Chickens, eggs and Libor fallbacks

The transition away from Libor is littered with ‘chicken and egg’ conundrums. Deep cash markets linked to new risk-free rates (RFRs) require a liquid derivatives market for issuers to hedge exposures, yet RFR derivatives liquidity can only blossom where ample cash activity sparks a real hedging need. Similarly, the development of term RFRs relies on plentiful swaps trading, but there’s a reluctance to adopt the new rates while they lack forward visibility. 

The latest causality dilemma relates to the timing of Libor’s death notice and an industry-wide protocol aimed at inserting standard fallback language in legacy swaps. 

Regulators suggest widespread uptake of swaps fallbacks would be a trigger for slapping an end date on withering benchmarks. Yet Libor users view the regulator’s cessation notice as the trigger for signing up to the fallback protocol.

Speaking at a Risk.net virtual event in June, Edwin Schooling Latter, head of markets policy at the UK Financial Conduct Authority (FCA) said there was a “good case” for a cessation announcement to be made once fallbacks had been inserted into swaps contracts. He added this could happen before year-end, giving 12 months’ notice of Libor’s demise. 

At that point, the International Swaps and Derivatives Association-led protocol and updated definitions were set to take effect in November. Now, after crawling its way through the US Department of Justice antitrust process, the protocol effective date has been pushed back to January 25. 

In theory, this could cast a Libor cessation notice out to 2021 and scupper any plan to shut down the rates according to the original end-2021 timeline, assuming the full 12 months’ notice etched in the Ice Benchmark Administration’s Libor rulebook. Unless, of course, the FCA opts to sign Libor’s death warrant before the protocol becomes effective. 

It’s certainly an outcome many Libor users prefer. In a September Risk.net webinar poll, more than half of participants said they would sign up to the fallback protocol only when a cessation notice had been made. Almost 9% said they had no intention of signing it at all. 

There’s good reason why many want to wait. A Libor cessation notice would lock in the credit spread adjustment for switching from Libor to its successor benchmarks. Those signing up with knowledge of Libor’s end date would do so with greater certainty of the economics. 

This interplay between the protocol and announcement timing may not be helpful to either, some warn. “The protocol is a very critical event, and having it completely stacked up against the announcement makes it a bit more challenging,” said Ivan Jossang, managing director in Morgan Stanley’s fixed income division, speaking at the September webinar.

There may be a middle ground. Swaps users will have a minimum of three months to sign up from the October 23 launch. Banks will be encouraged to adhere in escrow in the two-week run-up. It means the protocol could have high adoption at launch, which may give the FCA enough comfort to sound an early death knell.  

Yet there are many other considerations. Legislative powers aimed at mopping up tough legacy contracts by granting the FCA powers to create a ‘synthetic’ Libor are yet to be enacted. Exactly how and when this safety net rate can be used is yet to be thrashed out. 

“I would expect those things in an ideal state to be sorted out prior to any announcement,” said Doug Laurie, Barclays’ programme lead for wholesale technology and change, at the September webinar. 

Anyone waiting for a 2020 announcement should not hold their breath.

Libor Risk – Quarterly report Q3 2020
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