My previous LIBOR reform blog examined the enormity of change. This time I focus on market adoption and whether RFRs (risk free rates) are friend – or foe.
In the UK, the FCA’s announcement that, after the end of 2021, it will no longer use its influence to persuade Libor (London interbank offered rate) panel banks to provide quotes and will not exercise its powers to compel them to do so, acted as an effective starter-gun for change. Ever since, the race has been on, not only to agree a new RFR, but more importantly, to agree what the transition from old Libor to new RFR should entail.
What about other regions?
Despite the fact that benchmark reform will impact all major currencies, not everyone is moving in tandem:
- the European Central Bank (ECB) intends to start publishing their rate by October 2019 via the Euro Short Term Rate, Ester;
- the US has picked Sofr (secured overnight funding rate) as its Libor replacement and went live in April 2018;
- and the UK has gone for a reformed version of Sonia;
- while Switzerland selected the Swiss average overnight rate, better known as Saron.
The development of each RFR is then made even more complicated by the fact that the respective central bank working groups for each currency have not been consistent in choosing either a secured or an unsecured rate:
- while the US and Swiss RFRs will be secured rates, the UK has plumped for unsecured;
- the Japanese study group has leaned towards an unsecured rate, via the Tokyo overnight average rate (Tona).
- meanwhile in Europe, a decision on whether to use secured or unsecured is still to be made – but the option of Ester via the ECB (which is also unsecured) is looking most likely.
As a result, the probability of developing a single, global methodology for each currency’s fall-back rate is now even more difficult. And adding to these woes is the fact that liquidity will need to be built into new contracts within the current timeframe, in order to measure the basis between the new RFR and any replaced Libor rate.
Complexity and consistency
For many, liquidity is integral to the timing of when participants make the transition. The industry then needs to consider how to build liquidity in a term structure of a overnight rate. Given some RFR’s are more developed than others, that process isn’t straightforward (and liquidity is a topic I explore further in this blog series).
While these issues alone are enough to cause concern to many, the selection of a RFR is one of the easier decisions to take. What is more of a concern is how to agree on what should be the fall-back rate for Libor, Euribor, or similar ‘Ibors’ in other currencies. Right now, there is no clear solution to satisfy all.
Further complicating the matter is the fact that fall-back provisions vary by product, creating the risk that a basis could suddenly appear between two previously offsetting positions. To address this, the industry needs consistent protocols, otherwise all sorts of implications arise. Take hedging: if there is no consistency to ensure marry-up fall-backs across different rate products, you could suddenly be left with a very large gap, depending on the size of your portfolio. Consistency is essential across several dimensions: triggers, fallback rates and spread adjustments, otherwise the probability of hedges actually working quickly diminishes. Although ISDA has been leading the work on fall-backs for derivatives, a host of other trade bodies are also tasked with developing fall-back options for all these hedged products – and currently, many of the proposed fall-backs are deemed unworkable.
Establishing a process of moving away from Libor that pleases everyone is easier said then done – to such a degree that the difficulties are prompting participants to ponder whether Libor should continue in the long term. But this too produces its own conundrum: while operationally it’s a lot easier to continue with Libor, if it is not well supported in the derivatives market, then the issues could be even greater.
Indeed such is the magnitude of the transition, ICE Benchmark Administration, which administers Libor, is looking to lengthened its availability beyond 2021 to mitigate risks where banks do not implement change by 2021.
- Similarly ISDA has disclosed that it will amend fall back provisions to include risk free rates – but only for new derivatives. For vast swathe of existing legacy contracts and financial instruments referencing Libor, a “protocol” will be introduced to amend all derivatives in a streamlined fashion, with financial institutions currently in consultation phase and awaiting market feedback.
- Furthermore, the European Parliament stated only recently that it is open to delaying a ban on the market using Eonia (Euro overnight index average) and Euribor (Euro interbank offered rate) from the end of 2019, if their early discontinuation “affects the continuity of contracts” that reference them (the rationale being that this would allow time to build a derivatives market that uses Eonia’s replacement – Ester).
What happens next?
If regions continue to lack uniformity, market participants should look to mitigate their own risks where they can. Of the $370 trillion in outstanding products referencing Libor, approximately 80% will expire by the time panel banks are free to abandon the reference rate at the end of 2021 – but only if the market stops creating new Libor assets and quickly switches to risk-free rates. The unwinding of existing activity would be fairly significant if market participants can quickly and efficiently start using the new reference rates. Given the current issues, adopting the new RFR is easier said then done.
In my next blog, I delve into the issues surrounding valuations and risk management.
- Read my previous blog From LIBOR to RFRs; avoiding the headache of Herculean change in this series here.
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