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Libor Risk Q&A – Murex

How Covid‑19 is impacting transition preparations

Alexandre Bon, Group co-head of Libor and benchmark reform, and head of marketing and strategy, Asia‑Pacific, at Murex, discusses key industry concerns around the transition away from Libor, including how the discontinuation deadline will be impacted by the Covid‑19 pandemic, the benefits and challenges of pre-cessation triggers, and how firms are preparing for ‘big bang’ discounting switches

Considering the impact of the Covid‑19 pandemic, how realistic is the end‑2021 deadline for Libor’s discontinuation? 

Alexandre Bon, Murex
Alexandre Bon, Murex

Alexandre Bon, Murex: To date, there is no obvious sign that the end‑2021 deadline for Libor panel bank submission should be impacted by Covid‑19. The official sector is vocally reaffirming that Libor may not exist past 2021, and the UK’s Financial Conduct Authority (FCA) has reiterated it has no intention to revisit the deal struck with panel banks to compel contributions thereafter. However, major dealers might keep the benchmarks afloat through voluntary contributions for a while – especially if they find this to be in their interest. 

The Covid‑19 situation has also negatively impacted some preparation work. Some interim milestones were pushed, such as the euro short-term rate discounting switch or the deadline for issuing GBP Libor-denominated loans, adoption in the cash markets is now behind schedule – which is why national emergency loan programmes are still relying on Libor – and many banks’ client outreach efforts have slowed down during the turmoil. 

Certainly, the risk-free rate (RFR) working groups are closely monitoring the situation, and some relief may be granted later if it appears the market cannot meet the deadline. This does not seem justified yet, so I would not expect any official statement to that effect before next year.

Finally, one possible scenario is that not all Libor publications cease on the same date – GBP Libor could be discontinued before USD Libor, for example – which could bring some relief but also new challenges. It is still too early to tell.   

 

The FCA has extended the deadline for participants to cease issuance of cash products linked to Libor to the end of the first quarter of 2021 – what additional preparation is needed to ensure Libor cash products are no longer issued?

Alexandre Bon: An official RFR forward-looking term rate publication will, once again, make it possible to offer products with an upfront fixing structure. This can ease RFR adoption by corporate small and medium-sized enterprises, so the earlier the better. 

Second, we should stop looking at the transition in cash and derivatives markets as two distinct issues. Cash product issuances require liquid swap and derivatives markets to offer adequate hedging solutions. Both segments feed each other, so it is essential to encourage consistency and develop market conventions at a similar pace. So far, some divergence between both markets has compounded complexity and created some confusion – one example is whether RFR term rates can be used in fallback language or in new product issuances. Banks cannot yet offer black-and-white answers to their customers, which slows adoption.  

 

Considering the discrepancies between the two benchmarks in March, what can we learn about the suitability of the secured overnight financing rate (SOFR) as a viable fallback for US dollar Libor contracts? 

Alexandre Bon: Both SOFR and Libor behaved largely as expected, the spread widening was a rather logical outcome – and the jump far less pronounced than in the financial crisis that began in 2007–08. Not surprisingly, the SOFR proponents saw the confirmation that Libor was a flawed index and SOFR a better alternative, while to some SOFR sceptics this highlighted what they perceived to be issues with the new rate. The debate around whether SOFR is the most adequate fallback option still rages on, though – in practice – transition work is progressing on this assumption. 

More interestingly, the sudden widening of the Libor-SOFR spread seems to have raised awareness about the inherent risk of value transfers within the International Swaps and Derivatives Association’s (Isda’s) fallbacks. For instance, we have recently seen clients accelerate the work on alternative transition plans for portfolios they were initially thinking of managing through default fallbacks.    

 

What role will alternative, credit-sensitive benchmarks, such as Ameribor and the Ice Bank Yield Index, play in transition, and will multiple versions prevail?  

Alexandre Bon: Until now, most of the work has focused on SOFR. However, we have seen some expression of interest for credit-sensitive benchmarks – Ameribor in the US domestic market, for example. Ultimately, the $350 trillion question is whether the market prefers to use several kinds of benchmarks depending on activities and market segments, or whether the benefits of using a single common rate outweighs the view of some that SOFR is less adapted to their needs. The jury is still out.

 

Industry opinion appears to be moving in favour of pre‑cessation triggers – what are the challenges and benefits of this approach, particularly in light of current market uncertainty? 

Alexandre Bon: A first unknown is the duration of the ‘zombie-Libor’ period between the publication of a non-representative Libor and final cessation. It could be weeks or months. A fast phase-out minimises discrepancies between contracts transitioning at pre-cessation and cessation points, as well as the risks of manipulation. However, too short a period may not allow effective dealing with products that are difficult to transition, which seemed to have been the FCA’s initial concern. 

Even with consensus in favour of pre-cessation triggers, we should expect a sizeable portion of the market to prefer cessation triggers – at least for some parts of their portfolios – which could jeopardise the wide adoption of the upcoming Isda protocol. Hence, if the sentiment is that permanent cessation might only occur months after the pre-cessation trigger, we may see even more institutions exploring alternative transition strategies and custom fallback arrangements.    

 

What steps should firms take to prepare for Libor transition and how are firms coping with the operational challenges involved?

Alexandre Bon: The first step is reaching out to business partners to understand their views and needs for the transition. Will they sign the Isda protocol? Do they plan to repaper their credit support annexes (CSAs) and negotiate compensation for the discounting switch impact? Do they intend to transition their derivatives books early? Only then would you get a clear picture of all the variations, options, complexities and new business opportunities you should prepare for. 

Finally, transition events, such as the discounting switch or transaction fallbacks, bring huge operational complexity and significant challenges for infrastructure and back offices. For example, trades undergoing a fallback will use different fixing conventions than new trades on the corresponding RFR. Firms need to automate the corresponding contracts’ transformation – including specific adjustments for broken periods, treatment of foreign exchange-implied indexes or the application of custom fallback arrangements – and efficiently streamline the corresponding impacts across all business processes: settlements, profit and loss (P&L), hedge accounting, value at risk, confirmation messages, connectivity to market platforms and initial margin/value margin reconciliation. The impact on systems and processes should not be underestimated and will need to be tested well in advance. 

 

How are firms preparing for ‘big bang’ discounting switches, which central counterparties (CCPs) plan to run in July and October?  

Alexandre Bon: The priority is on anticipating the valuation impacts – P&L, sensitivities, valuation adjustments (collectively known as XVA) – and rebalancing hedges. A good proportion of Murex’s clients have relied on our Libor impact analysis features and its tool for emulating the CCPs’ swap-compensation mechanisms, and I believe most institutions seem well on track on this front. More advanced firms are now working on the thornier issues of the swaptions impacted by the discounting switch and the renegotiation of CSAs to realign collateral rates with the CCPs’ standards.

 

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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