Preparing for transition amid Covid‑19 delays

Arguably, banks have most to lose from transition away from Libor. Together with the sheer volume, value and range of contracts affected, the move to alternative reference rates makes product pricing and hedging more complex, and puts additional strain on resources, systems and processes. But, as banks get to grips with these large-scale change programmes and monitor the evolving regulatory and industry developments, the process also signals a key opportunity to rethink portfolios and refocus key client relationships, with rich rewards for those who plan and execute their strategies effectively. Two European banks respond to some of the key questions being posed in the current environment

Arguably, banks have most to lose from transition away from Libor. Together with the sheer volume, value and range of contracts affected, the move to alternative reference rates makes product pricing and hedging more complex, and puts additional strain on resources, systems and processes. But, as banks get to grips with these large-scale change programmes and monitor the evolving regulatory and industry developments, the process also signals a key opportunity to rethink portfolios and refocus key client relationships, with rich rewards for those who plan and execute their strategies effectively. Two European banks respond to some of the key questions being posed in the current environment

The panel 

• Subadra Rajappa, Head of US Rates Strategy, Societe Generale Corporate & Investment Banking
• Ian Fox, Group Ibor Transition Director, Lloyds Banking Group

To what extent will central counterparty (CCP) discounting switches act as a catalyst for secured overnight financing rate (SOFR) swap liquidity?

Subadra Rajappa, Societe Generale

Subadra Rajappa, Societe Generale: The ‘big bang’ transition to SOFR discounting and price alignment interest is in an important step in the transition from Libor to SOFR. As investors get more comfortable with SOFR as a benchmark, this could perhaps encourage trading in longer maturity swaps. That said, it is unclear if a CCP discounting switch will be the catalyst for liquidity in SOFR swaps. While the availability of a SOFR discounting curve and greater price discovery are positives – especially for longer maturities, where there are few SOFR swaps transactions – it might not be enough to encourage investors to make the switch. Ultimately, liquidity in SOFR swaps will depend on end-investor commitment to participation in SOFR swaps, which is still somewhat limited. The risk of an early announcement by the UK Financial Conduct Authority (FCA) of the cessation of Libor should hasten the transition to SOFR, although that has not yet happened. With the big-bang transition to SOFR discounting and broader adoption of International Swaps and Derivatives Association (Isda) fallbacks, the approaching deadline of Libor cessation should encourage greater participation and higher liquidity in SOFR derivatives.

Ian Fox, Lloyds Banking Group: It is hoped that the USD discounting switch to SOFR will be a catalyst for increased liquidity in SOFR derivatives, but how much of an impact it will have remains to be seen. The reality is, current liquidity in USD swaps is very poor compared with GBP and needs to increase soon to enable transition of other products.

 

Given the growing interest in alternative credit-sensitive benchmarks in the US, will SOFR remain the dominant rate? What are the pros and cons of a multi-rate environment?

Ian Fox, Lloyds Banking Group

Ian Fox: I would expect SOFR to be the dominant rate for USD derivatives, but it appears likely there will be a number of alternative rates in use across cash products, determined partly by the nature of the product and partly by the sophistication of the user. A multi-rate environment means that rates can be tailored to particular needs, but also that liquidity is diluted. The key is to ensure sufficient liquidity in each rate being used such that it is reliable and robust.

Subadra Rajappa: While alternative credit-sensitive benchmarks are gaining popularity and wider acceptance, I expect SOFR to remain the dominant rate as it is widely endorsed as the benchmark of choice by global regulatory agencies. A large volume of overnight transactions – a requirement for compliance of International Organization of Securities Commissions principles – is the mainstay of the new benchmark that is harder to achieve with other new and existing alternatives. While there is a case to be made for the coexistence of multiple benchmarks – especially now that SOFR is quite different from these benchmarks – historically, multiple benchmarks have struggled to coexist as investors tend to favour the most widely accepted and liquid. Despite its many flaws, Libor has remained popular since inception, with large volumes of cash and derivatives contracts contributing to liquidity, contrary to effective Fed funds or the sterling overnight index average (Sonia), both of which have coexisted with Libor for some time now. The advantage of a multi-rate environment is that investors get to choose the benchmark that best reflects their business needs and risk exposures. The downside is a bifurcated market, resulting in incompatibility between securities and trading instruments, poor liquidity and increased transaction costs. 

 

What are the main use cases for term SOFR/term Sonia?

Ian Fox: The paper issued by the Working Group on Sterling Risk-Free Reference Rates (RFR WG) in the UK gives clear guidance on the use cases for term Sonia: for less sophisticated customers (generally those not active in derivatives) and for products that clearly need a term rate at the start of the interest period (invoice discounting is a prime example). The expectation in the UK is that products that can use daily compounded Sonia in arrears should do so – being derivatives and circa 90% by value of cash products. The position is less clear-cut in the US, not least because Libor is currently used in a wider range of – particularly retail – products than in the UK. I expect term SOFR will be one of the range of alternative rates that replace Libor in the US.

 

How widely will Isda’s fallback language protocols be adopted by the market?

Subadra Rajappa: The market is expected to widely adopt Isda fallbacks as a part of prudent planning for transition. The sell side and – based on conversations with clients – probably around half of the investor community, including most of the larger asset managers, are going to sign on. Others will look at it after the protocols go live. So a good proportion of financial institutions are likely to sign up in the couple of months following the mid- to late-January 2021 effective date for the protocol. 

But there is still a high level of uncertainty among the broader participants in the swaps market as to whether they will be adopting the protocols. Over time, if they see a critical mass, they’re more likely to push for it and get it done. 

Regulators are counting on very swift adoption of the protocol – especially in light of the comments by Edwin Schooling Latter, head of markets policy at the FCA, that an announcement about Libor’s cessation could come as early as November. That proclamation is only consequential to those who have signed on to the protocol, because embedded in the protocol is language that would trigger a fallback if Libor is deemed an unrepresentative benchmark.  

Ian Fox: The FCA has made it clear it expects regulated firms to adopt the Isda protocol, and that any firm with significant derivatives exposure that chooses not to sign will need to be ready for some serious questions from their supervisor. That pretty much sets the scene for the UK. In the US, adoption is strongly recommended by the Alternative Reference Rates Committee (ARRC) and indications are that the majority of market participants will sign up.

 

How has the Covid-19 pandemic affected market participants’ transition plans? What are the main milestones firms should be focusing on?

Subadra Rajappa: The pandemic definitely affected the transition – initially, at least, given the focus on getting systems set up to work from home. The expectation in March was that transition would be delayed. But that changed quite abruptly with the announcements from the FCA and all of the US regulatory agencies that showed a strong commitment to sticking to the timeline. So urgency started to pick up again on the transition effort.

The road map set out by the ARRC is probably the best strategy that markets should be looking to adopt, but little progress has been made since the introduction of this road map. This is because participants are waiting for two key events – one is the signing of the Isda protocol; the other is the big bang of the SOFR discounting switch. 

If you look at volume of trades that are happening in SOFR, it’s still minuscule, so we need some critical mass and some external events to push it along. There is a lot riding on market expectations for these two events to be the trigger for broader adoption of SOFR-based derivatives. The questions centre around what happens afterwards if change is still slow to come. There will need to be a strong communications nudge from the ARRC and global regulators to move the market.

Ian Fox: Covid-19 hit us around the time that the RFR WG and authorities had planned to launch a range of events to communicate about Libor transition more broadly across the market, and banks were also planning bulk client outreach exercises. Clearly, those activities were put on hold as customers and banks dealt with more pressing needs. Now that immediate Covid‑19 pressures on businesses and banks have eased, it is time to re-engage on customer communication and to begin back-book transition activity.

The RFR WG’s milestones for the third quarter of 2020 are now upon us, so participants should be aware that new Libor loans will only be offered with mandatory transition language. From the end of Q1 next year, even that option disappears and no new GBP Libor loans will be available. In derivatives, GBP linear Libor derivatives are also expected to cease from the end of Q1 2021. The message is clear that Libor will cease sometime after the end of next year, and availability of Libor products will start to reduce rapidly from now, so participants need to make sure they are prepared.

 

^{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}

 

Libor Risk – Quarterly report Q3 2020
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