In a 2019 statement, the FCA and Bank of England encouraged market players to switch the convention for interest rate swaps from LIBOR to SONIA from today (2 March 2020) to build momentum for the transition from LIBOR. Further to this, initiatives announced last week indicate that the regulator is still committed to enforcing the departure on schedule.

In 2018 the FCA notified the market that the London Interbank Offered Rate (LIBOR) would be decommissioned by 2021, and replaced with Risk-Free Reference Rates (RFRs) such as the UK’s Sterling Overnight Index Average (SONIA) or the Euro Short-Term Rate (€STR) in Europe.

Regulators are pushing for a full retirement of LIBOR by the end of 2021, however as the benchmark is embedded in over $350 trillion financial product contracts across the globe, a divergence from the rate is an enormous task.

Are FIs on track?

“The official story is that yes, financial institutions and the regulators are and must be on track,” says Patrick Clancy, partner, derivatives and structured products at Shearman & Sterling.

“They [FIs] publicly assure everyone that they’re doing very well and that they’re making huge progress. However, we’ve got very little time left before the first deadline in January 2022 (22 months) and in my view to be ready by then FIs must be ‘fully baked’ about six months beforehand. This gives players a year and quarter and I don’t see how this is going to be enough time for most of them.”

Clancy notes that despite the huge amount of work banks are undertaking to expedite the transition such as engaging specialist accountants and deploying AI tools to analyse risk exposures, “there is a vast amount of work to do and the banks are realising just how big a task that is, blanching at how long it is going to take and how little time there is left to do it in.”

Will there be an extension to the deadline?

Clancy believes that an extension to the LIBOR transition deadline will ultimately eventuate, “although I have no real feel for when that extension might be granted.”

Over the past number of years, the implementation deadlines for various regulations have had stays of execution in the final week, or mere days before they were expected to come into effect, explains Clancy. While this outcome is possible with LIBOR, it would continue the uncertainty of the outcome here and any timing uncertainty in these markets is very bad news.

“If the regulator grants an extension of time very close to that final deadline, I think that would be quite damaging. I would hope the regulator would grant an extension while there is still six months to go, but there is no sign that that will be the case.”

“I think the mainstream UK banks are much more advanced in their progression toward the transition. Which is no surprise as the relevant regulator is in fact their regulator, making the urgency of the pronouncements much greater in the UK than elsewhere.”

Timing isn’t the only concern

Clancy notes that concerns around the replacement rates are two-fold. First, the question of just how different they are from the rate that they’re trying to replace, and second, concerns about the nature of some of the rates - the Secured Overnight Funding Rate (SOFR) in USD in particular.

He references the SOFR spike of September 2019, when Shearman & Sterling reported: “The confluence of a number of events has exposed insufficient elasticity in the USD overnight cash repo market.” A series of events “contributed to a cash crunch on 17th September 2019, that we refer to here as the ‘SOFR Surge Event,’ in which the SOFR rate increased by 282 basis points, compared with the previous day.”

The significance of this event demonstrated that whereas LIBOR is a forward-looking rate, the backward-looking cumulative 1-month SOFR incorporates surge events (such as the September spike) into the proceeding month’s rate calculation. The firm argues the incorporation of such a dramatic spike is a fundamental flaw of the rate and “of huge economic impact.”

Many players overlook LIBOR’s ability to exclude such anomalous and unexpected events.

Also, the robustness of the rate itself has been called into question given the Fed’s role (or ability to intervene) in cash market stabilisation, as well as the challenge of determining and informing customers of the change in risk profile the transition to SOFR presents.

Shearman & Sterling conclude: “All this raises questions as to whether the markets and the regulators have sufficiently thought through the appropriateness and benefits of adopting SOFR in place of LIBOR as the leading USD floating rate benchmark and the risks it poses to the cash and derivatives markets, and long term debt capital markets, as a fall back for LIBOR.”

Clancy notes that while the Fed brushed off the spike, he doesn’t think the market is willing to shrug off the implications of such risks under SOFR and adopt the rate as the ideal way of operating. SOFR is of course just one RFR, and as Clancy emphasises, other rates such as SONIA differ in structure and have not yet seen this level of concern or backlash.

Where does the market stand?

Last week the BofE pressured banks to “turbo-charge” their departure from LIBOR, with the announcement of a compounded SONIA index from July 2020 and a series of ‘haircuts’ on LIBOR-linked collateral from October 2020.

Clancy argues “the publication of an index, using an agreed framework for business days, is of significant assistance to the market in unifying the approach to the inputs for compounding and giving the market an easy mechanism for the determination of the compounded rate over any historic time period.”

While the market has accepted that interest calculations based on SONIA should be compounded daily, Clancy adds that “the calculations for daily compounding are not straightforward and facility agents and others would greatly prefer not to have to do the calculations.”

The timing of the ‘haircuts’ being introduced corresponds with a key aim of the Sterling Risk Free Rate Working Groups to ensure that the origination of new sterling LIBOR-based loans cease at the end of Q3 2020, he elaborates.

“If financial institutions suffer haircuts on GBP LIBOR loan funding, but no haircuts on SONIA loan funding (or other sterling rate funding), the financial institutions will be incentivised to stop originating loans linked to GBP LIBOR. The timetable is rather rapid, but it will force sterling floating rate lending into the SONIA space.”