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October 16, 2020
LIBOR has been deeply rooted in financial markets for over three decades, serving as the benchmark for everything – from consumer contracts to $190 trillion of USD interest rate derivatives.1 In fact, Interbank Offered Rates are referenced in approximately $400 trillion2 of wholesale and consumer global transactions.
However, following the global financial crisis, reforms prompted the U.K. Financial Conduct Authority (FCA) — tasked with overseeing LIBOR administration — to raise questions about the future sustainability of LIBOR. In response, regulators and market participants across the globe have identified alternative reference rates that are compliant with the standards issued by the International Organization of Securities Commission (IOSCO).
Global regulators have indicated that they expect LIBOR and other interest rate benchmarks to be phased out by the end of 2021. However, adoption and meaningful volumes in transactions that reference alternative Risk-Free Rates (RFR) may not presently be sufficient to ensure a smooth transition. For example, with derivatives, RFR transactions account for only 3.4% of total notional interest rate derivatives traded across 2018 and 2019.3
J.P. Morgan continues to provide leadership in this transition, engaging with our clients and being actively involved in public sector National Working Groups (NWGs), including the Alternative Reference Rates Committee (ARRC) in the U.S. and the Sterling Working Group on Risk Free Rates (RFRWG) in the U.K., to promote transition to alternative benchmarks. Below, we consider the progress made, and with the various challenges posed in further market adoption, the regulatory guidance and incentives provided for the transition away from LIBOR across cash and derivatives.
Significant drivers of change are emerging in regions where alternative RFRs have been proposed:
In June 2017 the Secured Overnight Financing Rates (SOFR) was identified by the ARRC as the recommended alternative to LIBOR, but the proportion of interest rate derivatives traded notional referencing SOFR remains small; it accounted for only 0.23% of U.S. dollar interest rates derivatives, and 0.15% of total IRD traded notional in 2019.4
Counterparties are highly encouraged to adapt their internal systems to offer RFRs. They should also understand the operational and economic implications associated with discounting changes for both cleared and non-cleared trades.
In the U.K., a more liquid market exists for swaps and futures based on the sterling RFR, Sterling Overnight Index Average (SONIA). According to the International Swaps and Derivative Association (ISDA), SONIA-traded notional equaled U.S. $8 trillion, with SONIA swaps representing 92.2% of transactions referencing alternative RFR (e.g., SOFR, SONIA, SARON, TONA and €STR) in 2019.5 Also, on January 15, 2020, it was reported6 that £700bn of SONIA volume was traded in a single day – a record at the time.
However, the majority of SONIA liquidity still resides in the short-end of the curve, with tenors of two years or less.
The pace of RFR market adoption will continue to vary across regions and impact cross-currency markets.
Unlike Libor, which is centrally managed by a single administrator across all five currencies, all of which bear similar features, each alternative risk-free rate has different characteristics. Accordingly, the pace of market adoption has, and will continue to, vary across regions, which will no doubt have an impact in cross-currency markets.
|Currency||“RFR” pre-reform||Administrator||Current “IBOR”(s)||Administrator||New “RFR”||Administrator||Type||New “RFR: Rates Published||Publication Timing|
|USD||USD Fed Funds||Federal Reserve Bank of New York||USD Libor||ICE Benchmark Administration||SOFR (Secured Overnight Financing Rate)||Federal Reserve Bank of New York||Secured||Apr 2018||At 10am the next business day|
|EUR||EONIA||European Money Markets Institute||Euribor||European Money Markets Institute||ESTR (Euro Short-Term Rate)||European Central Bank||Unsecured||Oct 2019||At 8am the next business day|
|GBP||SONIA||Wholesale Markets Brokers’ Association Ltd (up to April 2018)||GBP Libor||ICE Benchmark Administration||Reformed SONIA (Sterling Overnight Index Average)||Bank of England||Unsecured||Apr 2018||By 9am the next business day|
|JPY||TONAR||Bank of Japan||JPY Libor
JBA TIBOR; Euroyen TIBOR
|ICE Benchmark Administration
JBA TIBOR Administration
|TONAR (Tokyo Overnight Average Rate)||Bank of Japan||Unsecured||Jul 1985||At 9am the next business day|
|CHF||TOIS||ACI Suisse||CHF Libor||ICE Benchmark Administration||SARON (Swiss Average Rate Overnight)||SIX Swiss Ex ge||Secured||Aug 2009||At 6pm the same business day|
Source: J.P. Morgan, May, 2020
Additionally, a number of significant hurdles remain in the path to RFR adoption:
Existing contractual language may not have considered a permanent cessation of LIBOR. As a result, amended fallback language may need to be incorporated into existing contracts. Following pre-cessation consultation results published on April 15, 2020, ISDA plans to publish a protocol on October 23, 2020 to allow market participants to amend existing derivatives contracts to include robust fallback language.7
Simultaneously with the publication of the protocol, ISDA will publish revised interest rate definitions containing the protocol fallback language which can be incorporated into new transactions. This will become effective January 25, 2021. Although ISDA fallbacks do not apply directly to cleared derivatives, Central Clearing Counterparties (CCPs) intend to replicate ISDA’s fallback terms in their rulebooks, which will provide market participants with consistency across cleared and non-cleared trades.
National Working Groups are recommending fallback language for cash products. For example, the ARRC has released a full suite of recommendations8 across cash products. In addition, across jurisdictions, legislative solutions have been proposed to address the “tough legacy” contracts which may not be able to be remediated prior to cessation.
Since RFRs are overnight rates, certain parts of the market need to model a forward-looking term rate with different maturities, projecting future interest rate benchmarks. For both accounting and operational reasons, many loans and securities are indexed off one-month, three-month and 12-month points on the curve.
The availability of forward-looking term rates across all market products is the top request from J.P. Morgan clients. Indeed, if forward-looking term rates were prohibited in derivative markets, but available in cash markets, this could create basis risk and potentially raise tax, accounting and/or risk management issues. If a benchmark were to be considered IOSCO-compliant, market participants should be able to use that rate to meet their requirements. While regulators recognize this, concrete guidance is not readily available. The Bank of England’s (BoE) RFRWG is most advanced and has stated that “overnight SONIA, compounded in arrears, will and should become the norm in most derivatives, bonds and bilateral and syndicated loan markets given the benefits of the consistent use of benchmarks across markets and the robust nature of overnight SONIA. The future use of a forward-looking term rate in cash markets should be more limited than the current use of LIBOR. So, where possible, counterparties are encouraged to transition to overnight SONIA compounded in arrears.”9 The development of certain cash markets may depend on term rate introduction with the current plan to have term rates available by mid-2021.10 11 12
National Working Groups have dedicated forward-looking term rate working groups. In January 2020, the Working Group on Sterling RFR published13 use cases of the SONIA rate that limit the use of forward-looking term rates based on a product’s characteristics, capabilities and sophistication level of the end-user.
Market participants have been advocating for consistency across conventions to simplify operating structures between derivatives and cash products. ISDA has driven standardization within the derivatives market and quickly established compounded, in arrears, as the preferred long-term methodology for RFRs. This has been incorporated as the first step in ISDA’s Fallback Protocol, expected to be released on October 23, 2020.
Advancements in the derivatives market have not been reciprocated by the cash markets. The ARRC’s recommended fallback language for cash products (e.g., FRNs, syndicated loans and bilateral loans) all prefer forward-looking term SOFR14 as the leading alternative, which can ultimately result in hedging discrepancies.
Standardization across payment conventions remains inconclusive for cash products. While derivatives almost exclusively use payment delay, a variety of payment certainties (e.g., payment delay, lookback and lockout) have been observed within the cash markets. To support the standardization, the ARRC recently published documents in May and July 2020 on:
The Sterling RFR WG’s Loan Enablers Task Force has released17 its recommendations on conventions for adoption by SONIA loans, stating that SONIA compounded in arrears remains the WG’s recommended alternative to Sterling LIBOR. Operational infrastructure will need to adapt to long-term conventions adopted by the market. Ongoing discussions on establishing conventions without concrete direction may have negative implications on the preparedness of systems, particularly where there is dependency on vendor delivery.
National regulators, authorities and working groups have published their priorities and identified milestones for market adoption.
The BoE and FCA have stressed the need for market participants to prepare for the transition away from LIBOR by the end of 2021 as a “base case.” In July, 2020, the BoE, FCA and the RFRWG published documents outlining their priorities and a 2020 transition roadmap.18 It encouraged market makers to switch the convention for sterling interest rates swaps to SONIA on March 2, 2020. Additionally, it encouraged a framework for the transition of legacy LIBOR products.
On Feb. 27, the FCA sent an open letter to CEOs of asset management firms, confirming that LIBOR will cease to exist after end-2021.19 The letter urges buy side firms to consider their exposure to LIBOR across derivative and cash products, as well as how they plan to transition to a risk-free-rate, including the requirement to amend any related operational processes and systems.
The BoE began publishing a daily SONIA Compounded Index on August 3, 2020.20 This will standardize and simplify the calculation method for SONIA-linked instruments, with the potential to be referenced in documentation. The BoE believes this could reduce operational risk by facilitating reconciliation of interest amounts between counterparties, potentially allowing the use of compounded SONIA to scale across products.
The FCA communication follows similar letters to large and mid-sized banks in Q3 2018 and Q4 2019, respectively.
The FCA will assess LIBOR against the Benchmarks Regulation “representativeness” test at the end of 2021, with a negative outcome potentially resulting in the prohibition of LIBOR deals after that time. Her Majesty's Treasury announced on June 23, 2020, that it intends to introduce legislation that will amend the Benchmarks Regulation (BMR) to give the FCA enhanced powers. The FCA published a supporting statement21 and Q&As.22
Recognizing COVID-19’s impact on operating environments, the RFRWG, FCA and BoE released a joint statement in April. It amended their projection for when all sterling LIBOR-linked loans will have successfully transitioned.23 Previously, the target date was the end of Q3 2020, but the group conceded there will likely be continued use of loan products referencing LIBOR into Q4 2020.
Much like the RFRWG, the ARRC outlined its key objectives for 2020 in April 2020 that “aim to advance the group’s work and mission."24
|Support SOFR use and liquidity||
Establish an RFP process to select an administrator of a SOFR rate to be published in H1 2021, provided SOFR liquidity has developed sufficiently.
Finalize conventions for SOFR-based floating rate notes, business loans and securitizations.
Work alongside market participants, CME and LCH to facilitate the use of SOFR PAI and discounting for cleared USD interest rate derivatives, as well as to explore how to migrate legacy derivative positions from LIBOR to SOFR.
Sept. 30, 2020
July 31, 2020
|Strengthen market infrastructure and operations to support transition||Create tools that will facilitate market participants in making the necessary operational and infrastructure changes required for a successful transition to SOFR.||Ongoing|
|Create and encourage the use of contractual fallbacks||
Establish an RFP process for the selection of an administrator to publish the ARRC’s recommended spread adjustments and spread-adjusted rates.
Publish revisions to the ARRC’s fallback language.
Sept. 30, 2020
June 30, 2020
|Support consumer education efforts||
Issue recommended fallback language for new student loans referencing LIBOR, in addition to new student loans referencing SOFR.
Develop a clear and effective program for consumer education.
June 30, 2020
June 30, 2020
|Provide legal, tax, accounting and regulatory clarity||
Pursue legislative relief for legacy contracts that are difficult to amend and have no economically appropriate fallback language.
Work with tax and regulatory organizations to finalize proposals that will address the LIBOR transition.
|Advance outreach, education and coordination||Promote a broad outreach and educational effort around the LIBOR transition and ARRC’s work to support this.||Ongoing|
Source: ARRC, April 17, 2020
The ARRC also outlined recommended best practices25 to assist market participants as they prepare for the cessation of U.S. dollar LIBOR. The ARRC hopes to adopt these recommendations, and the respective timelines, according the size and complexity of each market participant’s activities.
|Product||Hardwired fallbacks incorporated by||Tech/Ops vendor readiness by||Target for cessation of new use of USD LIBOR by||Anticipated fallback rates to be identified by|
|Floating rate notes||June 30, 2020||June 30, 2020||Dec. 31, 2020||6 months prior to reset after LIBOR’s end|
Syndicated Loans: Sept. 30, 2020
Business Loans: Oct. 31, 2020
|Sept. 30, 2020||June 30, 2021||6 months prior to reset after LIBOR’s end|
Mortgages: June 30, 2020
Student loans: Sept. 30, 2020
|Mortgages: Sept. 30, 2020||Mortgages: Sept. 30, 202026||In accordance with relevant consumer regulations|
|Securitizations||June 30, 2020||Dec. 31, 2020||
CLOs: Sept. 30, 2021
Other: June 30, 2021
|6 months prior to reset after LIBOR’s end|
|Derivatives||Not later than 4 months after the amendments to ISDA 2006 definitions are published||Dealers to take steps to provide liquid SOFR derivatives markets to clients||June 30, 2021|
Source: ARRC, August 27, 2020
These milestones have been made on the assumption that LIBOR will not continue past 2021, and are grounded in the following principles:
In response to its supplemental consultation on spread adjustments,27 on June 30, 2020 the ARRC recommended28 a spread adjustment methodology. It is based on a median over a five-year lookback period, calculating the difference between USD LIBOR and SOFR. For cash products other than consumer products, the ARRC’s methodology will match the value of ISDA’s spread adjustments to U.S. dollar LIBOR. The ARRC will include a one-year transition period for consumer products, and hopes the adjustment will reduce the anticipated change in the value of contracts resulting from the USD LIBOR shift to SOFR.
Other regulatory action has been taken to encourage the market adoption of SOFR. Following the FCA’s expectations that LIBOR will cease to exist post-2021, the Commodity Futures Trading Commission (CFTC) stated29 that it would like to facilitate the transition from USD LIBOR-based swaps to SOFR. In December 2019, it issued no-action letters30 that provide relief from certain regulatory requirements, including margin on uncleared derivatives and the clearing requirement, for swap dealers and other market participants that are transitioning from LIBOR to RFRs and amending swaps referencing any of the IBORs. The relief covers amendments to existing swaps that either add a fallback provision, or change the reference to SOFR or another RFR.
On March 2, 2020 the Federal Reserve Bank of New York, the administrator of SOFR, in cooperation with the Treasury Department’s Office of Financial Research, began publishing 30-, 90- and 180-day SOFR averages to support a successful transition.31 32