As the summer break comes to an end and market participants get back to working at full capacity, Practice Insight speaks to the UK Financial Conduct Authority’s (FCA) director of markets and wholesale policy, Edwin Schooling Latter, to get the latest updates on the Libor transition.
Here we discuss all the key aspects and remaining challenges of the transition – from fallbacks to term Sonia, through to tough legacy and liquidity. We also asked Schooling Latter to assess, in hindsight, the extent to which the Covid-19 pandemic has stalled transition efforts.
Practice Insight: We’re now entering Q4, and the final phase during which market participants can still make progress on their transition plans before the end of 2020. As people come back from their summer breaks, how do you want them to be entering this period?
Edwin Schooling Latter: I would like people to be coming back to the office aware that the months ahead are a critical period for them to act. Everyone knows we have an agreement to continue producing Libor until end-2021, but that doesn’t mean that action can be deferred until then.
There are two crucial tasks for market participants in the months ahead. One of them, on the derivatives side, is the adoption of the Isda [International Swaps and Derivatives Association] protocol enabling the insertion of fallbacks in Libor derivative contracts when the rate is discontinued. The protocol will be open for people to adhere to this autumn, and it’s very important that they do as the existing language isn’t robust for the rate’s cessation. The new robust language will be embedded in outstanding contracts through the protocol.
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A huge amount of work has gone into preparing this. Now that this solution is about to be offered on a plate to the wider community, the final step is in their hands. It’s now for market participants to do their bit and seize this opportunity.
The second, wider task, is to complete the migration away from Libor in new business. As of the end of September, banks will have the obligation to offer non-Libor options for new lending, with a view to cease the issuance of Libor-linked cash products by the end of Q1 next year. Similarly, if you’re a borrower still relying on the interbank rate, you need to prepare yourself for life without it.
Could you give us a quick run through of where Sonia liquidity is standing?
Progress has been steady. The important thing to note is that the liquidity that is necessary to enable the transition in all the main product markets is now there. In bonds and securitisations, Sonia is already the norm. In the swaps market, more than 50% of notional traded is now in Sonia.
A key development on that front, however, is that there is Sonia liquidity across the entire maturity curve. At the beginning of the transition process, Sonia liquidity was almost exclusively in short-duration Sonia swaps, but there are now swaps with longer maturities too.
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Is liquidity where you would want it to be at this stage?
The picture does vary across different markets. We are delighted that for new bond issuance, the transition is now effectively complete. On the derivatives side, we are also very comfortable with liquidity in Sonia products. The loan market, as we all know, is the one that has been slowest to transition. It’s also an area for which we don’t have access to day-to-day data, as we do for others. We do know, however, that trial programmes have been put in place by the main UK lenders.
Looking back on the past few months, how would you assess the impact of the Covid-19 pandemic? Has it significantly hindered transition efforts?
It has had an impact, but not one that threatens the overall transition timeline. It will have pushed back some borrowers’ programmes, but I am confident that these can still be completed by the end of 2021. The revised targets have been agreed with market participants themselves through the risk-free rate (RFR) working group, and they still look manageable. The various milestones were created with market consensus, which should give everyone confidence that they are achievable, and will indeed be achieved.
We haven’t conducted a comprehensive survey of market readiness, but the information that we are hearing from banks is that they are on track – not the opposite.
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What other lessons can the market take away from this period?
For non-financial corporate borrowers, the focus in March, April and May was obviously to keep credit and liquidity flowing. That was absolutely right and fully supported by the authorities.
Changing systems to be ready for Libor’s discontinuation was also not at the top of borrowers’ interests and priorities. This had an impact, which is why the deadline for the end of Libor loan issuance was shifted back. It remains the case, however, that from the end of Q3, lending banks will have to offer non-Libor alternatives for all new loans. From the end of Q1 next year, all new Libor lending must cease.
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Again, it should be remembered that the end-Q1 deadline for cash products issuance was not just imposed by the Bank of England (BoE) and the FCA, but was agreed with the working group. This means that there was representation from key lenders and from the borrower side.
The virus was also a timely reminder of why the transition is important, as corporate borrowers who had already moved to Sonia for their financing directly benefitted from the BoE’s interest rate cut. The cut immediately flowed through the RFR, while those still using Libor saw the greater part of the reduction offset by an increase in the spread of Libor over the RFR.
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We have heard many updates on tough legacy, but many market participants are still unsure how the legislative fix will work in practice. Can you give us an update on this?
Our previous public statements have set out the broad plan for how this will work. The measures announced by the UK Treasury will give powers to the FCA through legislative changes to the on-shored version of the EU Benchmark Regulation (BMR). This will put in place a mechanism whereby the FCA can compel the administrator to change the methodology through which Libor is produced in some circumstances – notably, if panel banks pull out and it is no longer possible to produce the rate in a representative way.
This is the first necessary condition to be able to produce what the market refers to as synthetic Libor. The most obvious way to recreate something that approximates the interbank rate is to take a forward-looking interest rate based on the relevant RFR and add a spread to it. We have clearly indicated that this spread would be fixed, and that it would approximate the credit risk premium that Libor contains.
Isda has reached global consensus on the best way to calculate a fixed spread, and we will look to that consensus to establish the way we would do it if we compel the administrator to produce a synthetic Libor.
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Will the powers granted to the FCA also extend to other Libor jurisdictions?
Market participants shouldn’t assume that the existence of this power in the UK means that it will apply in all of the five Libor currencies. A few other elements need to be in place for this to happen.
The first question is: is it necessary or desirable to use it? There may be consensus in other Libor currencies that the tough legacy problem isn’t material enough to warrant trying to continue the rate, and that it’s actually better to just discontinue the rate.
Secondly, if it’s considered necessary, the administrator would need to have access to the relevant inputs, the most important of which is a forward-looking term rate based on the RFR. As we know, several of these term rates are now being published in the UK for Sonia, but the existence and availability of such term rates varies across the other Libor currencies.
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In addition, not only does the term rate need to exist, but its producer has to be willing to share it with the Libor administrator if it is to be used in the new methodology. All of these pieces need to be in place for the synthetic Libor option to take effect.
Has there been much collaboration between the FCA and other Libor jurisdictions on this matter?
We regularly communicate with other authorities, as market participants would hope and expect. The EU recently made some proposals on tough legacy, which are a useful complement to what we are doing. The UK, however, is in a unique position, as Libor is produced here. This means we can make modifications at source.
If all the pieces of the puzzle are in place, a synthetic Libor option could be created. It could also be used in other Libor jurisdictions, should they wish to embed this solution into their plans to address tough legacy issues. It’s up to the relevant authorities to decide what they want to do and when they want to do it.
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Three Sonia term rate issuers are currently competing, and a fourth one will probably soon join. Could we get an update on the term rate process? Will there be another consultation by year-end?
The plan for Sonia term rates was always that they would be available for a period of observation in their beta versions. What this means is that they can’t be actively used in contracts, but that the relevant parties – potential users, administrators, authorities – can observe how they behave. The roadmap sets out a six-month observation period for this, after which the rates are due to evolve from beta so they can be used in real contracts.
Alongside this, the BoE has made significant progress on its Sonia index: earlier this month, it began publishing the compounded Sonia rate. It’s worth bearing in mind that for most Libor users, Sonia compounded in arrears will continue to be the most appropriate alternative to Libor, and not term Sonia.
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A burning question on market participants’ lips is whether different term rates will be allowed to coexist. What’s your stance on that?
We think it is healthy that there are some alternatives. I don’t think the UK authorities are going to narrow it down to a single one. It’s a good thing that different providers can compete on the quality of their products.
In another interview earlier this year, you said a formal announcement about the timing and manner of Libor’s discontinuation could be made later this year, possibly as early as November. Is this still on the cards?
The Libor administrator, ICE Benchmark Administration (IBA), has a public policy of giving a one-year notice of the rate’s cessation to market participants – which we support. Given that end-2021 is clearly a very possible date for the cessation, logically, there is a need to confirm over the next few months whether it’s desirable and viable to continue the various Libor panels. This is with a view to making formal announcements a year ahead of the cessation to give the market clarity on what is going to happen.
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The Isda protocol also sets out what will happen to people’s contracts once these announcements are made, so it will be beneficial to market participants to adhere to it before then.
Any final words?
The two main things to remember are: don’t miss the chance to sign that protocol when it comes out in early autumn, and do make sure you have completed the migration of your new business and aren’t going to remain dependent on Libor for new business after Q1 next year. Market participants will have already made substantial progress if they tick those two boxes.
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