US dollar Libor’s fate in doubt after IBA delays funeral plans

Decision to exclude US dollar Libor from cessation plan is being treated as effective extension

Ice and US dollar montage

Ice Benchmark Administration’s decision to exclude US dollar Libor from a plan that would see most other versions of the benchmark axed after 2021 is being taken as a sign that the rate could have a longer shelf-life than previously thought.

“The assumption is that [US dollar Libor] cessation will be pushed back by a minimum of six months to a year,” says Navin Rauniar, partner for Libor transition at Consultancy TCS.

IBA confirmed on November 18 that it will consult on its plan to cease publication of all Libor tenors denominated in sterling, euro, Swiss franc and yen after the end of 2021. It said the decision was made based on “information received from the panel banks and following discussions with the FCA and other official sector bodies”.

Some US lenders are treating IBA’s statement as an effective extension for US dollar Libor and “are now considering slowing transition and moving back to a wait-and-see approach”, Rauniar says. 

In a co-ordinated move, Libor’s regulator opened a two-month consultation on how legislation currently being considered by the UK parliament could be used to support so-called “tough legacy” contracts, which cannot be switched to new rates. The Financial Conduct Authority indicated it would create a “synthetic Libor” for the most heavily used sterling tenors. 

The developments suggest the US dollar Libor transition will proceed on a separate and slower track.

“In the UK market, I’d say this cements the path we’re already going down,” says Phil Lloyd, head of regulatory customer engagement at NatWest Markets. “The fact the [IBA] consultation to end Libor does not include dollar, optically does make it harder for broader parts of the market to get on the same path. Some might see it as increased likelihood dollar Libor will stay, but it could be that in two weeks or a month a consultation does start on dollar and it’s only a small delay.”

US dollar Libor’s anointed successor – the secured overnight financing rate, or SOFR – has faced scepticism from smaller regional banks, which deem the rate ill-suited to lending. A working group convened by US regulators to address those concerns has yet to settle on a solution. 

The market for SOFR-linked derivatives has also failed to take off. Data compiled by the International Swaps and Derivatives Association shows SOFR swaps traded just $253 billion notional in the first half of 2020, representing less than 1% of the $63 trillion traded in dollar Libor over that window. By comparison, swaps referencing Sonia – sterling Libor’s successor – represented more than half the $18 trillion notional of sterling swaps traded during the same period.

The assumption is that [US dollar Libor] cessation will be pushed back by a minimum of six months to a year
Navin Rauniar, Consultancy TCS

Swaps activity is a pre-requisite for building a robust term SOFR rate, which could kick start transition in trade financing and other short-dated lending transactions that require forward rate visibility.

The decision to exclude dollars from IBA’s consultation is understood to be a nod to legislative efforts currently afoot in the US to deal with tough legacy contracts. 

Federal legislation currently being drafted by Democrats in Congress would provide safe harbour for contracts without adequate fallback language to be re-hitched to alternative rates when Libor dies.  The bill closely mirrors legislation taken up by the New York State legislature and initially proposed by the Alternative Reference Rates Committee – the Federal Reserve-backed group tasked with transitioning markets to SOFR.

The Federal Reserve is also understood to be working on a mechanism that would give time-limited relief for tough legacy contracts to mature on their existing basis in the event of Libor’s demise. At a Senate banking committee hearing on November 10, Fed vice-chair for supervision Randy Quarles said a fix would be forthcoming in the next two months.

Some say it makes sense to test the cessation process with smaller markets and iron out any wrinkles before pulling the plug on US dollar Libor.

Maybe this is an indication that the dollar consultation will only occur once the dust has settled on these less contentious rates
Sharon Freeman, Antevorta Consultants

“It’s sensible to deal with the low-hanging fruit acting as a litmus test to give us an indication of readiness: client awareness, the state of contracts, pipework, etcetera,” says Sharon Freeman, benchmarks regulation consultant at Antevorta Consultants. “It would be reckless to start doing a dollar cessation first given its extensive use. Ending sterling is not really going to make much of a difference, because Sonia is a mature market and there are not vast exposures from a global perspective.”

Data from the Bank for International Settlements shows $109 trillion of dollar-denominated interest rate swaps outstanding at the end of June, compared with $38 trillion-equivalent of sterling swaps.

Freeman notes IBA’s consultation is on ending publication of the four Libor currencies after – rather than on – December 31, 2021. “Maybe this is an indication that the dollar consultation will only occur once the dust has settled on these less contentious rates,” she says.

Rauniar at TCS agrees it is premature to consult on ending US dollar Libor. “The market is not ready to move off dollar Libor yet, and this gives smaller banks time to wait for a term SOFR rate, and potential additional Iosco-compliant risk-free rates,” he says.

Others warn against reading too much into IBA’s consultation. The FCA could still label US dollar Libor as a non-representative rate, alongside other currencies and tenor pairs, regardless of whether the market has been consulted.

Such an announcement is now expected in late January at the earliest. The FCA’s consultation on new benchmark powers granted under the UK government’s pending Financial Services Bill – which would permit the regulator to force publication of a new, formula-based version of Libor – is due to close on January 18. Isda’s fallback protocol will become effective a week later – on January 25 – meaning trillions of dollars of US Libor swaps would be poised for a smooth transition to SOFR.

“Once regulators know that enough counterparties will fall back to SOFR plus a spread as a result of adhering the protocol, it paves the way to proceed with the plan,” says Fabien Carruzzo, head of the derivatives and structured products group at Kramer Levin. “I wouldn’t see this as a delay. I think regulators could act quite quickly, and if they do I don’t think they would leave US dollars aside. US dollar Libor is still an issue and one can argue it’s not representative right now.”

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