As a former senior adviser at the Bank of England, where he led work developing and promoting alternatives to LIBOR and contributed to the 2014 Fair and Effective Markets Review (FEMR), Edward Ocampo has had a close involvement on the development of alternative benchmarks.
Currently advisory director at Quantile Technologies and a non-executive director at the FICC Markets Standards Board (FMSB), here Ocampo talks to treasury consultant James Leather about LIBOR transition.
Interest rate benchmark reform stems from the decline in confidence in the reliability and robustness of the major interest rate benchmarks, such as LIBOR, EURIBOR and TIBOR.
Cases of attempted manipulation and false reporting had undermined confidence in these benchmarks.
An evolution in bank sources of funding, including the decline in interbank unsecured lending transactions – the key inputs for IBOR settings – has also been a factor.
Uncertainty surrounding the sustainability of these reference rates represents a potentially serious source of vulnerability and systemic risk. In 2013, the G20 asked the Financial Stability Board (FSB) to undertake a fundamental review of major interest rate benchmarks and plans for reform to ensure that those plans are consistent and coordinated, and that interest rate benchmarks are robust and appropriately used by market participants.
Alongside that, derivative markets had decided as far back as 2008 that IBORs were not the ideal rate for valuing derivative contracts; the financial crisis made it clear they were not risk free.
This created a huge move to value derivative contracts off risk-free rates (RFRs) such as SONIA. Once this happened, the risk management benefits of adopting RFRs as the reference rates for these contracts, rather than IBORs, became apparent.
Finally, in 2017, the Financial Conduct Authority (FCA) made clear that LIBOR’s availability could not be assured beyond end-2021 due to the absence of active underlying deposit markets. So, for LIBOR, it is about transition to alternative rates, rather than further reform.
Market participants who fail to transition to alternative rates over the next two years face many risks, including legal uncertainty and unforeseen changes in the value of their financial contracts.
All major IBORs across the G20 are undertaking benchmark reform. However, it is the sustainability of LIBOR that is imminently in peril.
LIBOR is published in five currencies: USD, EUR, GBP, JPY and CHF. USD, GBP and CHF are most impacted because there are no IBOR alternatives for these currencies.
The plan is to move completely away from IBORs to new RFRs: SOFR, SONIA and SARON respectively.
Other FSB members, including those in Europe and Japan, are pursuing a ‘multi-rate’ approach, whereby they have reformed their existing IBORs to strengthen them, while also encouraging adoption of alternative RFRs.
There is still some debate as to whether reformed IBORs are a long-term solution. The drivers to move away from these are strong and may accelerate as derivatives markets in major currencies move to robust, transaction-driven RFRs.
The work relating to RFR transition is being taken forward by national working groups convened by supervisory authorities (a recommendation of the FSB). While this work is market-led, the official sector is taking meaningful steps to support and encourage the transition process.
National working groups are providing guidance, helping to establish RFR infrastructure and product conventions, as well as setting targets for key transition milestones.
The International Swaps and Derivatives Association (ISDA) is also playing a critical global role through the implementation of robust contractual fallbacks in the event of a LIBOR discontinuation.
Across currency areas, sterling markets have made the most progress. That is mainly due to the choice of SONIA as the RFR alternative.
Other alternatives were considered, including the Bank Rate and a Gilt repo rate. SONIA – an unsecured overnight deposit rate – was eventually chosen by the UK national working group after the Bank of England took on and reformed it to ensure its reliability and robustness.
SONIA is well established, having been in use since 1997. It is stable and closely tracks Bank Rates, off which the SME and retail banking sectors price their lending. For all of these reasons, SONIA enjoys broad-based market buy-in.
In sterling markets there is now little interest in a credit-sensitive GBP LIBOR alternative, with the prevailing view being that markets can adapt to overnight RFRs for most applications.
USD market transition has so far proceeded at a slower pace. SOFR, an entirely new rate introduced by the Federal Reserve in 2018, was selected as the RFR.
It is a secured rate that tracks the US Treasury repo markets, and these markets experienced unexpected technical volatility last autumn.
While SOFR enjoys strong support among major participants in derivatives and capital markets, some US market participants – including regional and mid-sized banks – are keen to explore a credit-sensitive USD LIBOR alternative for lending markets.
For such a rate to take hold, it will need to be robust, representative and compatible with a SOFR-centric ecosystem in derivatives and capital markets.
The status of the USD as a major international reserve currency also increases the complexity and scope of transition efforts.
I think the most useful lesson from sterling markets is that transition from LIBOR to RFRs is feasible.
We are not there yet, but progress has been encouraging, plans are in place and implementation is well under way.
Without meticulous planning, cessation of LIBOR poses systemic risk. Market-wide LIBOR transition efforts need to accelerate as we approach the end of 2021.
However, one consequence of LIBOR transition is that new RFR curves need to be adopted as the discount rate for valuation and margining of cleared derivatives.
This is currently planned for EUR and USD in July and October 2020, respectively.
It is not necessary in GBP because SONIA is already used for discounting.
The FCA is very focused on ensuring that customers are treated fairly when replacing LIBOR
Transitioning the curve is particularly challenging for bilateral swaptions with post-July and October exercise dates. Consultations are ongoing, but it may be challenging to avoid unforeseen value transfer in some swaption contracts due to the change in cleared discounting.
Another consequence is that we might see the splitting out of multi-currency borrowing facilities into their separate currencies, since different currencies have selected different RFRs and are transitioning at different speeds.
So, what was once a relatively simple facility that had one margin and referenced one family of rates (IBORs) would probably need to incorporate different reference rates and different margins.
I will focus on sterling markets, as these are the most advanced and will hopefully establish precedents for other currency areas. I would highlight five key milestones in rough order of when we should expect them:
Step 1
Carefully consider the publicly available guidance on LIBOR transition provided by national working groups and international authorities. For example, the Working Group on Sterling Risk-free Reference Rates has recently published a very helpful paper detailing the path to discontinuation of new GBP LIBOR lending.
Step 2
Familiarise yourself with all available alternatives to LIBOR-based instruments and the product conventions associated with each of these. Identify and implement system changes which may be required to accommodate these conventions.
Step 3
Don’t hesitate to seek out independent advice from relevant professional service providers.
The FCA is very focused on ensuring that customers are treated fairly when replacing LIBOR and has published a helpful paper, Conduct risk during LIBOR transition. Banks and other wholesale market participants are also focused on facilitating a fair and effective transition. The FMSB is planning a paper on conduct risk in LIBOR transition that will include case studies relevant for members of The Association of Corporate Treasurers.
While there are many issues to consider, I think it is particularly important that service providers price instruments linked to new RFRs transparently and, wherever possible, cross-reference relevant inputs against independent pricing sources.
There have been large moves in LIBOR-RFR spreads, but no material change in ISDA’s plans at this time. And while the spread might make it more expensive for borrowers to transition during the crisis, recent rate moves do demonstrate that RFR-linked loans can provide materially lower borrowing costs in a period of financial distress.
On the other hand, corporates are facing so many challenges right now that LIBOR transition may be well down the list of priorities. Despite the widening of the spread, new SONIA loan deals are still getting done.
Recent deals have evidenced solid progress in SONIA and SOFR take-up. In December of last year, Shell signed a $10bn SOFR-linked revolving credit facility (RCF).
In March, BAT signed a £6bn multi-currency RCF linked to SONIA and SOFR. And in April, Riverside signed a £100m SONIA-linked RCF, the first facility to complete following the onset of COVID-19.
Although the aim to cease issuance of all new LIBOR-linked GBP products by the end of Q3 this year has been moved to end-Q1 2021, authorities have not so far made changes to the end-2021 time frame. So the issue of LIBOR transition will require continued focus.
Key rates
EURIBOR – Euro Interbank Offered Rate
IBORs – Interbank Offered Rates
LIBOR – London Interbank Offered Rate
SARON – Swiss Average Rate Overnight
SOFR – Secured Overnight Financing Rate
SONIA – Sterling Over Night Index Average
TIBOR – Tokyo Interbank Offered Rate
Edward Ocampo worked at Morgan Stanley for 24 years, where he was an MD in the fixed-income division and a member of the board of directors for its UK bank. In 2014, he joined the Bank of England as a senior adviser, where he led the work to develop and promote alternatives to LIBOR and contributed to the FEMR. He is now an advisory director at Quantile Technologies, which provides portfolio risk management services for derivatives markets, and a non-executive director at the FMSB (fmsb.com), a standards setting body that aims to raise standards of conduct in global fixed-income, currencies and commodities markets so that they are more transparent, fair and effective for all participants in those markets.
James Leather is a freelance treasury and finance professional with an interest in international benchmark reform
This article was taken from the June/July 2020 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership