Calling time on Libor – Half empty or half full?

A critical halfway stage has been reached on the Libor transition journey – at least in terms of timing. It’s just over two years since the UK’s top financial regulator called notice on the discredited benchmark. It’s also just over two years until the rate could cease to exist. When it comes to action, however, it’s not clear whether this halfway point is even in sight given a to-do list that never seems to stop growing.

Much has happened since mid-2017, when the UK’s Financial Conduct Authority (FCA) chair, Andrew Bailey, made life without Libor a reality by freeing panel banks from the shackles of Libor quote submission after 2021. Most crucially, perception has gradually shifted. Denial has been replaced by widespread acceptance that Libor’s days are numbered, accelerating efforts to embed regulator-preferred successor rates throughout the system.

There’s a long way to go, but in some markets, alternative risk-free rates (RFRs) have become the norm when entering new trades.

New sterling floating rate bond issues are a prime example. Here, the Libor habit has been kicked altogether as every new issue in 2019 has been pegged to the sterling overnight index average (Sonia) – Libor’s successor in UK markets. In the US, the secured overnight financing rate (SOFR) now underpins $236 billion of floating rate notes (FRNs).

New cash instruments still linked to US dollar Libor – FRNs, loans and securitisations – now have standard fallback language detailing how new Libor instruments fix to alternatives in the event of the benchmark’s demise. In swap markets, half of new sterling swap notional cleared at LCH is now linked to Sonia.

That’s the easy part of the journey. When it comes to transitioning the $350 trillion stock of legacy instruments linked to interbank offered rates (Ibors) on to next-in-line rates, hardly a dent has been made.

That’s not to say there aren’t bright spots. In June, UK port operator Associated British Ports (ABP) became a poster child for Libor transition, the first corporate to re-reference legacy public debt from Libor to Sonia. The firm also switched more than £500 million of interest rate and cross currency swaps to the overnight rate.

In practice, ABP’s success is tough to replicate. Altering terms on public bond issues requires consent from a vast majority – sometimes 100% – of bondholders, which are widely dispersed and difficult to locate on notes that may change hands multiple times in secondary markets.

Derivatives have a shortcut. Governed by standard documentation, swap contract changes can be made en masse via a protocol. The International Swaps and Derivatives Association is now finessing final methodology for standard fallbacks, but the devil is in the detail, and that is still being thrashed out.

For three Libor currencies, industry participants have settled on a backward-looking, compounded-in-arrears rate for swap fallbacks, which maps overnight benchmarks to the term nature of Libor. The remaining currencies look likely to follow suit. A new consultation, launched on September 19, will establish the methodology for calculating a fixed spread to be loaded on top of RFRs – to bridge the gap between overnight RFRs and interbank lending, which incorporate a credit spread.

It is yet to be decided whether swap fallbacks should only kick in upon Libor’s death, or whether ‘pre‑cessation triggers’ should be included, allowing swaps to make the leap in the event regulators deem the ailing benchmark to be unrepresentative.

When it comes to more exotic instruments, the route to the finish line is paved with little more than guesswork. For example, a market for Sonia swaptions is beginning to emerge, but will struggle to zoom ahead with no standardised settlement benchmark. Swaptions traders use Ice swap rate – a measure of vanilla interest rate swap prices – to value and settle contracts. Currently the rate is calculated only for Ibor-linked swaps, but this could change. The rate’s administrator, Ice Benchmark Administration, is consulting on a version linked to Sonia swaps. There’s a snag, however. The Ice swap rate methodology uses only firm prices from electronic central limit order books. Sonia swaps still only trade via request-for-quote protocols – an issue recently picked up by the FCA, which is spearheading efforts to push the instruments on to lit venues.

Buy-side preparations are patchy, at best. BMO Global Asset Management is leading the pack, having switched £10 billion of pension liability swap hedges to Sonia, but others are still in the dark. Insurers are forced under Solvency II to discount their liabilities to a Libor-linked curve approved by the European Insurance and Occupational Pensions Authority (Eiopa). There’s little clarity from Eiopa over how and when this curve will be adapted to RFRs, putting instruments linked to the alternative rates out of reach for many insurers.

At a recent industry conference, a bank treasury head in Asia warned that basic technicalities are little understood by the buy side in the region and that many have “absolutely no clue what is going on”.

There’s no magic fix, but some turbo-charged remedies look promising. For example, machine learning and natural language processing have already proved their worth in sifting through financial contracts and picking out those that may require the most immediate attention.

It might take more than advances in artificial intelligence to smooth the transition from Libor. The derivatives and cash markets have work ahead before they can confidently dispose of the ubiquitous Libor benchmark.

Participants may need a fortifying drink – even if their glass is only half full.

Libor transition and implementation – Special report 2019
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