On Thursday, the risk-free rate working group at the Bank of England published its priorities for the transition away from Libor to Sterling’s risk-free replacement interest rate, Sonia.
Making a firm, if entirely predictable, statement that “the time to act is now”, the group declared that its requirements now include ceasing the issuance of cash products linked to Sterling Libor by the end of the third quarter of 2020; pushing a further shift of volumes from Libor to Sonia in derivative markets; establishing a framework for the transition of legacy Libor products; and considering how best to address “tough legacy” contracts.
Regulators are now vocally upping the ante on Libor transition because of the ticking clock and the vastly differing levels of preparedness both between asset classes and between geographies.
The problem they face is that these increasingly strident calls for action may become white noise as they increase in frequency up until Libor is due to expire.
The Sterling market is widely viewed as being well advanced in the transition process, but at the end of last year Sonia derivative traded volumes were still languishing behind Libor volumes in tenors greater than two years.
In the cash markets, 85 Sonia-linked bond issues worth more than £40 billion have been written, but just eight consent solicitations with a total nominal value of £4.2 billion have been done to transition legacy bond contracts from Libor to Sonia.
Three Sonia-linked loans have been written – bilateral facilities with willing and engaged counterparts.
In the US, where initial progress was comparatively slow, the pace of transition has accelerated. Weekly secured overnight financing rate (Sofr) swap-trading volume tripled from less than $5 billion in January 2019 to $14 billion in September 2019; in late November last year, LCH had cleared a total of $1 trillion notional of Sofr swaps.
However, in its December 18 progress report on interest-rate reform, the Financial Stability Board (FSB) stated that the continued reliance of global financial markets on Libor poses risks to financial stability.
Noises from both the FSB and Bank of England have taken the tone of a disappointed teacher, mystified that the dog has eaten a substantial volume of the market’s homework again
It warned that the transition away from Libor requires real commitment and sustained effort from both financial and non-financial firms, and grumbled that while there has been good progress in many derivative and securities markets, the transition in lending markets has been slower – and must accelerate.
Noises from both the FSB and Bank of England have taken the tone of a disappointed teacher, mystified that the dog has eaten a substantial volume of the market’s homework again.
With some impatience, the FSB warned that “regulated firms should expect increasing scrutiny of their transition efforts as the end of 2021 approaches”.
Having tried the carrot, it looks like the regulators will now be wielding the stick in their efforts to get the transition away from Libor on track.
Help to transition
In their January 16 comments, the Bank of England and the FCA said that they are encouraging market makers to switch the convention for Sterling interest-rate swaps from Libor to Sonia on March 2, 2020, “to help progress transition” in the derivatives market.
Tushar Morzaria, chair of the working group on Sterling risk-free reference rates, added that the end of issuance of Sterling Libor cash products by the end of the third quarter of this year was a key priority.
The Financial Conduct Authority and Prudential Regulation Authority have sent a joint letter to banks and insurers under their supervision setting out their expectations for transition progress during 2020.
The letter warned that “the Financial Policy Committee has considered further potential supervisory tools that authorities could use to encourage the reduction in the stock of legacy Libor contracts to an absolute minimum before end 2021.The FPC will keep the potential use of supervisory tools under review in light of transition progress made by firms.”
And they added once more, with feeling: “The intention is that Sterling Libor will cease to exist after the end of 2021. No firm should plan otherwise.”
Describing this challenge as “the most significant and complex change in the financial industry since the introduction of the euro”, a McKinsey report in November warned that many banks are at risk of falling behind schedule.
McKinsey estimates that 50% to 75% of banks’ models involve Libor and will need to be redeveloped, and almost all systems will require some remediation. For some banks, more than 80 document types will need to be reviewed for potential “repapering.”
At least one large law firm that Euromoney spoke to in January is working on a Libor matrix, a system that will allow contracts to be repapered automatically using artificial intelligence.
If it works, this could be enormously helpful in markets where contracts exist digitally, though it won’t be much use for many legacy loans that only exist in paper form in a vault somewhere.
Tellingly, McKinsey warns that “we have seen only a handful [of banks] address specific client needs based on clients’ knowledge of the rate changes and the complexity of their unique Libor exposures.”
This is important. Banks need to demonstrate to the regulators that they have established sensible and sound outreach programmes to educate their clients about the situation, many of whom have not even started to think about this.
Along with quantifying exactly what their exposure is – both now and what it will be when Libor ceases at the end of 2021 – banks must have a clear transition plan and a clear budget to deal with repapering, model redevelopment and systems remediation.
Banks are very exposed to conduct risk in how they deal with Libor transition. If loans have been sold alongside interest-rate swaps, then this process could see clients being called by two different business lines within the same bank and given different advice.
A client could be holding a bond linked to Libor that is hedged with a derivative on a central counterparty clearinghouse that is switching to the relevant risk-free rate: that client faces a hedging mismatch that could turn into a legal nightmare for the bank if it is not handled correctly.
There is understandable debate about whether or not the timetable the regulators are imposing with growing impatience is achievable, but banks must up their game and engage with this process now if they do not want to face a raft of conduct-related lawsuits further down the line.