Swaps market heading for Libor fallbacks clash

Euro market goes own way on question of how to replace term Ibors with overnight RFRs

RFR headache
RFR headache: euro working group wants a forward-looking term rate as a fallback

The swaps market is heading for a clash on the vital question of how contracts respond to the death of scandal-hit Ibor benchmarks, after participants in the euro market ignored guidelines laid down by international regulators, and diverged from the results of the market’s first consultation on four other swaps currencies.

Any split in the choice of the so-called fallback – to replace an interbank offered rate (Ibor) when it stops being published – would undermine attempts to safeguard the market, some participants are warning.

“Fallbacks only work if adopted en masse. If everyone takes a different fallback you start to get market fragmentation,” says a London-based portfolio manager.

The issue arises because the new risk-free rates (RFRs) chosen as the successor for the Ibors are overnight benchmarks, while the Ibors are term, creating the risk of an abrupt change in value at the point the old benchmark stops being published. Regulators have urged the market to use adjusted versions of the overnight rates as their fallback, particularly in interest rate derivatives products, but respondents to a recent consultation of the euro RFR working group instead called for a forward-looking term rate to be used.

The swaps market’s first fallbacks consultation was run by the International Swaps and Derivatives Association last year, for four derivatives currencies. It excluded forward-looking term rates as an option, following guidance from regulators on the Financial Stability Board’s Official Sector Steering Group – and a planned follow-up consultation on other swaps currencies will also toe the line.

“In accordance with guidance from the FSB OSSG and global regulators indicating that most derivatives should not reference forward-looking term rates, Isda is implementing fallbacks based on an adjusted version of the relevant risk-free rate,” says Ann Battle, assistant general counsel at Isda.

Regulators would prefer to see adjusted RFRs as fallbacks because the underlying markets – overnight deposits and repo, for example – are more robust. A term version would probably have to be based on derivatives that reference the RFRs, and could fall into the low-liquidity trap that has fatally undermined the Ibors. Compounding the challenge for the euro market, its chosen RFR – the euro short-term rate, or Ester – will only be published regularly from October.

Fallbacks only work if adopted en masse. If everyone takes a different fallback you start to get market fragmentation
London-based portfolio manager

Despite that, more than half of the 73 respondents to the euro RFR group’s consultation – published on February 22 – said a forward-looking term rate was “essential” or “desirable” for over-the-counter derivatives.

Some market participants argue they need term rates in order to forecast their interest costs. Respondents to Isda’s consultation chose to simply add up the overnight rates over the required period – a method known as compounding in arrears, which means the three-month rate would only be known at the end of the relevant three-month period, rather than at the outset.

The euro group flagged the looming clash, noting Isda is planning its own consultation on the switch from Euribor to Ester once the latter starts being published, and that Isda is not planning to offer a term option.

“The working group strongly encourages market participants, in particular end-users, to prepare for responding to this key consultation by Isda,” says the results of the euro consultation, which gathered feedback on a host of rates products – from swaps to loans and floating-rate notes (FRNs).

It adds that the group “will continue its work on helping market users to understand the issues and on finding simple and efficient solutions. It will consider the work done by related working groups in other currency areas and by Isda, while taking into account the specific features of the affected euro-denominated products and markets.”

The portfolio manager argues this is misguided: “Unco-ordinated approaches to fallbacks, which try to cater to specificities in local markets, just create a lack of fungibility and basis risk because everyone ends up with a different version. You’ve got Libor with an Isda fallback, Libor with a loan fallback, Libor with an FRN fallback – at which point the whole thing stops working.”

Liquidity doubts

Regulators appear to be less worried about consistency than about robustness.

In guidance on the transition from term to overnight rates published in July last year, the FSB warned: “If the major derivative markets that are currently reliant on Ibors at risk of discontinuance were to fall back to RFR-derived term rates rather than overnight RFRs, and these RFR-derived term rates did not have sufficient liquidity to support production of a benchmark robust across the range of market conditions, this would not be effective in addressing systemic risks.”

It welcomed the Isda consultation’s decision to focus on fallbacks derived from the RFRs.

A forward-looking methodology could only be established on the back of a liquid derivatives market in the new RFR – something that could put such a fallback framework out of reach for months – perhaps years. Once Ester appears in October, futures and overnight index swaps referencing the new rate are expected to begin trading shortly after, but evidence from the US suggests it could take time for liquidity to build. The US Federal Reserve began publishing US Libor’s successor, the secured overnight financing rate, in April 2018. The first swaps contracts referencing the rate traded in July, but by the end of 2018, just 52 swap contracts linked to the new benchmark had traded.

“For people to be talking about using a term rate as a fallback for Ester, which hasn’t been published, and for it to be based on swap quotes in a market that doesn’t yet exist, you’re making a number of leaps. We don’t know how long it will take for Ester swaps to be liquid and viable and whether you’ll actually have the requisite volumes to meet the relevant criteria to be Benchmark Regulation-compliant and meet all of the Iosco [International Organization of Securities Commissions] standards,” says the portfolio manager.

Cornelia Holthausen
Cornelia Holthausen, European Central Bank

Efforts to transition the euro interest rate swaps market away from Euribor may not be as pressing as for other markets, however. In 2018, Cornelia Holthausen, deputy director-general in the directorate general market operations division of the European Central Bank told Risk.net that the euro interest rate swaps market could remain linked to Euribor for the foreseeable future if reform efforts prove successful.

Euribor’s administrator, The European Money Markets Institute, is seeking to secure the rate’s compliance under the European Union’s Benchmark Regulation, which becomes effective in 2020, with new hybrid methodology. Critical benchmarks have been given a further two years to comply.

“The Isda fallback consultation is more urgent as it’s focused on Libor. Given the end of 2021 deadline, you need fallbacks that are already feasible, hence the focus on overnight rates. For euros, it doesn’t surprise me there’s demand for a term rate as there’s a general assumption that Euribor reform will be successful,” says Serge Gwynne, a consultant with Oliver Wyman.

Consistency conundrum

Most respondents to the euro group’s consultation, which closed on February 1, viewed forward-looking fallback rates as “essential” for corporate lending, retail markets, floating-rate notes and securitisation. The consultation found less of a requirement for forward rates in leasing, derivatives and money markets, but the majority of participants still found term rates to be at least “desirable” in those markets.

The European Fund and Asset Management Association said forward-looking term rates were essential for fallbacks in a range of asset classes including OTC and exchange-traded derivatives.

“Efama agrees with the views in the consultation paper in favour of forward-looking fallback rates, given Euribor is also forward looking. It would allow for a smoother transition to the fallback rate, if it is triggered,” the association said in its response.

The Loan Market Association described a forward-looking term rate as “key” for transition in the syndicated loan market.

“Transitioning from a forward-looking term rate to a backward-looking daily rate will involve more radical surgery to documentation, processes and systems than a move from one term rate to another,” said the lending body in a joint paper with the Association of Corporate Treasurers.

What is essential in our view is global cohesion in the fallbacks for Ibors and for fallbacks to be consistent across the derivatives and cash markets
Stephen Fisher, BlackRock

But many respondents also called for consistency across asset classes and jurisdictions.

“What is essential in our view is global cohesion in the fallbacks for Ibors and for fallbacks to be consistent across the derivatives and cash markets, in particular with respect to triggers and spread adjustments,” said Stephen Fisher, managing director for global public policy at BlackRock, in the asset manager’s written consultation response.

With Isda already settled on backward-looking standards for the swaps market, some respondents called for all markets to align by adopting the same compounding-in-arrears approach. Others felt forward-looking fallbacks for derivatives should be limited to those used solely for hedging purposes, where a divergence in cash and derivatives fallbacks could create a basis that makes existing hedges less reliable and could even break hedge accounting treatment.

Isda intends to address potential divergence in the way different asset classes make the switch to RFRs as part of an expansion of its fallback consultation to other currency groups.

“We expect some market participants will be able to use derivatives based on a compounded-in-arrears rate to hedge cash products based on a forward-looking term rate that may be published in the future, and we will continue to work with market participants that may need different solutions for their individual hedging,” says Isda’s Battle. “It is important to note a forward-looking term rate is not expected to exist until there is a sufficient level of derivatives trading based on Ester.”

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