Goodbye LIBOR: Industry Planning For The End of LIBOR Accelerates

As regulators escalate their calls for financial firms to plan for the discontinuation of LIBOR, industry bodies are working to ensure that the transition to a post-LIBOR world is smooth. At the center of efforts in derivatives markets is the International Swaps and Derivatives Association (ISDA), which has taken the lead in standardizing adjustments to derivatives contracts to allow for a switch from IBORs to risk-free rates. However, much work remains to be done, and the transition threatens to be painful and disruptive.

In June, both the Bank of England and the Federal Reserve Bank of New York issued calls urging financial firms to ramp up their preparations for the discontinuation of the LIBOR series.

The BoE told the industry that it still plans to retire LIBOR – which has been managed by the UK’s Financial Conduct Authority since 2012 – by the end of 2021 and that firms must speed up their too-lax preparations for the change. The Fed reiterated this stance, with vice-chair for supervision Randal Quarles telling the industry, “You should take the warnings seriously.”

Derivatives and the end of IBORs

The shift away from LIBOR is part of a broader move away from using interbank rates, which are often based on surveys of traders, to using risk-free rates (RFRs) – based on actual transactions in overnight markets – as reference rates in financial contracts (see Issue 1, 2019 for more detail).

While banks are struggling to plan for a highly complex transition involving thousands of bespoke loan contracts, documentation in the derivatives industry has the advantage of relying primarily on standardized master agreements and definitions published by ISDA. The vast majority of derivatives contracts reference ISDA’s terms and its 2006 Definitions, and thus, ISDA is well placed to oversee and guide the transition away from IBORs.

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To this end, ISDA has undertaken a series of public consultations on the best path forward. Following a successful 2018 consultation on contracts involving GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR, and BBSW, ISDA has released a call for feedback on proposals for USD LIBOR, Hong Kong’s HIBOR, Canada’s CDOR, and Singapore’s SOR. Euribor, the second-most widely referenced IBOR in financial contracts, and its sister rate, Eonia, have not yet come up for discussion because work on an alternative RFR, €STR, remains ongoing.

ISDA’s approach to the transition of thousands of bilateral derivatives contracts is relatively simple. First, it is working to build a methodology for calculating replacement rates based on RFRs for all the IBORs in question. The challenge is to create replacement rates that are truly equivalent. This involves agreeing to solutions to two problems: RFRs are overnight rates, while IBORs have a term structure, and RFRs are, by definition, risk-free, while IBORs include an element of credit risk.

Once the methodology is agreed, ISDA plans to publish amendments to its 2006 Definitions, changing the existing fallback arrangements – which specify what happens in the event of a temporary disruption to a benchmark rate like USD LIBOR – to capture the impact of the permanent discontinuation of the IBOR benchmarks and their replacement with RFRs.

These new definitions will apply automatically to contracts signed after the amendments are implemented. ISDA anticipates that existing contracts could be modified through a protocol under which market participants could agree to make all their contracts subject to the new definitions, provided the counterparties to each contract agree to do the same.

In order to align its plans with those of the Fed’s Alternative Reference Rates Committee (ARRC), which has been working to identify replacement reference rates for cash markets, ISDA is also considering implementing pre-cessation triggers. Such triggers would see contracts transitioning to RFRs before the relevant IBORs are discontinued, rather than after. Regulators have expressed a desire for such an approach, but its implementation remains a work-in-progress.

Some market observers believe that discontinuities between ARRC-led approaches in cash markets and ISDA-led approaches in derivatives markets could emerge. While lenders may prefer ARRC’s approach, traders and hedging desks may prefer ISDA’s, creating the potential for basis and other risks.

The transition away from IBORs is fraught with challenges, including struggles with equivalence, methodologies, timing, and approaches. As the deadline for the transition nears and regulators remain determined to proceed with the changes, the risks of significant market disruption are growing.

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