Regulators may be reasonably happy with the progress being made on alternative reference rates to Libor, but the need to clarify exactly what will happen to instruments referencing Libor once the benchmark no longer exists is becoming hard to ignore.
This issue underscores the uphill battle that they face in replacing Libor: issuers and investors still like it.
Much has been made of the $170 trillion of derivative contracts that are linked to Libor, even though many of these will roll off long before the benchmark is due to cease in 2021.
However, in June the Bank of England’s financial policy committee noted that the stock of Libor-linked sterling derivatives maturing beyond 2021 was continuing to grow.
There are also $864 billion dollar-denominated floating-rate notes outstanding that reference Libor and mature after 2021. What happens to investors in them after this date is a big question.
It is a problem the regulators are acutely alive to. Issuers and investors, however, not so much.
In September, the UK’s Prudential Regulation Authority and Financial Conduct Authority (FCA) wrote to around 30 of the country’s largest firms giving them a deadline of December 14 to submit detailed and board-approved analysis of the Libor-related risks they are running.
The purpose of the letter was to seek assurance that the firms’ senior managers and boards understood the risks associated with the transition and were taking appropriate action.
Ensuring that this is the case could be an uphill battle.
The regulators are pushing hard for the adoption of Sonia (sterling overnight index average) and Sofr (secured overnight financing rate) as Libor replacements.
Corporates still issue in Libor because it is liquid and they are able to achieve a lower cost of funding. They also don’t want to create an asset and liability mismatch.
“We haven’t followed the EIB [European Investment Bank] and the World Bank into Sonia,” Isabelle Laurent, deputy treasurer and head of funding at the European Bank for Reconstruction and Development, explained recently at the ICMA Primary Market Forum in London.
The EIB issued a £1 billion five-year benchmark deal based on a Sonia benchmark in June, the first use of the rate by a supranational body since 2010. The World Bank sold a £1.25 billion Sonia-based bond in September.
“Our loan book is still Libor-based and you can’t shift away from that overnight,” says Laurent. “We have bonds outstanding beyond 2021, but put in greater risk warnings to mitigate this, as well as fallback clauses to take account of the situation where Libor still exists but is no longer deemed the term reference rate for debt instruments.”
That possibility is becoming more remote.
On Wednesday, the Financial Stability Board (FSB) released a progress report on the reform of leading interest-rate benchmarks, in which it states in no uncertain terms that “it should be presumed that Libor will not be sustainable”.
In July, Andrew Bailey, CEO of the FCA, emphasized that the discontinuation of Libor should not be considered a remote probability “black swan” event, but something that will happen and for which the market must be prepared.
The 20 Libor-submitting banks reportedly only executed 15 transactions of size in the past year, emphasizing the extent to which the world for which Libor was designed has changed.
“Sonia is now supported by 370 transactions a day and is far more robust than Libor,” claims one UK-based observer. “It tracks central-bank policy rates far more closely than Libor and is a better measure for interest rates and interest-rate risks.”
He says that the share of the swaps market executed in Sonia has grown from 10% in June last year to 20% now.
The problem is cost and someone has to pay- Sean Taor, RBC
There is little doubt that while banks have committed to submit to Libor until 2021, they will be reluctant to do so afterwards. Indeed, if Libor still exists after 2021, but is no longer the reference rate, the impact on deal documentation could be chaotic.
Regulators are pushing the message that issuers writing deals beyond 2021 run the risk of a mismatch between assets and liabilities when Libor disappears.
However, Laurent argues that by adopting the new rates now there is a mismatch today.
“The UK regulators are promoting the use of the new risk-free rates (RFRs) by saying that it may be inappropriate for underwriters to underwrite deals where there may be a mismatch between assets and liabilities once Libor disappears, but clearly the RFRs create a definite mismatch now,” she argues.
Libor could continue to exist after 2021, given that it is largely based on estimates rather than actual deals already, but that outcome looks unlikely. Just how concerned are investors about being invested in paper that is exposed to this risk? And how incentivized are issuers to do something about it?
“The problem is cost and someone has to pay,” points out Sean Taor, head of DCM and debt syndicate at RBC. “Who pays? If a deal is going from a Libor rate to an overnight rate plus spread, who will agree on the terms?
“Some issuers will see the cost of consent solicitation as worthwhile and some will simply buy back the bonds. Others may decide to do nothing.”
It is the ones that decide to do nothing that are the target of the regulators’ attentions. They want to make sure that investors fully understand the risks that they are exposed to post-2021 if nothing is done.
And they want to pressure issuers to change now to avoid the risk of market chaos when Libor submitters are no longer required to submit.
The market’s reliance on Libor is a systemic concern given the volume of legacy instruments that need to be transitioned in just over three years’ time.