LIBOR Transition: taking a market-led approach

Regarding LIBOR transition, the Financial Conduct Authority (FCA), BoE, and the members of the working group on Sterling Risk-Free Reference Rates (RFRs) have issued several statements on the impact of coronavirus on banks’ LIBOR transition plans¹, which reiterates the unchanged dates:

• "...end of 2021…should remain the target date for all firms to meet." 
• "...preparations for transition will be able to continue. There has, however, been an impact on the timing of some aspects of the transition programmes of many firms". 
• "All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.” 

Whilst GBP LIBOR transition makes progress, the biggest risk is of the ISDA protocol being recently delayed from November 2020 to January 2021, followed by the prohibition of LIBOR pricing on cash products & linear derivatives by end Q1 2021.

Table 2: Recommended GBP LIBOR Transition Milestones (Source: BoE)

Similarly, the Federal Reserve Alternative Reference Rates Committee (ARRC) has acknowledged similar target dates for USD LIBOR and recommended the following transition milestones (see Table 2). 

As well as the delay to the ISDA protocol, key risks include the success of the “Big Bang” for CME & LCH to move from Fed Fund to SOFR PAI discounting on new & existing swaps in mid-October, as well as regulatory guidance around “USD LIBOR tough legacy” products that cannot transition to RFR’s.

Table 3: Recommended USD LIBOR Transition Milestones (Source: US Federal Reserve)

Impact of 2020 Market Volatility on LIBOR Transition

The COVID-19 volatility in March 2020 impacted rates products across the financial sector. Several global currencies with a Forward Rate Agreement (FRA) based on 3M LIBOR-OIS (overnight index swap) spread, are seen by many as a proxy for risks in the banking sector. The OIS is effectively the RFR. The USD FRA-OIS spread significantly widened in March, proving the criticality of LIBOR and its use as a proxy to ascertain funding, term premium, bank credit, and overnight rate risks. The excessive widening of the basis in stressed times is one of the main reasons behind the move to replace LIBOR.

With Fed Funds at near-zero levels and 3M USD LIBOR at an all-time high, at the end of March 2020, driven mainly by increase in CP/CD & “expert judgement” rates (see Table 3), the basis significantly widened.

Table 4: 3M fixed bank CP/CD transactions’ matched spread to OIS (bp): 3ML-OIS (bp)

Whilst funding pressures have now been addressed by global central banks, institutions are currently analysing the basis to understand impacts now on the ISDA fallback rate that will form the spread over the RFR, this is the Secured Overnight Financing Rate (SOFR) rate for USD, followed by SONIA (Sterling Overnight Index Average) for GBP, and €STR (€ Short Term Rate) for EUR.

The impact on RFR’s are now at an adoption point. Despite the COVID-19 crisis, SOFR is not exhibiting the volatility seen in LIBOR rates. 

Whilst repo markets are not showing funding stresses seen in the past (such as the September 2019 SOFR spike), SOFR is trading in the range of 7bps to 10bps over Sept 2020. SONIA continues to follow at half a basis point, in line with BoE central bank rate. 

Table 5: 3M USD & GBP LIBOR to SOFR & SONIA (Source: Bloomberg)

Market concerns now turn to US Elections, Brexit & China policies, and as of October 2020, multiple subsequent waves in COVID-19, which will drive volatility in the basis between LIBOR and RFR’s. Whilst this basis is converging (see Table 4), the impacts on spread adjustment, calculated by taking the five-year median between LIBOR & RFR, must be assessed by the CFO function carefully.

Key CFO impacts from the LIBOR Transition

The prevalence of LIBOR throughout the financial system requires financial institutions to prepare to transition away from to RFR’s and manage the associated risks. 

The risk of market disruption, litigation, and destabilised balance sheets if existing contracts cannot seamlessly transition to new RFR’s or alternative rates, are potential risks, if the rates do not attract enough market-wide acceptance. 

A bank's risk exposure from LIBOR’s expected cessation depends on the financial institutions’ product profile.

Exposure to LIBOR can exist both on and off the balance sheet, including in the following categories:

• Derivatives (e.g.: interest rate swaps)
• Non-Linear Derivatives (e.g.: forward rate agreements, LIBOR in-arrear swaps)
• Cash instruments
• Commercial loans (e.g.: syndicated or non-syndicated business loans and commercial real estate loans)
  • Retail loans (e.g.: adjustable rate mortgages, home equity lines of credit, credit cards, private student loans, and reverse mortgages)
  • Securities (e.g.: floating rate bonds, notes, securitizations, and preferred stock)
• Funding
  • Borrowings (e.g.: term and overnight borrowings)
  • Deposits (e.g.: non-maturity and time deposits)

Impacts to P&L, Value Transfer, Funds Transfer Pricing, Cost of Funds, Backtesting, IPV, Hedge Accounting, Capital Management and Balance Sheet Management need to be assessed on a product by product basis, as well as at the aggregated enterprise and group level.

In the second part of my article next month, we will discuss the specific impacts to the CFO function including Data Strategy, P&L activities, Balance Sheet controls, IPV, Financial Reporting & Accounting impacts.

About the Author: Navin Rauniar is a Partner at TCS where he runs the LIBOR Transition globally for buy side and sell side clients. He is also a SteerCo member for the Professional Risk Managers Association (PRMIA). Prior to joining TCS, Navin worked in investment banking for over 16 years.