Bruised, not broken: execs say Libor switch on track despite Covid

Compressed timeline for transition may leave smaller firms struggling to meet end-2021 deadline

  • Dealers and buy-side firms are weighing up the impact of the coronavirus on their plans to transition away from Libor.
  • Some put projects on hold during the volatility seen in March; others say the impact has been limited.
  • Communication and client education on the transition has proved particularly difficult with meetings moving online.
  • In loan markets, users are worried that delays to interim deadlines will stunt the volume of products referencing alternative rates.
  • Regulators are reinforcing the end-2021 deadline, but accept Libor could also limp on beyond that date.

The financial industry may soon have an answer to an age-old paradox, as the irresistible force of the coronavirus pandemic smashes into the immovable object of the timeline to abandon the Libor interest rate benchmarks.

Some firms paused elements of their switch to alternative risk-free rates amid the turmoil that has engulfed markets since March. Broadly, many believe the work can still be completed by the end of 2021 – the earliest point at which publication of Libor could cease – but the picture varies by firm, by instrument and by geography.

“I don’t think our focus has ever come away from the Libor transition. The problem is that the dislocation in the market that we saw, particularly in March, meant it wasn’t sensible to continue with the transition until the market calmed down a bit,” says one head of derivatives at a UK asset manager.

To accommodate those delays, industry working groups are pushing back their transition milestones, compressing the time available to get it all done. Smaller firms in particular may struggle to muster the resources.

Liquidity has been building in financial instruments pegged to replacement rates such as SOFR in the US, and Sonia in the UK. But many users are stubbornly clinging on to Libor. The swaps market is awaiting a new fallback protocol that would automatically rehitch Libor contracts to new risk-free rates, due in July. Loans are not predicted to adopt new rates in meaningful numbers until next year.

“The date of 2021 is very challenging if you consider we are 18 months out from the deadline and we haven’t yet observed a massive change in contracts to something other than Libor,” says the head of Libor transition at a European bank. “Time is running out.”

Regulators are keeping up the pressure. The UK’s Financial Conduct Authority, which oversees Libor, revealed during a event this week that notice of Libor’s cessation could arrive as soon as the end of this year. That would give the market certainty. It would also yank away a comfort blanket – the common belief that Libor will be allowed to limp on for months or years after the end of 2021 if transition efforts ultimately fall short.

Lost in transition

Coronavirus has interrupted the switch from Libor in a number of ways. With legions of staff exiled from offices, individuals have had to adapt to new methods of working. The move has proved a distraction for many.

The extreme volatility in March also prevented dealers from getting in touch with clients to discuss plans for the benchmark switch. The head of Libor transition at the European bank says the only client calls on the changeover have been negotiations around credit support annexes ahead of the shift of discount curve at European central counterparties in July. Wider Libor education is on hold.

Patchy communication was one reason cited for the delay of an important report on so-called tough legacy contracts – instruments that can’t shift to an alternative rate and also lack a fallback. The report by the working group on sterling risk-free reference rates was expected to be published at the end of March but finally arrived on May 29. Its content was criticised by observers for a lack of substance.

James Grand, partner at law firm Simmons & Simmons and member of the working group, says: “It’s very difficult to have that kind of technically detailed conversation remotely. And I think people are rightly concerned that conducting these discussions over the internet does create the problem that you might end up with a leak that could potentially wrong-foot the market.”

The vendors have a lot of work to do, especially for cash products. A lot of end-users rely on the vendors to be prepared

Credit valuation adjustment head at a US bank

Phil Lloyd, head of market structure at NatWest Markets, and co-chair of the risk-free rates communications group, says the delay in publishing the paper was due more to the volatility in March, and the industry trying to “find its new normal”.

Delays are occurring elsewhere. Third-party vendors have struggled to complete software projects designed to support the transition, sources say. Systems upgrades are seen as a crucial part of the benchmark change.

“The vendors have a lot of work to do, especially for cash products. A lot of end-users rely on the vendors to be prepared,” says a credit valuation adjustment head at a US bank. “If more vendors have a problem staying on track with timelines, that might slow down everything else.”

Another sticking point has been uncertainty over whether electronic signatures are legal. Some believe only certain documents can be signed electronically, and others must be physically signed with witnesses present, depending on the jurisdiction.

Grand at Simmons & Simmons says English law is clear on this: e-signatures are effective and can be used for the remediation process.

All aboard?

Although many of the large market participants may be on track, there are concerns their clients and counterparties aren’t.

Speaking in May, Jason Granet, head of firm-wide Libor transition at Goldman Sachs, described the cost and effort that some small institutions are facing during the transition. When visiting a small bank, Granet said the staff showed him a cupboard full of documents yet to be uploaded to electronic databases.

Many in the industry had expected to begin remediation processes and transitioning clients in the second half of this year, but that has now slipped to the beginning of next year.

Condensing the timetable to move clients across brings its own challenges and could reveal technological and operational gaps in the process, says a head of Libor at a US bank.

A split may be emerging in preparations for derivatives and for cash products. Swaps users are quietly optimistic that a forthcoming change in the discounting rate at European central counterparties will kick-start more issuance of swaps fixed to new risk-free rates.

Libor-transition-struggle montage
“For cash markets, I think the challenges are much greater than they already were”

On July 27, clearers will switch from Eonia to €STR to discount the value of future cashflows and calculate interest payments on collateral, known as price alignment interest, for interest rate swaps. US central counterparties will move from the federal funds rate to SOFR in mid-October.

The European deadline was delayed by five weeks from its original June date; the US deadline has remained unchanged.

Another imminent milestone may ease the transition for derivatives. In July, the International Swaps and Derivatives Association will publish a revised protocol for Libor-linked swaps to reference alternative risk-free rates en masse. Many dealers are waiting for the new protocol before starting the process of changing legacy Libor instruments and working out compensation payments for clients. The protocol will take effect from November.

“I think the derivatives market will be fine,” says the head of derivatives at the UK asset manager, adding ominously: “For cash markets, I think the challenges are much greater than they already were.”

Moans, groans and loans

The cash market was always going to be the toughest nut to crack for Libor transition. Loan users have long insisted that a replacement for Libor should have a forward-looking element – a principal factor behind the painstaking development of term versions of overnight rates.

On April 29, the Financial Conduct Authority announced a hefty six-month delay of the deadline for new loans expiring after end-2021 to cease referencing sterling Libor. The new deadline is March 2021.

“Pushing the date for new loans to switch to Sonia in the first quarter of next year really doesn’t give much time to deal with all of the stuff that’s going to be building up, or has already built up and continues to build up until that point,” says the head of derivatives at the UK asset manager.

The market’s lack of preparedness for Sonia was evident in the emergency loans announced by the UK government in April to assist businesses affected by Covid-19. The loans are linked to Libor or central bank base rates, rather than Sonia. In a parallel move, the Federal Reserve pegged its emergency loans to Libor after vocal opposition from the industry to using SOFR.

“The Federal Reserve loan facility does not use SOFR, it uses Libor. You can infer something from that in terms of operational readiness,” says the credit valuation adjustment head at the US bank.

Over the next couple of months, the sterling risk-free rates communications subgroup will be stepping up efforts to educate end-users about Libor transition, says Lloyd at Natwest Markets. The group plans to launch five-minute webinars focusing on core topics such as the difference between Sonia and Libor, and then later there will be short videos on specific parts of the transition.

But the group will have to shout to make itself heard above the hubbub of Covid disruption. Many corporate clients are still preoccupied with repairing damaged business models and shoring up finances, rather than focusing on Libor transition, says the head of derivatives at the UK asset manager.

“They will issue in whatever form is the most convenient for them, not thinking necessarily, ‘I must do it in Sonia or SOFR’,” says the head.

The date of 2021 is very challenging if you consider that we are 18 months out from the deadline and we haven’t yet observed a massive change in contracts to something other than Libor

Head of Libor transition at a European bank

A senior markets source says Covid-19 disruption means clients will probably look to transition later than previously planned. Although Sonia issuance was happening, particularly in the shorter maturities, uptake of the new reference rate hasn’t been significant. He says only a handful of corporate clients have begun asking about Sonia hedges for loans they are expecting to take out in the future.

The head of Libor transition at the US bank says that regulators may need to reconsider if end-2021 is an appropriate time for Libor to cease for legacy products. Allowing Libor to be published for legacy products after the end of 2021 for a short time may reduce operational and legal costs which will be hard felt by the market, particularly after the impact of Covid-19, the head suggests.

Lloyd at Natwest Markets points out that although regulators will not force panel banks to submit quotes beyond 2021, this doesn’t necessarily mean Libor has to end at that point. “The actual end of Libor could be somewhere between 2022 or 2023,” he says.

The official steering group responsible for benchmark transition in the US remains committed to the final deadline, though.

“It remains clear that the financial system should continue to move to transition by the end of 2021,” said a spokesperson for the Alternative Reference Rates Committee via email.

Most firms that spoke to for this article said they are pressing ahead with plans to transition away from Libor before the end of next year. The schedule may be more ambitious but the end goal remains the same. It appears that the irresistible force may cede to the immovable object.

Editing by Alex Krohn

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