A forum of industry leaders, which includes sponsors of this report, discusses key industry concerns around the transition away from Libor, including the risks investors will face once the rate is discontinued and how to manage them, whether forward-looking term risk-free rates (RFRs) will prove a long-term requirement, and when liquidity in RFR markets will be sufficient for constructing robust and compliant forward rates
- Shaun Kennedy, Group Treasurer, Associated British Ports
- Barry Hadingham, Head of Derivatives and Counterparty Risk, Aviva Investors
- Chris Dias, Principal, Global Libor Solution Lead, KPMG
- Rick Ho, Principal, US Libor Lead, KPMG
- James Lewis, Director, UK Libor Lead, KPMG
- Franz Lorenz, Director, Germany Libor Lead, KPMG
- Eamonn Maguire, Managing Director, US Libor Lead, KPMG
- Maurizio Garro, Senior Lead – Ibor Transition Programme, Lloyds Banking Group
- Edward Ocampo, Advisory Director, Quantile
What types of risk will investors face once Libor is discontinued?
Chris Dias, KPMG: Immediate investor risk is very specific to fallback language and the operational implications of implementing specific fallback choices when triggers are initiated. Assuming investors have adopted fallback language reflecting appropriate and up-to-date regulatory guidance, the risk to investors will be focused on institutions’ capability to implement the choices outlined by the fallback waterfall or the choice determined through a negotiation process. These risks are heightened by the fact that market infrastructure and market conventions are still evolving, making operational readiness uncertain.
Shaun Kennedy, Associated British Ports: Even for firms fully prepared for the discontinuation of Libor, there remains a range of legal, conduct and liquidity/demand risks for any instruments that remain using Libor and that lack a clear legal mechanism for moving to a new rate.
Barry Hadingham, Aviva Investors: Libor has been central to financial markets for a very long time. With trillions of dollars in financial products still dependent on its publication, it seems unlikely that all of these will be fully transitioned before the end of 2021. Inevitably, discontinuance is going to crystallise a number of risks – particularly for legacy Libor contracts that cannot be transitioned and remain in place beyond 2021.
There is a real risk of significant value transfer for legacy contracts falling back to new RFRs as Libor volatility is likely to increase significantly in the run-up to its demise. Firms should also be considering conduct risk because potential adverse outcomes for clients are likely to be closely watched by regulators where firms have taken insufficient action to transition prior to the end of 2021.
The proposed inclusion of pre‑cessation triggers in International Swaps and Derivatives Association (Isda) contracts is also a significant risk for firms relying on the Isda fallback provisions. In practice, regulators can make a pre‑cessation determination on Libor at any point post-2021, which could lead to the application of a significantly different fallback rate to legacy contracts than under the proposed Libor cessation trigger that would only come into effect once Libor publication ceases.
However, it seems inevitable that at least some market participants, through a lack of knowledge or other factors, are likely to end up in a scenario where they have no fallbacks. At that point, they will be faced with the choice between termination and renegotiation in the event of Libor’s discontinuation, which is clearly the biggest risk.
Edward Ocampo, Quantile: Libor is widely referenced in contracts across the global financial markets, and most existing contractual fallback provisions are woefully inadequate. Without meticulous planning, Libor’s cessation could have systemic consequences. Market participants risk facing a loss of contractual continuity, contract frustration, changes in the market value of financial instruments and tax effects – all with potentially material financial consequences.
National working groups and international authorities have worked intensively over the past five years to develop robust Libor alternatives and provide guidance on benchmark transition. Market participants should draw on this important work to ensure they are adequately prepared for Libor’s cessation.
How can firms manage the risks and costs associated with the transfer of existing transactions to RFRs?
Barry Hadingham: It is important to establish robust governance arrangements at the most senior level to manage Libor transition across the business. For example, asset managers need to consider the decision-making process around the transition and whether they have discretion to do so under the client’s investment management agreement. Even where they do, it can be challenging if client assets are being managed against a Libor benchmark that also needs to change. For example, insurance clients may be reluctant to amend Libor-linked benchmarks until they know what RFR-based discounting methodology the European Insurance and Occupational Pensions Authority is going to recommend under the Solvency II capital rules.
Firms also need to establish a conduct framework to manage potential conflicts of interest and best execution, and ultimately deliver the best outcome for clients. This also requires portfolio managers to understand and monitor market activity and Libor/RFR spreads to deliver a fair and cost-effective outcome for clients. The Isda fallback consultation and resulting calculation methodology has been extremely helpful in providing broad parameters for the market to determine an expected range for the fallback and thus an appropriate trading range for transition today.
Edward Ocampo: At Quantile we are working closely with our clients to facilitate the transition of over-the-counter derivatives portfolios to RFRs.
Broad-based adherence to Isda’s interbank offered rate (Ibor) fallback protocol will provide a safety net for legacy swap portfolios in the event of a permanent cessation. But national working groups and international authorities have made clear that fallbacks should not be used as a primary transition mechanism – a ‘big bang’ conversion would entail significant operational risk.
Instead, market participants are advised to close out Libor swaps and replace these with overnight index swaps (OIS) referencing RFRs before a fallback trigger event. There is already significant liquidity in sterling overnight index average (Sonia) swap markets, and this will only improve following the recent change in GBP swap market conventions. Expect to see a significant uptick in secured overnight financing rate (SOFR) swap liquidity following the October 2020 shift to SOFR discounting for cleared swaps.
Transition of legacy swap portfolios can be implemented through two key steps: risk transfer from Libor to RFRs via traded swap markets, and termination of residual Libor cashflows via compression processes.
Quantile’s multilateral compression service terminates Libor-linked cashflows, collapses Libor-OIS basis positions and rebuilds portfolios using OIS referencing RFRs. As of January 2020, our sterling compression service no longer uses Libor-referencing risk replacement trades – we only rebuild sterling exposures using Sonia-referencing swaps.
Market participants will need to transition both cleared and uncleared portfolios. Moving uncleared interest rate delta onto central counterparties (CCPs) can materially facilitate transition. That’s because cleared positions are easier to trade, easier to compress and easier to transition. Quantile’s multilateral risk rebalancing service can facilitate efficient margin management as uncleared risk is swept efficiently into CCPs.
UK-regulated firms now need to quantify and report their Libor exposures on an ongoing basis. This should strongly encourage firms to significantly reduce their stock of Libor-referencing contracts before the first quarter of 2021 target established by the UK RFR Working Group.
Maurizio Garro, Lloyds Banking Group: Model risk is one of the key risks associated with the Ibor transition because of a number of model changes implemented across valuation and risk models that require significant effort in model risk governance. In addition, the required model changes – for regulatory capital, for example – may require regulatory approval, the timing of which could be constrained by regulatory capacity for review of model applications.
For this reason, it is important to adopt a phased and structured approach to development and validation of model changes. The key driver is the model inventory across the enterprise. Finally, evaluating potential synergies across the model changes may help to make the process more efficient and cost‑effective.
Eamonn Maguire, KPMG: The risks and costs can be considerable if not managed appropriately. Performing a comprehensive risk assessment to include operations, technology, clients and business impacts will be critical to effectively managing both outcomes and associated costs. Prioritising, sequencing and aligning activities to business as usual, as well as transformational initiatives – both in-process and anticipated – will help alleviate the burden on resources and budgets. Cost-effective transition can be influenced strongly by developing a pragmatic and strategic overlay. Combing this overlay with playbooks will help firms better understand activities and requirements, and identify synergies critical to containing costs.
Shaun Kennedy: There will inevitably be costs for managing the transition of existing transactions to RFRs. Over time, these costs will reduce as firms test new approaches and standards, and best practice is established. The trade-off remains whether these costs, combined with the risk of doing something less than perfect, outweigh the costs of staying in transactions linked to Libor.
Should fallback language currently being penned for Libor referencing interest rate swaps include pre-cessation triggers?
Barry Hadingham: The original Isda consultation on pre‑cessation triggers in 2019 received a very mixed response from market participants, with some suggesting the inclusion would significantly impact the take-up of the cessation trigger protocol, which could be detrimental to market stability.
If there is to be a second Isda consultation, market participants will need further clarity on how the pre‑cessation triggers would work, as well as the ability to opt out of the protocol for certain derivatives transactions. These include hedging instruments with either no fallback or a different timeline. Ideally, pre‑cessation triggers for the bilateral market should align with clearing house triggers, leading to transition of legacy cleared Libor contracts and ensuring they move at the same time. This would create alignment between cleared and non-cleared markets as well as protecting the clearing house default management process.
As LCH is just beginning the consultation process, it will be hard for Isda to push ahead with a new pre‑cessation trigger consultation until there is consensus and clarity for the cleared market.
Maurizio Garro: It is important to maintain consistency on this point between derivatives and the underlying assets to minimise value transfer and distortions. For example, multiple spread adjustment transitions may add an operational burden on the development, implementation and maintenance of the market data, financial library and IT infrastructure. On this basis, it is important that the market choose a consistent solution, including aligning cleared and non-cleared derivatives.
Edward Ocampo: Swap market participants are keen to ensure that fallbacks trigger uniformly across products and markets. CCPs have proposed changes to their rule books to incorporate pre-cessation triggers. If these proposals are agreed, it would be sensible to also include pre-cessation triggers in bilateral derivatives.
But the best outcome would be to avoid an unrepresentative Libor altogether. Instead, any permanent cessation of Libor should be announced well in advance, while the benchmark is still representative.
James Lewis, KPMG: Three significant developments have occurred influencing greater considerations for pre-cessation language in the context of derivatives. First, large clearing houses have signalled their intent to update their terms and conditions or rule books to include a pre-cessation trigger. Second, industry groups representing a number of cash markets participants have expressed a strong need that pre-cessation triggers be included in any amendment to the fallback provisions. To that end, the Alternative Reference Rates Committee has included pre-cessation language in its recommended fallbacks for all cash products – syndicated and bilateral loans, floating rate notes and securitisations. Third, the UK’s Financial Conduct Authority and the Ice Benchmark Administration have issued statements indicating that a reasonable period, during which a ‘non-representative’ Libor would be published, will be minimal. Clearly, any differences in fallback language related to pre-cessation triggers between uncleared derivatives and cleared derivatives contracts or cash products could lead to market fragmentation or hedging discrepancies.
Regulators have deemed forward-looking term RFRs a requirement for transition – but are they required for the longer term?
Shaun Kennedy: In sterling markets, use cases for forward-looking term rates have been set out. Discounting-based loan instruments used in trade finance and invoice factoring are two examples that could be required in the longer term. The majority of products will, however, be able to use RFRs directly and this should be the case for new products and for the transition of legacy positions.
Edward Ocampo: Term RFR benchmarks – based on pricing in RFR derivatives markets – will be useful over the long term. These benchmarks can provide price transparency across the RFR yield curve – from overnight out to 30 years – and help reduce asymmetric information regarding the valuation of financial instruments referencing RFRs.
Barry Hadingham: As cash and derivatives markets are beginning to align closely in terms of compounding methodologies, there is a reasonable argument that forward-looking term rates are not required for new products in the long term. A decisive shift in bond and loan markets to compounding in arrears will also make it easier to hedge these products.
There is, however, potentially an argument for some parts of the market – particularly legacy Libor contracts that cannot be transitioned – to continue using some form of term structure, but not the market as a whole.
Franz Lorenz, KPMG: Forward-looking term rates are appealing, but not essential. Very few cash or derivatives products cannot be adapted or modified to function using an overnight rate. So, while a term structure is not technically necessary for the long term, it is absolutely necessary for widespread market adoption. Derivatives markets have been trading in OIS for some time with significant evident volume, and adoption of an overnight RFR may be trivial for derivatives markets dealers. Cash markets, on the other hand, have grown accustomed to having a forward-looking term structure in place and have hardwired many processes and systems to look for a forward rate. Changing these processes and systems will present a major challenge for a great number of industry participants.
At least four vendors are vying to provide term rates in the Sonia and the euro short-term rate (€STR) – how will users navigate this multi-rate landscape?
Maurizio Garro: Currently there are four candidates with different methodology on the table. Providers consolidating around a single term rate would be preferable for market liquidity and the evolution of hedging products – but this is for the market to decide. From an operational perspective, it may increase the burden on the IT/financial libraries as financial institutions may need to consider different methodologies to develop, implement and test the pricing and risk models and conduct all the necessary quantitative impact assessment on key market risk figures including value-at-risk, sensitivity limits and regulatory capital charges for
Finally, the potential different conventions across the four methodologies – for example, day count – may require some reconciliation activity, which presents an additional operational challenge for banks.
Barry Hadingham: Given the likely limitations on the use of Sonia and the reluctance of UK regulators to see broad market adoption of term rates post‑2021, four vendors seems significant. In time, the market is more likely to coalesce around one particular vendor – potentially the current Libor administrator – which has significant experience of calculating term rates as well as access to a range of panel banks. It’s also important to ensure a consistent market-wide methodology is being developed by vendors across a range of currencies.
In the eurozone, there is likely to be a broader remit for €STR-based term rates as the European Central Bank is more comfortable with their potential use, for example, as a fallback for Euribor-linked swaps. However, there are likely to be concerns around who calculates the rates, and again this could lead to the current Euribor administrator filling this role.
Edward Ocampo: Competition is healthy and should encourage the development of robust, representative and reliable benchmarks. But successful benchmarks benefit from network effects, so market participants are likely to settle on a single provider in short order.
When will liquidity in RFR markets be sufficient for constructing robust International Organization of Securities Commissions (Iosco)‑compliant forward rates?
Edward Ocampo: Sonia swap markets are already sufficiently liquid to support Iosco-compliant term fixings. As RFRs become the market convention for interest rate swaps and futures in other currency areas, it should be feasible to construct Iosco-compliant term fixings in those currencies as well.
Chris Dias: For a term rate to be compliant with Iosco’s principles, it requires sufficient observable market data in the swaps and/or futures markets. Liquidity is starting to build in both, albeit at slow pace. Watershed events such as the big bang – when CCPs move to Sonia and SOFR discounting – will bring a significant boost to liquidity and a step forward for term benchmarks. While these types of market events are significant contributors to it, nothing will generate more liquidity than focusing demand on a single rate. Demand for alternative rate products needs to increase in order to achieve the liquidity needed to support an Iosco-compliant term rate.
How will the switch to the SOFR discounting for US dollar swaps take place, and what impact is it likely to have on SOFR derivatives liquidity?
Rick Ho, KPMG: The two major CCPs, CME and LCH, are planning to transition to SOFR discounting and price alignment in October 2020. Market participants with US dollar interest rate swap products cleared by these CCPs will have the positions revalued, moving from the effective fed funds rate (EFFR) to SOFR. To neutralise the value transfer as a result of this change in discounting, the valuation will include a cash adjustment equal and opposite to the net present value change, and an EFFR versus SOFR basis swap to offset the risk profile.
The creation of these EFFR versus SOFR basis swaps would facilitate secondary trading of SOFR derivatives, given that a significant number of market participants do not intend to hold these swaps because of infrastructure or investment guideline restrictions. Liquidity for SOFR swaps – including SOFR versus fixed and SOFR versus EFFR – will improve following CCP conversions on SOFR discounting. The benefit will be most pronounced in the long end of the curve where current liquidity is minimal. For non-linear SOFR-based derivatives such as swaptions, caps and floors, SOFR discounting may not create immediate liquidity benefits. Additional market infrastructure, such as volatility surfaces, will be required.
Edward Ocampo: The switch to SOFR discounting provides a use case for long-dated SOFR derivatives – US swap market participants will need to use SOFR swaps to manage their discounting risk. SOFR discounting is a necessary condition for SOFR swap liquidity.
But RFR discounting may not be a sufficient condition to ensure SOFR liquidity. We will also need to see broad adoption among end-users, including those who do not actively hedge their discounting risk. That will help generate the two-way flows necessary to support a well-functioning market.
Finalising the methodologies for Isda’s fallbacks should also help – leading to more stable and predictable pricing in SOFR basis swap markets and, consequently, more liquidity provision from the dealer community.
Given the surprise September spike in SOFR, is it the right benchmark for US dollar lending markets, or are there more
Eamonn Maguire: SOFR rose to a record 5.25% on September 17, 2019 – an increase of 282 basis points over the previous day’s mark. This surge in the rate was mainly caused by an increase in demand for liquidity driven by a confluence of factors – quarter-end cash needs, treasury settlements, tax payments, broker-dealer position financing and the need for cash reserves to support capital requirements. The spike in rates was ephemeral, demonstrated by the fact that rates returned to their previous pre-demand levels the following day. Although the spike was significant, the impact becomes muted over various averaging or compounding periods. The key takeaway here is that SOFR is a market-derived rate, which is subject to supply and demand factors. This market-derived attribute is a key principle underpinning benchmark standards.
Barry Hadingham: The September spike has highlighted the potential volatility in SOFR as a result of market stresses and a lack of capacity in the US dollar overnight cash repo market when these stresses occur. The 282bp rise in SOFR on September 17 impacted a range of instruments including interest rate swaps. This has reduced confidence in SOFR. As Libor is a forward-looking rate, it is less susceptible to unexpected events as market participants can factor in foreseen moves across the relevant time horizon in advance. This is an important component of Libor highlighted clearly by the recent SOFR spike.
The other component is the role played by the repo market, which is managed through discretionary mechanisms controlled by the US Federal Reserve. SOFR is largely dependent on Fed activity and its ability to stabilise the market. Going forward, SOFR may suffer higher volatility than US dollar Libor as a result of one-off market events. If these spikes continue, it will be difficult to convince end-users to adopt SOFR and is likely to hinder the transition away from US dollar Libor. More time may be needed to observe its behaviour against legacy Libor to confirm that it is in fact a worthy successor.
Edward Ocampo: In sterling markets there is little interest in a credit-sensitive GBP Libor alternative. Loan market participants are solely focused on RFRs as replacements for GBP Libor – Sonia, base rate or a term version of Sonia. But some US market participants – including regional and mid-sized banks – are keen to explore a credit-sensitive USD Libor alternative for lending markets. A multi-rate approach in US markets could allow users to choose a rate that best meets their economic needs.
USD Libor alternatives should be welcomed as long as they are robust, representative and compatible with a SOFR-centric ecosystem in derivatives and capital markets.
€STR is a recent addition to the RFR family – how will liquidity develop alongside regulator support for Euribor reform?
James Lewis and Franz Lorenz: €STR is effectively a more robust replacement for Eonia. It is grounded in more readily available transaction data and is similar to Sonia in that it is an unsecured overnight rate. €STR is likely to become a key capital markets rate for the euro.
Euribor will continue – arguably more broken and grounded in less interbank data than Libor is today. But Euribor is used widely across the eurozone for underpinning mortgages and European regulators have decided to keep it in place, at least for the medium term. Whether this is the right decision for the robustness and reputation of the market, only time will tell.
Barry Hadingham: I would expect €STR liquidity to develop fairly swiftly, given the effective demise of the euro overnight index average (Eonia). The bigger question is what happens to Euribor and whether liquidity switches into €STR as other jurisdictions move to RFRs. It seems unlikely that in the longer term, euro‑based cross currency swaps will continue to reference Euribor, and this will likely be a catalyst for the market transitioning to €STR.
Edward Ocampo: Euribor’s methodology has been reformed and its administrator has received authorisation under the European Benchmarks Regulation, so I would expect to see continued widespread use of Euribor over the medium term.
But Eonia is no longer an independent benchmark – it is now pegged to €STR, and the plan is to discontinue Eonia on January 3, 2022. That should facilitate the seamless transfer of liquidity from Eonia to €STR in derivatives markets.
As RFRs are adopted as the market convention for interest rate swaps in other currency areas, expect cross-currency swap markets to move to an RFR convention on both pay and receive legs. This should further encourage the development of €STR liquidity in derivatives markets.
To aid the transition, Quantile’s cross-currency compression service will allow clients to rebuild their portfolios using new swaps that reference RFRs.
The KPMG name and logo are registered trademarks or trademarks of KPMG International. This article represents the views of the authors and does not necessarily represent the views or professional advice of KPMG LLP.
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
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