LIBOR transition: 85% of uncleared UK derivatives market ready
27 January 2021 UK
Image: Edwin Schooling Latter
The UK's Financial Conduct Authority (FCA) has confirmed that 85 per cent of the uncleared UK derivatives market is ready for the end of the London interbank offered rate (LIBOR) as 12,500 firms sign the International Swaps and Derivatives Association (ISDA) protocol.
Speaking at the City & Financial's Managing LIBOR transition event, the FCA鈥檚 Edwin Schooling Latter, director of markets and wholesale policy, described 25 January as a 鈥渓andmark day鈥� in the LIBOR journey as the closed proposals on its cessation and new ISDA language on IBOR fallbacks became effective.
Latter explains that the fallbacks arrangements now apply as the standard arrangement in all new ISDA interest rate derivatives referencing LIBOR.
They will also take effect in all outstanding covered ISDA contracts where both parties have signed ISDA鈥檚 protocol, which contracts will convert from LIBOR to a fallback rate based on the chosen risk-free rates (RFRs).
Of the 12,500 firms that have now signed the ISDA protocols, the US led the way accounting for just over 10,000, followed by the UK in second place with over 450 signatories.
Also into triple figures was Singapore with 234, Thailand with 191, Japan with 149, India with 147 and Switzerland, with 136.
Elsewhere, there were 115 signatories from Canada, 57 from France, 34 from Germany, and 22 from Italy.
Latter highlights that the protocol is still open for signature for those firms that 鈥渉ave not been quick off the mark鈥�.
He estimates that there is $260 trillion in LIBOR-referencing contracts. Around 80 per cent of this total is accounted for by cleared interest rate swaps and exchange-traded derivatives.
Meanwhile, a further 9 per cent of this total is accounted for by uncleared derivatives, most of them covered by ISDA language.
Based on who has signed the protocol already, Latter says the FCA estimates just over 85 per cent of uncleared sterling LIBOR-referencing swaps now have effective fallbacks in place because of dual-sided adherence, while 99.7 per cent have at least one-sided adherence.
Adding the 85 per cent coverage to cleared swaps and futures means 97 per cent of sterling interest rate derivatives are covered by fallbacks.
He says: 鈥淚f you assume similar levels of protocol coverage across the other LIBOR currencies, and adjust for contracts maturing naturally, it takes out, by the time the relevant LIBOR panels are proposed to cease, around $245 trillion from that $260 trillion total of outstanding LIBOR-linked contracts.鈥�
Latter emphasises: 鈥淲e should not 鈥� and do not 鈥� underestimate the challenges associated with managing other LIBOR outstandings, notably in bond, securitisation, loan and mortgage markets.鈥�
But, he suggests the success of this protocol means 鈥渁 major reduction in risk faced by the 12,000 plus firms who have already signed, and for the system as a whole鈥�.
IBA consultation
Another milestone as mentioned by Latter was the closure of the IBA鈥檚 consultation on cessation dates for the 35 LIBOR currency tenor settings.
Of the currency tenor settings, 30 of them including all the sterling, yen, Swiss franc and euro settings would cease at end-2021.
In its consultation, the IBA proposed that the remaining five US dollar tenors would continue to be published for a further one and a half years, before also coming to an end.
Latter says: 鈥淚n some ways, that difference in timing overstates the difference in the proposed future path for US dollar LIBOR.鈥�
The US authorities have previously stated that the five US dollar LIBOR settings proposed to continue beyond end-2021 would be for use in legacy but not new transactions after end-2021.
Targets to stop new LIBOR lending, deliberately set to be achieved comfortably before the proposed end date, will bite sooner than end-2021, Latter notes.
For example, the date to stop new LIBOR lending for sterling is at end Q1 this year.
But Latter says the industry 鈥渉as risen to the challenge of this transition鈥�.
鈥淩egulators, supervisors and public authorities across many jurisdictions have worked to support those industry efforts through co-ordination, guidance and indeed legislative proposals,鈥� he explains.
鈥淭hat progress made on transition is of course interlinked with IBA鈥檚 December proposals on cessation dates, as panel banks, themselves among the biggest users of LIBOR, have become increasingly confident that end-December 2021 is an appropriate date to draw their participation in four of the five panels to a close, and end-June 2023 appropriate for the fifth.鈥�
With the consultation closing, the IBA will work to assess the feedback to the consultation, complete the necessary internal governance and then advise the FCA of its determinations on how it intends to proceed, having taken those responses into account, according to Latter.
He says: 鈥淣otwithstanding the difference in proposed end dates for US dollar LIBOR, the single consultation covering all five LIBOR currencies opens the way to determining and making announcements on the future path for all five simultaneously.鈥�
Giving clarity to the market on all 35 settings as soon as practicable 鈥渉elps maximise time and prospects for an orderly transition鈥�, he adds.
Synthetic LIBOR
In addition to the IBA鈥檚 consultation, the FCA consulted on a framework where the industry might consider it desirable and feasible to require continued publication of any LIBOR currency tenors on the basis of a changed methodology, also known as 鈥榮ynthetic鈥� LIBOR.
The FCA鈥檚 changed methodology is also based on the RFRs, combined with a fixed spread that is identical to the spread in ISDA鈥檚 fallbacks.
Latter explains: 鈥淭he implications of the proposed framework and methodology for synthetic LIBOR were that we didn鈥檛 think it would be desirable and feasible to compel continuation on a synthetic basis for euro or Swiss franc LIBOR, or indeed lesser-used tenors in any currencies.鈥�
However, he suggests that it did deem 鈥渁ppropriate鈥� for the more commonly used sterling settings and the FCA would continue to assess whether this might also be the case for more commonly used yen and US dollar settings.
Latter says: 鈥淚f IBA confirms to the FCA that following its consultation it intends to cease LIBOR settings, and the FCA is satisfied that the benchmark can be ceased in an orderly fashion, and the FCA confirms a policy that would not envisage compelling continued production on a changed methodology basis of a relevant setting, then we could announce that these settings will cease.鈥�
Another possibility for some settings is that it is clear the panel will end, he explains, but the FCA does anticipate consulting on requiring continued publication on a synthetic basis under proposed new powers set out in the financial services bill.
He comments: 鈥淚n that case, it would be clear that the rate will no longer be representative beyond the relevant panel end date. The only way it could continue would be on an unrepresentative, synthetic basis. For these settings we could make a so-called 'pre-cessation announcement' in terms of ISDA documentation.鈥�
Although Latter could not confirm a specific date for the post-consultation announcements, he highlights there is 鈥渘o case for delaying decisions or announcements beyond the time necessary properly to assess the consultation responses that have now been received鈥�.
Synthetic LIBOR will not be for use in new contracts but will be intended to help the problem of tough legacy contracts.
In his concluding remarks, Latter states: 鈥淭he need to transition is clear. The economic terms of fair transition have been worked out, they stretch across markets and across jurisdictions. Fair spreads for conversion will be locked in when cessation and pre-cessation announcements are made. Press on with your transition.鈥�
Speaking at the City & Financial's Managing LIBOR transition event, the FCA鈥檚 Edwin Schooling Latter, director of markets and wholesale policy, described 25 January as a 鈥渓andmark day鈥� in the LIBOR journey as the closed proposals on its cessation and new ISDA language on IBOR fallbacks became effective.
Latter explains that the fallbacks arrangements now apply as the standard arrangement in all new ISDA interest rate derivatives referencing LIBOR.
They will also take effect in all outstanding covered ISDA contracts where both parties have signed ISDA鈥檚 protocol, which contracts will convert from LIBOR to a fallback rate based on the chosen risk-free rates (RFRs).
Of the 12,500 firms that have now signed the ISDA protocols, the US led the way accounting for just over 10,000, followed by the UK in second place with over 450 signatories.
Also into triple figures was Singapore with 234, Thailand with 191, Japan with 149, India with 147 and Switzerland, with 136.
Elsewhere, there were 115 signatories from Canada, 57 from France, 34 from Germany, and 22 from Italy.
Latter highlights that the protocol is still open for signature for those firms that 鈥渉ave not been quick off the mark鈥�.
He estimates that there is $260 trillion in LIBOR-referencing contracts. Around 80 per cent of this total is accounted for by cleared interest rate swaps and exchange-traded derivatives.
Meanwhile, a further 9 per cent of this total is accounted for by uncleared derivatives, most of them covered by ISDA language.
Based on who has signed the protocol already, Latter says the FCA estimates just over 85 per cent of uncleared sterling LIBOR-referencing swaps now have effective fallbacks in place because of dual-sided adherence, while 99.7 per cent have at least one-sided adherence.
Adding the 85 per cent coverage to cleared swaps and futures means 97 per cent of sterling interest rate derivatives are covered by fallbacks.
He says: 鈥淚f you assume similar levels of protocol coverage across the other LIBOR currencies, and adjust for contracts maturing naturally, it takes out, by the time the relevant LIBOR panels are proposed to cease, around $245 trillion from that $260 trillion total of outstanding LIBOR-linked contracts.鈥�
Latter emphasises: 鈥淲e should not 鈥� and do not 鈥� underestimate the challenges associated with managing other LIBOR outstandings, notably in bond, securitisation, loan and mortgage markets.鈥�
But, he suggests the success of this protocol means 鈥渁 major reduction in risk faced by the 12,000 plus firms who have already signed, and for the system as a whole鈥�.
IBA consultation
Another milestone as mentioned by Latter was the closure of the IBA鈥檚 consultation on cessation dates for the 35 LIBOR currency tenor settings.
Of the currency tenor settings, 30 of them including all the sterling, yen, Swiss franc and euro settings would cease at end-2021.
In its consultation, the IBA proposed that the remaining five US dollar tenors would continue to be published for a further one and a half years, before also coming to an end.
Latter says: 鈥淚n some ways, that difference in timing overstates the difference in the proposed future path for US dollar LIBOR.鈥�
The US authorities have previously stated that the five US dollar LIBOR settings proposed to continue beyond end-2021 would be for use in legacy but not new transactions after end-2021.
Targets to stop new LIBOR lending, deliberately set to be achieved comfortably before the proposed end date, will bite sooner than end-2021, Latter notes.
For example, the date to stop new LIBOR lending for sterling is at end Q1 this year.
But Latter says the industry 鈥渉as risen to the challenge of this transition鈥�.
鈥淩egulators, supervisors and public authorities across many jurisdictions have worked to support those industry efforts through co-ordination, guidance and indeed legislative proposals,鈥� he explains.
鈥淭hat progress made on transition is of course interlinked with IBA鈥檚 December proposals on cessation dates, as panel banks, themselves among the biggest users of LIBOR, have become increasingly confident that end-December 2021 is an appropriate date to draw their participation in four of the five panels to a close, and end-June 2023 appropriate for the fifth.鈥�
With the consultation closing, the IBA will work to assess the feedback to the consultation, complete the necessary internal governance and then advise the FCA of its determinations on how it intends to proceed, having taken those responses into account, according to Latter.
He says: 鈥淣otwithstanding the difference in proposed end dates for US dollar LIBOR, the single consultation covering all five LIBOR currencies opens the way to determining and making announcements on the future path for all five simultaneously.鈥�
Giving clarity to the market on all 35 settings as soon as practicable 鈥渉elps maximise time and prospects for an orderly transition鈥�, he adds.
Synthetic LIBOR
In addition to the IBA鈥檚 consultation, the FCA consulted on a framework where the industry might consider it desirable and feasible to require continued publication of any LIBOR currency tenors on the basis of a changed methodology, also known as 鈥榮ynthetic鈥� LIBOR.
The FCA鈥檚 changed methodology is also based on the RFRs, combined with a fixed spread that is identical to the spread in ISDA鈥檚 fallbacks.
Latter explains: 鈥淭he implications of the proposed framework and methodology for synthetic LIBOR were that we didn鈥檛 think it would be desirable and feasible to compel continuation on a synthetic basis for euro or Swiss franc LIBOR, or indeed lesser-used tenors in any currencies.鈥�
However, he suggests that it did deem 鈥渁ppropriate鈥� for the more commonly used sterling settings and the FCA would continue to assess whether this might also be the case for more commonly used yen and US dollar settings.
Latter says: 鈥淚f IBA confirms to the FCA that following its consultation it intends to cease LIBOR settings, and the FCA is satisfied that the benchmark can be ceased in an orderly fashion, and the FCA confirms a policy that would not envisage compelling continued production on a changed methodology basis of a relevant setting, then we could announce that these settings will cease.鈥�
Another possibility for some settings is that it is clear the panel will end, he explains, but the FCA does anticipate consulting on requiring continued publication on a synthetic basis under proposed new powers set out in the financial services bill.
He comments: 鈥淚n that case, it would be clear that the rate will no longer be representative beyond the relevant panel end date. The only way it could continue would be on an unrepresentative, synthetic basis. For these settings we could make a so-called 'pre-cessation announcement' in terms of ISDA documentation.鈥�
Although Latter could not confirm a specific date for the post-consultation announcements, he highlights there is 鈥渘o case for delaying decisions or announcements beyond the time necessary properly to assess the consultation responses that have now been received鈥�.
Synthetic LIBOR will not be for use in new contracts but will be intended to help the problem of tough legacy contracts.
In his concluding remarks, Latter states: 鈥淭he need to transition is clear. The economic terms of fair transition have been worked out, they stretch across markets and across jurisdictions. Fair spreads for conversion will be locked in when cessation and pre-cessation announcements are made. Press on with your transition.鈥�
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