Basis spreads reprice as FCA confirms Libor end-dates

Fallback adjustments for US dollar Libor swaps were not fully priced in by the market

US dollar Libor markets repriced on March 5 after the UK's Financial Conduct Authority confirmed the end-dates for the discredited benchmarks, fixing the spreads at which more than $300 trillion of interest rate swaps will transition to replacement rates.

Publication of most Libor benchmarks will cease on December 31, 2021, while five US dollar versions will continue for another 18 months for use in existing contracts. The announcement triggered the calculation of fallback spreads designed to smooth the move to new risk-free rates (RFRs).

Three-month sterling Libor will be replaced by a three-month version of Sonia, plus a spread of 11.93 basis points. This rises to 25.66bp for the six-month rate. The fallback spreads for three- and six-month US dollar Libor were set at 26.16bp and 42.83bp, respectively.

The US dollar Libor markets, where participants had been second-guessing the timing of the spread calculations, adjusted quickly to the news. Prior to the announcement, the 3s/6s basis for two-year swaps forward starting in three years (3y2y) was quoted at just 14.1bp. Soon afterwards, this widened by 12.8% to 15.9bp – some 0.75bp shy of the 16.67bp gap between the final fallback spreads.

The remaining gap likely reflects the possibility of US dollar Libor continuing beyond its scheduled end-date in mid-2023. “While the spread is now known with certainty, there’s always the very small tail risk the cessation date moves again,” says Henry St John, a US rates strategist at JP Morgan. “If the timeline were to be pushed back for whatever reason, the fallback itself wouldn’t change, but we’d just inadvertently have a few more cashflows on those swaps coming from 'real' Libor sets, rather than the fallback.”

The 3s/6s basis for spot-starting five-year swaps widened nearly 11% from 8.225bp to 9.125bp, while the 1s/3s basis jumped over 14%. The reaction in the futures market was more muted. The spread between June and September 2023 eurodollar contracts climbed 1.1bp, or 4.7%, to 24.5bp – leaving it 1.7bp short of the 26.2bp fallback spread for three-month US dollar Libor.

 

The FCA's announcement had little effect on Libor swap pricing in sterling markets, which had been anticipating the FCA's announcement.

“It has been very orderly. I think it reflects good communication leading up to the announcement,” says Ivan Jossang, managing director at Morgan Stanley. "I think the derivative markets are now pretty much done. Transition market risk is becoming smaller and smaller and is primarily an operational challenge.”

The 3s/6s basis for spot-starting five-year swaps referencing sterling Libor moved less than 1%, from 12.75bp to 12.8bp. 

“It’s been priced in for a while,” says a buy-side trader at a European insurer. “The banks we’ve been talking to all thought the announcement was going to come in February and the market levels reflect that.”

The fallback spreads were devised by the International Swaps and Derivatives Association to avoid a step-change in rates when Libor ceases publication. Unlike Libor, the RFRs that will take its place do not incorporate bank credit risk, so will typically be lower than the outgoing benchmark. The spread adjustments are calculated by taking the five-year historical median of the basis between each Libor benchmark and its replacement rate. The spreads will be added on top of the relevant RFR to minimise value transfers. The fallback arrangements were inserted into legacy Libor contracts en masse via a voluntary Isda protocol, which took effect on January 25.

The 3s/6s basis is a widely traded proxy for the final spread adjustments. When the fallbacks are triggered, three-month US dollar Libor will be replaced by a three-month version of the US secured overnight financing rate, or SOFR, plus the spread adjustment. Six-month US dollar Libor will also be replaced by six-month SOFR, plus a different spread adjustment.

At that point, the 3s/6s basis will be dominated by the difference between the fixed fallback spreads for three- and six-month US dollar Libor, since the difference between three- and six-month SOFR has historically been fairly minor. That makes it highly sensitive to the timing of the fallback spread calculation.

Traders betting on the 3s/6s basis suffered severe losses last year after the most heavily used US dollar Libor settings were given an 18-month reprieve, causing the spread to collapse. A later fixing would have resulted in a lower spread adjustment, given the current low-rate environment.

Liquidity in the US dollar Libor basis market has worsened since then, and deteriorated further this week following the recent volatility in fixed income markets. “Engagement on leveraged basis trades targeting a convergence of 1s/3s and 3s/6s to the likely fallbacks had been a lot lower after the volatility we saw in early December,” says St John. “But all things considered, the news seemed to be well absorbed.” 

 

Isda’s fallbacks protocol will automatically apply the spread adjustments to outstanding bilateral Libor contracts when they transition to new RFRs. The fallback spreads are also being adopted by clearing houses, including LCH and CME, when they switch contracts to reference RFRs ahead of Libor's cessation. A so-called ‘synthetic Libor’ designed for use in tough legacy contracts with no fallback arrangements will incorporate the same adjustments.

An exception is being made for contracts referencing one-week and two-month US dollar Libor. These benchmarks will cease at the end of the year, alongside sterling, Swiss franc, yen and euro currency settings. However, contracts referencing one-week and two-month US dollar Libor will not immediately trigger fallback clauses. Instead, they will reference a synthetic version of these benchmarks, calculated using a linear interpolation of next-door tenors – for instance, two-month US dollar Libor will be based on the one- and three-month settings, which 14 panel banks will continue to support with quotes for an additional 18 months. Fallbacks for US dollar Libor settings will trigger across the board after June 30, 2023.

This approach was set out in Isda’s ‘discontinued rates maturities’ protocol, which was published in 2013 and was incorporated into the fallback methodology. The protocol allows swaps contracts to continue referencing a Libor-based rate instead of a fallback based on a different benchmark as long as Libor is still available. 

“It makes perfect sense because to trigger the fallback now for a rate that’s not really going to cease for another two years would seem bizarre. It could end up being completely detached form the reality of where the rate should be in a couple of years’ time,” says the buy-side trader at the European insurer.   

Synthetic alternatives

The FCA will also consult the market in the second quarter on the use of new legal powers to compel Libor's administrator, Ice Benchmark Administration, to continue publication of so-called ‘synthetic Libor’ for tough legacy contracts. This alternative methodology, comprising a term version of the relevant RFR plus the Isda spread, is under consideration for one-, three- and six-month sterling settings. The FCA will also consult on similar approach for yen settings for a period of 12 months and consider creating synthetic versions of some US dollar settings.

“There’s a big question around what’s going to be included in the definition of legacy and actually be allowed to use synthetic Libor. I think there’s going to be an awful lot of stuff falling into this tough legacy bucket – much more than they originally envisaged,” says the buy-side trader.

 

The FCA estimates the volume of tough legacy contracts outstanding has been whittled down from $260 trillion to $15 trillion, due to strong take-up of Isda's fallback protocol and moves by CCPs to switch contracts to successor rates. The regulator also estimates more than a quarter of bonds referencing sterling Libor have transitioned via consent solicitations.

According to the International Capital Markets Association, more than 500 sterling Libor bonds still remain with maturities beyond 2021, rising to 750 including securitisations. More than 3,400 US dollar Libor bonds remain outstanding under English law. 

“In many areas – such as bonds, securitisation and trade finance – where these triggers do not exist, there is a much larger repapering exercise left to be done to avoid being left with positions referring to a rate that no longer exists,” says Guy Usher, partner at Fieldfisher.

He adds that derivatives users should not rely on fallbacks, but consider active transition. “Institutions can, and probably should, still look to replace their Libor exposures now, rather than having to apply Isda fallbacks when Libor is ultimately discontinued or becomes non-representative.”

Additional reporting by Ben St Clair