffrey Peck, Partner, Morrison & Foerster
- James Schwartz, Of Counsel, Morrison & Foerster
- Liang Wu, Vice-President, Financial Engineering, and Head of CrossAsset Product Management, Numerix
- Frances Hinden, Vice‑President, Treasury Operations, Shell International
What are the key challenges associated with moving from Libor to alternative benchmarks?
Christian Behm, LPA: From the perspective of the market, the key challenge is to establish feasible and trusted alternatives, and create liquid markets. The amount of time it will take to solve the many technical issues is also crucial. In particular, there is very little time remaining for transitions in the euro market.
From the perspective of market participants, the main challenge is complexity. Any transformation programme will be required to deliver two distinct capabilities:
- To operate in an environment with both legacy and new rates side by side.
- To deal with an interbank offered rate (Ibor) cessation event with a substantial number of affected contracts.
In addition, the plans of the institutions responsible for the Group of Five currencies are not fully aligned. Finally, potentially different approaches depending on product and jurisdiction are to be expected.
The upcoming Eonia migration may act as a wake‑up call to the industry and its institutions. A much greater challenge will be the upcoming transition from Libor and Euribor.
Andy Ross, CurveGlobal: The ability to hedge risk effectively is of paramount importance for ensuring a smooth, orderly transition away from Libor. As a result, it is vital that participants have access to a liquid and active futures market, which in all cases needs to align with regulatory requirements while supporting competition and choice, and enabling best execution.
Fortunately, growing endorsement of new benchmarks by market participants is prompting competitive innovation. This includes the launch of new futures contracts referenced to the Bank of England’s (BoE’s) reformed Sonia benchmark, and products that make it possible to trade the spread between Sonia and Libor with no legging risk.
James Schwartz, Morrison & Foerster: Libor has been central to the financial system for decades and is the basis for trillions of dollars in financial products. Replacing it will involve numerous challenges and risks.
The initial question is: what will replace Libor? So far, market participants have agreed that overnight rates are the preferred option. However, there are complex questions about how overnight rates can be adjusted for use in contexts that have been historically dominated by term rates such as Libor.
Difficult questions stem from legacy Libor transactions that will remain outstanding beyond 2021, when regulators state their preference to no longer require banks to make Libor submissions.
Certain products may contain fallback language in case Libor is not available, but in many cases those fallbacks are intended to address a temporary unavailability of Libor, not a permanent one. In other cases – such as in the derivatives context – contractual fallbacks seem unlikely to be helpful, meaning parties would be well advised to reach an agreement on what should happen when Libor is discontinued.
In either case, for legacy contracts the discontinuation of Libor raises the possibility of significant and disruptive value transfers because whatever replaces Libor is unlikely to be its economic equivalent.
Jonathan Rosen, Fincad: Switching to alternative benchmarks could have a sizeable impact on bottom lines when positions linked to Libor are forced to transition to new benchmarks. This will depend on the market conditions when Libor ends, but the impact will be at least a few percentage points, and there really is no upper limit within the currently proposed transition methodologies. Furthermore, the loss of the Libor derivatives market data as input to interest rate models will mean a drastic increase in the modelling complexity for pricing trades considered standard today. This is due to impacts ranging from disrupted curve-building, the need for new volatility models to directly model the alternative rates and the sudden demand to handle the effects of convexity that result from this transition. Unless new markets emerge to fill the void by supplying the data needed to model derivatives, the future looks uncertain for markets that rely heavily on Libor‑linked derivatives for interest rate modelling.
Liang Wu, Numerix: A widely recognised challenge is the question regarding the level of market adoption that will exist for new alternative reference rate (ARR) products. The reason for this is that liquidity will be considered the single most important qualification for the adoption of these alternative rates. In that regard, a successful transition away from Libor would necessitate a sufficient level of liquidity for these products, but we must keep in mind that market participants tend to move only when others have moved first.
Another significant challenge is the amending and renegotiation of legacy contracts. What if some contracts, whether bilateral or multilateral, become impractical to negotiate, given they require 100% consent from all issuance holders? What if conflicts of interest arise? Banks may be wary of potential litigation.
Additionally, Libor-based instruments are still heavily relied on today for hedging, note and securitisation issuances, as well as curve construction. With banks given the option to no longer support Libor after 2021, and with the transition to several new alternative short-term interest rates well under way, market participants are concerned about the impact on derivatives valuations and risk management.
Roy Choudhury and Philippe Vidal, EY Financial Services: Ibors are deeply embedded in a wide range of cash and derivatives products, contracts, business processes, pricing and risk models, and technology infrastructure.
Thus, the challenges of moving to ARRs are manifold and include readiness to offer a full suite of products referencing ARRs; client communication; adoption of new fallback language and repapering; managing value transfer and basis risk; updating models; and process, data and technology infrastructure readiness.
Christopher Dias, KPMG: The transition from Libor to new risk-free rates (RFRs) is fraught with challenges that must be solved by the industry working together and, in some cases, industry participants taking the lead to establish a functioning market. The following are key among the many identified challenges:
- The structural requirements of each new RFR must evolve, including term structure, liquidity and underlying product growth.
- RFRs must be broadly adopted by market participants, including originators, issuers, buy side, sell side and consumers, across all aspects of financial markets.
- An effective method to reduce value transfer impacts for legacy contracts and acceptable across major participants must be developed.
Frances Hinden, Shell International: The biggest challenge is getting the Libor-dependent world to start actively working on it. Large derivatives traders and financial debt issuers may be there, but there is an enormous tail in the $750 trillion of existing ‘legacy’ Libor products lacking time, information, knowledge and resources. Many are small businesses or – particularly with US dollar Libor – retail customers. Long-dated Libor products are still growing because the alternatives – term rates and euro products, for example – are not yet there.
Do you anticipate Libor remaining ‘alive’ after 2021? Why?
Geoffrey Peck, Morrison & Foerster: While regulators have clearly stated their expectation that in 2021 Libor will be discontinued, year-end 2021 appears to be aggressive timing. Given the many legacy contracts that reference Libor and mature after 2021 – and the enormous amount of work still required to transition to a new benchmark – it seems reasonably likely that, one way or another, Libor will remain alive after that date. It may be that, to avoid a significant value transfer, the authorities will decide to keep it – or a placeholder for it – alive for some time while legacy Libor contracts are concluded.
Liang Wu: It is still too early to make a call on that, and the market appears to share that view, according to the Ibor global benchmark transition report, published in June 2018, which is based on the Ibor global benchmark survey transition roadmap. Nonetheless, market participants should be prepared for a world without Libor after 2021. One reason is that the UK Financial Conduct Authority (FCA) – the regulator of Libor – has made it very clear that the current agreement it can reach with panel banks is only to sustain Libor until the end of 2021. There is no regulatory requirement after that for panel banks to continue making Libor submissions, which may present significant uncertainty. Currently, panel banks, despite their discomfort, are conducting the submissions based on judgement rather than actual borrowing transactions as reform intended, so it is entirely possible to see banks leaving the panel after 2021, which will then render the publishing of Libor unfeasible.
Moreover, as new ARRs are identified, if there is sufficient liquidity to support the market adoption of new derivatives and cash products it will help the market transition more quickly to the new rates and decrease dependency on Libor, which would further diminish the chances of Libor being active after 2021.
Christian Behm: The question is more about when the cessation events will occur. A fair assumption would be to have a minor currency such as the Swiss franc undergo a cessation event first. Such a scenario would probably happen between 2022 and 2024. Other currencies will follow once the markets in successor rates are well established and legacy transactions have been reduced substantially. I do not expect an uncontrolled cessation in any of the major currencies.
A continuation of the panel-based ‘hybrid’ Ibors is unlikely, since the underlying money markets are not liquid, and operational risk – as well as cost associated with a panel membership – remains significant.
Frances Hinden: No. The regulators don’t want it, the banks don’t want to quote it, it is barely used for interbank funding and it is theoretically unsuitable for most uses to which it is put. To quote Andrew Bailey, chief executive officer of the FCA, in July: “Libor is measuring the rate at which banks are not borrowing from one another.”
Christopher Dias: Although global regulators are resolute in their message that discontinuation of Libor is inevitable, they have not communicated much more in terms of substance. The announcement that the FCA will not compel contributing banks to submit rates after 2021 may portend the death of Libor, but nothing else. The reality may be that the timeline to sunset Libor will extend beyond 2021. The case for this longer timeframe is driven by the size of the market and the related effort to effect a transition, the complexity involved with creating and sustaining a functioning market, and – most importantly – the need for broad adoption from all industry participants.
Andy Ross: It’s hard to imagine everyone completely abandoning a reference rate that includes bonds and swaps not due to mature for decades and, over time, it will become less feasible to quote Libor rates as they become less liquid. But, ultimately, it is in the hands of the Libor administrator, which will need to secure long-term commitments from a large number of panel banks to continue beyond 2021.
If Libor and a new RFR such as Sonia coexist in a multi-rate regime after 2021, it’s possible they will each be used for very specific products and transactions. For example, Sonia might be the best choice for derivatives, while a term Libor benchmark – perhaps with a new name and structure – might continue to be used in other circumstances.
What is the future of Ibors beyond 2021?
Roy Choudhury and Philippe Vidal: While Ibor governance has been enhanced and it is possible some panel banks will be willing to continue submissions post-2021, there is a significant risk that panel banks will not be willing to submit Ibor indefinitely beyond 2021, especially for currencies and tenors with limited underlying transactions. Furthermore, even if panel banks are willing to submit beyond 2021, regulators may not allow use of the rate if it is deemed non-compliant with International Organization of Securities Commissions (Iosco) principles.
As such – and highlighted in speeches by global regulators – market participants should prepare for a potential scenario where Ibors are no longer available post-2021. In addition, across a number of Group of Five currencies, regulators have been clear that Ibor should not be used for new transactions beyond 2021.
If panel banks are willing to submit post-2021, and the rate is deemed to be compliant with Iosco principles, there may be a multi-rate environment for a number of currencies where Ibor, ARRs and, potentially, other rates exist in parallel for new and existing contracts, although there will be a remaining risk that Ibors may cease sometime thereafter.
Who do you think will be the first to move away from Libor?
Geoffrey Peck: The first movers away from Libor will likely be large global banks and other large sophisticated financial institutions with more operational resources to handle the transition. Derivatives dealers, in particular, may transition from Libor more quickly because they are accustomed to overnight discounting. Regional and small financial institutions are likely to follow next, then other financial entities, then corporates and other end‑users.
Roy Choudhury and Philippe Vidal: The transition will be staggered rather than a big-bang process by the end of 2021. Furthermore, the transition process and speed will vary by currency, depending on the maturity of the proposed ARR. For example, the paced transition plan for the derivatives markets in the US to the secured overnight financing rate (SOFR) is likely to be different compared with Sonia in the UK, which is an existing rate. In the case of cash products, wholesale funding markets are expected to be early adopters of ARRs followed by commercial lending and, finally, consumer lending. There have already been issuances in the wholesale funding markets by government-sponsored entities and financial services firms with strong investor demand.
Liang Wu: Companies with Libor exposures that are concentrated on the derivatives market instead of the cash market, in my opinion, will be the first-movers. Derivatives contracts focus on hedging the general level of interest rate movements and do not necessarily stick to term rates such as Libor where bank credit risk is embedded. Furthermore, the concept of alternative overnight reference rates is not new to the derivatives markets.
On the other hand, cash markets still rely on term rates, which are quite different from alternative overnight reference rates.
Frances Hinden: Outside the derivatives markets, we are already starting to see government agencies (Fannie Mae) and supranationals (the European Investment Bank) issuing bonds linked to overnight RFRs. That is the obvious starting point, and corporate issuers will slowly start to follow suit, but it’s going to be slow taking off because no corporate wants to risk wider spreads due to investor unfamiliarity or systems that can’t cope. The past couple of weeks have seen some banks issuing fairly small amounts of Sonia- and SOFR-linked debt, but nothing yet in any size.
Christopher Dias: The move is largely motivated by regulators stressing the importance of safe and sound markets based on transparency and market transactions. With that in mind, large financial institutions have come together in support of safer markets to develop plans for transition and solve key issues. Given the largest number of touchpoints to those impacted by the Libor transition resides with banks, it will be incumbent on them to lead the way. The effort will be significant. Banks will need to be at the forefront in terms of new products, market infrastructure development, liquidity, communication and – most critically – guiding market response to key issues.
Andy Ross: Based on first-hand experience, buy-side institutions and liability-driven investment managers in particular are already actively moving away from Libor. They recognise that, given the shrinking support for the legacy benchmark, the shift to an alternative RFR such as Sonia is inevitable. As they don’t want to have to rely on fallback mechanisms, they are keen to be on the front foot, so they can mitigate any arbitrary and unhedgeable downsides.
Christian Behm: First movers are in the markets already. Most visible are the primary markets activities in the SOFR and Sonia, with some issuance activity. In the derivatives space, we see the large central counterparties competing for market share by offering support for new products and announcing the introduction of new futures contracts. However, it will be interesting to see when the first true post-Libor retail products will be made available. The smaller currencies, especially, might become more innovative earlier.
What are the drawbacks with the new RFRs sponsored by global regulators?
Liang Wu: I wouldn’t use the word drawbacks, but rather what are the characteristics of the new RFRs? First, these rates are selected or recommended by different working groups and there is no unified methodology in creating them, as is the case with Libor. Second, RFRs of different currencies are not necessarily following the same synchronised transition plan, which will post challenges and complexities in cross-currency swaps. Third, all RFRs are overnight rates; however, certain markets such as the cash market need term rates, which are currently not available via RFRs.
Christopher Dias: Not all problems can be anticipated or easily solved. In the case of Libor, the sheer number of contracts, market participants, currencies and transition-related issues exacerbate an already complex problem. Large industry participants are trying to solve this, yet there are some key drawbacks in moving from Libor, in particular the following:
- There will be very real value transfers moving from Libor to the new RFRs. Mapping legacy contracts to new rates and introducing a new basis will recalibrate current market positions, which can only result in creating winners and losers.
- The overall real‑dollar cost will be significant but may vary by industry participant. If you consider the activities needed to transition by participant, the costs start to add up quickly. For example, the cost of amending millions of contracts; changing systems, operations and processes; along with customer outreach and tracking will all amount to a significant outlay for the industry.
James Schwartz: The new RFRs are qualitatively – and quantitatively – different from Libor. They are overnight rates, unlike Libor, which is a term rate, an unsecured rate, and reflects a credit spread. The International Swaps and Derivatives Association (Isda) has published a consultation to determine the best way to adjust overnight rates to make them work in the context of the derivatives markets, and there certainly are complexities. In addition, liquidity needs to be built into the new benchmarks for them to play the role envisioned for them.
It is important to bear in mind, however, that the new rates have a major strength that Libor has lacked in recent years reflecting large numbers of actual, observable transactions. Whatever drawbacks there may be in the new rates, they will not have some of the deep weaknesses that Libor has exhibited in recent years.
Jonathan Rosen: While interbank loans now have low volume – leaving Libor easily manipulated – Libor itself remains a useful benchmark with considerable volume in Libor-linked trades in the form of derivatives. The new RFRs are less prone to manipulation since they are chosen for their high liquidity, but they are not term, unsecured benchmark rates. When markets shift to trades linked to overnight benchmarks, there will no longer be a useful benchmark for term unsecured loans, which is a major problem since Libor is probably the best gauge of the systemic credit risk in the economy and a vital benchmark for commercial funding arrangements.
Another drawback to consider is having benchmarks for both unsecured and repo rates. These rates will behave very differently to Libor in times of market stress, and their behaviour will depend on whether there are securities held in collateral against these borrowing rates. This could have unexpected consequences – for example, the foreign exchange carry strategy could encounter basis risk between the repo and unsecured rates in times
Christian Behm: The largest drawback with the RFR is the missing definition of a fix-in-advance pay-in-arrears term rate. The potential solution of using fixings of overnight indexed swaps (OISs) is a challenge. Individual traders are raising concerns that liquidity in short-term OISs has almost vanished due to low interest rates and low absolute volatility. In markets with little or no tradition of short-term interest rate futures – such as Europe – this may cause serious problems.
A move to an overnight RFR‑based product range will therefore require substantial work on settlement infrastructure and processes. It is also not favoured by some market participants, such as corporates.
Given these issues, we might also see new fixing methods. In some markets, such as Scandinavia, retail mortgage rates are already fixed via an outright auction.
Frances Hinden: The rates are theoretically much more suitable than Libor as they have no bank credit or term premium embedded. There are two main drawbacks. The first is that the rates in different currencies are split between secured rates such as SOFR and unsecured rates such as Sonia, so we have gained some basis risk. In most normal market conditions, this should have minimal impact because the rates are all virtually risk-free.
The other drawback is practical: there are big operational advantages, particularly for smaller companies, from having certainty in interest cashflows three months – or even one month – in advance. Accounting, payments, cashflow forecasting and all other treasury processes are simpler when you know how much is going to move to whom on what date. The emerging market standard for RFR-linked debt – or at least Sonia-linked debt – is to settle five days later. But this is a lot shorter than three months – compared with the OIS market, where the standard is two-day settlement.
The issue is not in the cleared derivatives market – which is typically used by large financial counterparties with the systems and liquidity to manage overnight rates – but with smaller borrowers/lenders or asset managers that may have both debt and interest rate derivatives to hedge it. Regulators understand there is a real need for term rates in some segments of the market, but how these will work has not yet been decided – there’s a BoE consultation on the subject, which closed at the end of September. There will remain the challenge of hedging a term‑rate‑based loan instrument with an overnight‑rate‑based derivative.
Andy Ross: Although Sonia may not have all of Libor’s currency and tenor pairs, it is robust and underpinned by significant transaction volumes. In contrast, Libor is now more fragile and suffers from a dearth of qualifying transactions. According to the FCA, in one currency-tenor combination there were just 15 qualifying transactions in all of 2016. I struggle to see how anyone can credibly build a daily benchmark by averaging multiple quotes from a dataset such as that.
However, unlike Libor, which is most frequently referenced in three- and six‑month tenors, Sonia is an overnight rate with no obvious forward-looking term rate. While this will merely be an inconvenience for some participants, for others – such as corporate treasurers – it may cause difficulties for firms used to interest rates being set at the beginning of an interest accrual period.
Despite these potential challenges, however, there’s no reason why anyone in the interest rate market needs to trade on anything other than real, transaction-driven rates.
What types of risk will investors face once Libor is discontinued?
Jonathan Rosen: The end of Libor will throw payout calculations in current trades into chaos, triggering fallback definitions, which could ultimately lead to an immediate impact on valuation. Fallbacks only help counterparties agree on how to calculate payments, not how to value trades. The most natural method for pricing uses the Libor rate curves, but instead fallbacks must be valued consistently with the overnight rate derivatives market.
Today, the derivatives markets used for interest rate forecasting are linked to Libor, and we would lose this valuable data for curve-building and pricing derivatives. The result could be many different prices for participants, with a potential impact on model risk. The fallback definition and pricing models relying on the derivatives markets as a whole need to evolve closely together towards the goal of a smooth transition and the avoidance of model‑dependency fragmentation.
The default risk embedded in Libor cannot be completely transferred to the overnight benchmarks, so amended deals will transfer the exposure to market funding rates from borrowers to lenders. Hedges may not remain adequate once amended, and some hedging strategies could be disrupted by the disappearance of trades that reference Libor.
Will some participants be unlikely to ever move away from Libor?
Andy Ross: Some participants have a commercial interest in preserving Libor’s dominance. In a recent industry survey conducted by Isda, 60% of respondents indicated they would continue trading Ibors – excluding short-term instruments – if they were to be published after 2021, with 18% indicating that they didn’t plan to use alternative RFRs at all.
However, participants in the derivatives markets should ask themselves if a rate with so few underlying transactions is their best option, and be encouraged to use Sonia as fully as possible. It’s also important to remember that there’s a regulatory imperative – driven in the UK by the FCA and the BoE – to transition away from Libor.
Christopher Dias: It is highly likely there will be late but willing adopters of the new RFR structures, as well as a number of participants who outright refuse to adopt. Even if the transition away from Libor becomes more nuanced and less binary than anticipated, the benchmark’s demise is inevitable. Participants refusing to adopt change will be faced with the choice of termination or negotiation. Those that choose to negotiate will find their choices do not include Libor.
Geoffrey Peck: The regulators have stated that Libor will be discontinued, so at a certain point there will presumably be no choice in the matter. But it seems likely that certain market participants will continue to transact based on term rates other than Libor. A subset of market participants, which can be loosely described as end-users, will likely wish to continue to use term rates, both for economic and operational reasons. For example, a recent consultation in the UK found that there would be strong demand for term rates in relation to corporate lending and securitisation structures, and medium demand for term rates in relation to retail loans, mortgages and floating-rate notes.
Christian Behm: Once markets in alternative rates are established, it will be too risky to continue making new Libor business. Also, there is little incentive. If there is demand for Libor-style risk containing bank-funding cost, there is room for innovations. For example, commercial paper auctions could be used in such an approach.
Frances Hinden: There are some participants in cash markets that do not want to move away from Libor because it is more expensive and resource-intensive than sticking with Libor, despite its flaws. However, there will eventually be no choice: the ‘fallback’ in their documentation may leave them with a fixed rate equal to the last published value of Libor. Failing that, they will have no choice but to change to something else, and by leaving it until the last minute, negotiations with counterparties will be more stressful than actively working on a transition plan.
Liang Wu: It’s possible. For some existing issuances of bonds and securitisations, there could be cases for which the terms and conditions require a large percentage of holders (75–100% of them) to consent to amend the reference rate. It is possible that the required percentage of votes to switch out of Libor cannot be obtained.
What will be the impact on deals that currently reference Libor?
Jonathan Rosen: There is no consensus on the best way to remove Libor from the trades that currently reference it, and work is under way to standardise fallbacks in the event of Libor’s disappearance. When Libor fallbacks are triggered, they will involve adding a spread onto the new benchmarks to emulate the Libor term risk but, depending on how this spread is calculated, it could affect the value of current trades referencing Libor. Current proposals involve static spot spreads, which do not change with market conditions and build spot spreads into the payout – very different to how Libor is calculated today.
For pricing trades with fallbacks, the best scenario is for fallbacks to mimic the payouts of standard derivatives linked to the alternative rates so the standard curves can still be used for pricing – otherwise there will be a significant issue with convexity. For example, unlike Libor, overnight rates have a different frequency to the payments of most interest rate swaps – so pricing a trade that directly replaces Libor with overnight rates will need a convexity adjustment, which means modelling the volatility of the new benchmarks and prices will become model-dependent.
Exotic trades that indirectly reference Libor – such as constant maturity swap (CMS) rates from Libor swaps – will have no clear definition. Once Libor is gone, and Libor-linked trades are no longer cleared, there is no agreement on how CMS and similar payouts should be determined. These are sweeping changes for the rates market and significant turmoil could be on the horizon for current participants.
How safe a benchmark is Libor today?
Christopher Dias: Libor as a benchmark rate is safe for the time being. First, contributing banks have agreed with the FCA to continue providing rates until the end of 2021. Second, the ICE Libor benchmark has revamped its methodology to make rates more transparent, which suggests the improbability of Libor being discontinued prior to 2021. Last, a large number of Libor-referenced consumer contracts have terms that extend beyond 2021. This suggests Libor could stick around at least until greater run-off has occurred or the process to manage legacy contracts has more fully evolved. The challenge of managing communication with the number of consumers involved before the end of 2021 is enormous.
Geoffrey Peck: Institutionally, Libor is at present a fragile benchmark. There are so few actual unsecured interbank lending transactions that an Ibor is arguably a fiction. Given the importance of the benchmark, the regulators are correct to seek replacements. However, Libor’s centrality to the financial system means the regulators would do well to assure the market of its continuing safety while the market transitions to new benchmarks. There is no telling what the Libor curve could look like, or how it could move, if the regulators were to announce a near-term date on which Libor is to be abolished. Perhaps the safest route might be to forbid the use of Libor in new transactions while keeping alive a synthetic Libor curve, perhaps derived from historical data, for legacy transactions.
Andy Ross: Trading risk that depends on a fixing based on the input from a small group of ‘experts’ is a cause for concern. Libor has been irreversibly weakened and is in precarious health – perhaps even on life support – so the risks are now considerable.
The markets that underpin Libor are extremely thin, hence the reliance on so‑called ‘expert judgement’ rather than actual transactions. Trading decisions in the trillion-dollar markets in which we operate need to be firmly rooted in fact.
Christian Behm: In terms of manipulation, the reforms did improve the overall process significantly. From an operational perspective of a benchmark user, the move to alternatives is certain. This increases the operational risk of a Libor cessation event, which is certainly a very tangible risk.
Frances Hinden: That depends on what one considers ‘safe’. Changes to the way Libor is administered make it unlikely that it is being actively manipulated – as in the past – but it is not robust and it has the same technical issues it has always had. By definition, it still contains an element of bank credit risk, which can be quite volatile.
Liang Wu: On November 24, 2017, the FCA confirmed that all 20 panel banks have agreed to sustain Libor until 2021. So today, Libor itself can still be considered as a safe benchmark in terms of rate availability. However, since Libor submissions are mainly based on judgement instead of actual transactions, the rate itself is still vulnerable to misconduct, although that does not signify any misconduct today.
What are the key differences between Ibors and ARRs, and how can firms manage the differences?
Roy Choudhury and Philippe Vidal: The ARR selected in each currency area is typically an overnight rate, and either secured or unsecured. The Ibors they seek to replace are available for tenors ranging from overnight to one year, and are unsecured, thus including a bank credit premium. In addition, there are structural differences between ARRs across the major G5 currencies. For example, SOFR in the US is a secured rate, whereas Sonia in the UK is an unsecured rate. To manage the differences between Ibors and ARRs, market participants will be required to understand, measure and manage the impact of this basis in their pricing, trading and hedging activities.
Why are ARRs considered safer than Ibors?
Roy Choudhury and Philippe Vidal: A key deficiency of Ibors is that they are based on transactions in the interbank funding markets that have significantly diminished in volume since the 2007–08 financial crisis. This lack of liquidity has resulted in Ibor significantly relying on expert judgement by panel banks. ARRs are based on transactions in liquid markets. Limited judgement is used in the calculation of ARRs, thereby making them more robust and less vulnerable to disruption or manipulation. ARRs are expected to be compliant with International Organization of Securities Commissions principles and provide a more robust reference rate in the long term.
What will be the impact of the move away from Libor on market pricing and risk management models?
James Schwartz: Libor continues to represent an important basis for pricing and risk management, even after the [most recent] financial crisis, when certain derivatives dealers began discounting collateralised swaps at an overnight rate. The move away from Libor, from the standpoint of pricing and risk management, will require significant resources and co-ordinated efforts across risk, pricing and operations.
A central part of the effort will involve constructing new term interest rate curves – fundamental for valuing future cashflows – based on the RFRs. So far there is no consensus, however, on the methods for building those curves and how an overnight rate is to be projected onto a term rate.
Roy Choudhury and Philippe Vidal: Firms need to develop new interest rate projection and discounting curves to support ARR products, and market data proxies to support risk measurement and modelling. The impacts are pervasive, affecting many other models that rely on benchmark base curves such as asset-liability management, funds transfer pricing, deposit modelling, loan origination and other models that are dependent on interest rates.
Andy Ross: Effecting change in financial markets invariably involves cost and considerable effort, and this is certainly the case with the shift from Libor to an alternative RFR. But it’s worth remembering that the new benchmarks are robust, backed by central banks globally and based on actual transactions.
When trading over-the-counter (OTC) or listed derivatives with a maturity over 2.5 years, there is a risk associated with changing the underlying benchmark. The challenge facing market participants is how to assess what risk premium to pay or receive for changing the rate to Sonia from Libor. When weighing up the decision to trade futures or OTC, how do you choose where and what to execute for best execution?
There are signs that the market recognises the need to move quickly, including robust adoption of the CurveGlobal inter-commodity spread (ICS) and Sonia futures contracts.
Even so, participants are still figuring out how to assess best execution on the same benchmark between two similar risk products. But choice is important here – let firms choose what is best for them. For example, are they better off trading the ICS between Sonia and Libor, or the forward rate agreement (FRA)/OIS International Monetary Market package OTC? The answer will clearly depend on factors such as market access, fees and liquidity, but choice is preferable to forcing every client down the same one-size-fits-all route.
Liang Wu: ARR-based derivatives contracts already exist in the market, and more will emerge, so curve construction, instrument pricing and risk models should be updated to adapt to cover those products. New curves reflecting ARR discounting and projection should be supported. Basis risks between Libor and ARRs, and between ARRs of different currencies, need to be taken into account. On the other hand, some parts of the cash markets require term rates. It is still not clear how alternative overnight reference rates can fit into the pricing and risk management models of term rates. ARR working groups are consulting to explore a potential solution.
Jonathan Rosen: There will potentially be a cascade of reactions to removing Libor and Libor-linked trades as modelling inputs. Interest rate curves at the various Libor tenors will disappear, leaving far fewer curves available to a market that has been multi-curve for a decade. However, investors cannot forget the embedded credit risk in term lending. This means it could be necessary to include more complex credit models – such as credit valuation adjustment exposure modelling on a sector basis – to recover the full multi-curve modelling that is currently standard.
Wherever interest rate volatility will be needed, it is unclear where the volatility data will come from once Libor is discontinued. Currently, the sources for interest rate volatilities are linked to Libor, such as swaptions on swaps that reference Libor. There will be a definite need for new volatility markets on the alternative benchmarks to carry out derivatives pricing, and the industry should strongly consider clearing new trades such as compounded overnight rate caps and swaptions. There will be a real need for these to model volatility and price vanilla legacy trades with fallbacks after Libor.
Furthermore, advanced models with baked-in Libor, such as the Libor market model, will need to be transformed to model the new benchmark rates. The overall impact on the current industry standard for volatility models is going to lead to a sea change for modelling requirements and complexity following Libor’s discontinuation. This could lead to a big bang in new modelling approaches and a further need for standardisation in the interest rate volatility markets to provide the data needed by pricing models.
Christopher Dias: The transition from an uncollateralised rate to an RFR will necessitate changes to market pricing and give rise to risk management considerations. There will be a fundamental change in how new loans, swaps and other new products are priced, with the key changes rooted in how pricing desks treat credit basis adjustments. Going forward, pricing cash or derivatives products that previously referenced Libor will need to reflect that the starting point for RFR products is a RFR rather than an AA bank rate. To the extent any models used a Libor curve, whether for pricing or risk management, a basis adjustment will be required to reflect the credit difference between Libor and the RFRs.
Christian Behm: The bad news is that, while new RFR‑based products are established, it may become even more complex and less transparent to price individual transactions. In particular, markets for non-linear products – such as options – will take some time to digest the change.
On the upside, it might be possible to significantly reduce the complexity associated with multi-curve approaches required today. In a RFR world there would be one curve per currency, which could increase efficiency significantly.
Is there enough time to move the industry away from Libor before the end of 2021?
Frances Hinden: There is enough time if all industry players start acting now. Unfortunately, they are distracted by Brexit, US tax reform, and so on. There are two interrelated areas where action is needed: the first is to get the infrastructure in place to manage, measure, report on and account for products based on overnight rates, and the second is to start using the rates in cash markets. In theory, derivatives will follow – in practice, derivatives are leading the way. One challenge to transition is that derivatives traders have been at the forefront of developing instruments and standards for near-RFRs, but it is the ‘real economy’ that has to catch up.
Roy Choudhury and Philippe Vidal: The move to ARRs will be an enterprise-wide transformation, and many market participants will execute a phased transition plan. This requires significant legal efforts, documentation, modelling, systems, process, client outreach, operational readiness and other efforts, so the sooner planning and prioritised implementation begins, the better. Although 2021 may seem far away, firms that mobilise early and prioritise this topic within their organisations will find the transition more achievable, and are likely to drive business and reap competitive benefits from being early adopters. For example, banks able to offer a full suite of ARR-based cash- and derivatives-based products will be able to retain – and possibly gain – market share.
Firms with a significant exposure to Ibor-linked contracts that mature after 2021 will also have to move earlier than others to mitigate the risk of discontinuance. The transition of legacy Ibor contracts within a short period of time will be a significant, resource-intensive effort.
James Schwartz: The consensus is that, to move away from Libor before the end of 2021, the pace of the transition must accelerate dramatically. Liquidity needs to be built into products referencing the new RFRs. In addition, most market participants either have not mobilised a transition programme or have had only initial internal discussions about the transition. Relatively few have allocated budget and other resources to a Libor transition plan.
Unfortunately, given the uncertainties in this transition away from Libor, up to this point it has been tenable, if perhaps not advisable, to take a wait-and-see approach. If the Isda consultation on the RFRs reaches durable consensus, that could change quickly.
Andy Ross: Libor is deeply entrenched, and market participants need to have a solid grasp of the extent of their exposure, as a transition could have a material impact on the profit and loss of their businesses. The market has been given adequate notice but needs to take action sooner rather than later – now, in fact – to minimise the risks associated with the benchmark transition.
Products referencing alternative rates, such as Sonia, which allow participants to migrate from Libor in both the OTC and exchange-traded spaces already exist. Adoption is increasing, and liquidity continues to grow on a daily basis. In the swaps market, for example, there has been more than 100% growth (year to date) on LCH-cleared GBP swaps notional with a Sonia underlying rate to over £32 trillion notional outstanding (as of August 2018).
Christopher Dias: It is going to take a great deal of effort to achieve the move away from Libor by the end of 2021. Although large financial institutions have begun to mobilise their teams to identify their Libor exposure and plan a transition process, there is still a lot of work to be done. For certain products, this move will likely be easier than for others. Isda, for example, has undertaken efforts to modify definition language and issue protocols that will help with the transition of derivative contracts. All other Libor contracts, however, will require more direct effort, and progress here is moving more slowly. Regulators have expressed concerns with the current pace of transition and urged institutions to move more quickly. The real-time pressure will ultimately come from firms’ failure to heed such guidance.
Christian Behm: That is dependent on currency. The US dollar market is ahead of the Alternative Reference Rate Committee‑paced transition plan – particularly if the use of SOFR discounting is established over the next six to nine months.
In Europe, there is the opposite: planning for euro short-term rate (Ester) to replace Eonia has just started. If the EU Benchmark Regulation is enforced, it will have to be completed by 2020. In contrast to the Libor post‑2021 statement, no clear Euribor policy statements have been issued so far.
The real test of the timetable is not the US and EU migration to a new RFR, but the creation of RFR term rates to mimic the Libor fix-in-advance pay-in-arrears procedure. The simplest method to derive term rates would be to use short OISs with a maturity of up to one year, which would be a challenge.
Overall, this situation has a complex and partially unknown timeline. This is why transformation programmes need to be able to deliver two capabilities: one for the parallel phase with two or more benchmarks at the same time, and the ability to manage and process an Ibor cessation event.
Liang Wu: It depends on the specific currency as well as the specific market. For example, while ARRs had already been identified for other currencies, only recently has Ester been identified as the ARR for the eurozone. The delay could compress the timeline for a full and successful transition away from Libor.
On the other hand, there might be enough time for the derivatives market to move away from Libor since an overnight reference rate is not a new concept in that market. For example, Sonia-based derivatives contracts are already well established. But it could still be challenging for the cash market because an equivalent replacement term rate is not readily available for that market. The creation of such a term rate is possible once sufficient liquidity is present in the underlying ARR derivatives market. However, whether that will leave enough time for the cash market before the end of 2021 is open to speculation.
What should firms do now?
Roy Choudhury and Philippe Vidal: The pace of transition implementation is accelerating, and firms with significant Ibor exposures need to mobilise immediately. Kicking off or accelerating enterprise-wide impact assessments and scenario analyses, formalising transition programme governance, project plans and budgets, and confirming senior executives to co-ordinate enterprise-wide transition efforts is paramount.
Consistent with this view, on September 19 the Prudential Regulation Authority and FCA delivered a ‘Dear chief executive’ letter to certain banks and insurance companies requesting board-approved information describing Ibor transition readiness to be submitted to regulators by December 14, 2018.
This is expected to drive a significant focus on Ibor at many firms, further increase client and counterparty awareness of transition, and be a blueprint of expectations for firms to demonstrate Ibor transition readiness in many other jurisdictions. To satisfy the need to support regulators and other stakeholders – such as clients, information requests and the significant implementation effort by the end of 2021 – the time to act is now.
The views expressed herein are the individual views of the respondents and do not necessarily reflect those of their respective organisations.