LIBOR to RFR Transition

Welcome to our October 2021 issue of the Risk-Free Rates (RFR) Regulatory Round-up - LIBOR. With less than 3 months left until the end of non-USD LIBORs, actions have been taken to encourage and assist with the transition, and the details of tough legacy solutions are becoming clearer. However, there is growing concern from regulators that market participants may be considering transitioning to rates that have similar underlying vulnerabilities as LIBOR.

Global developments

IOSCO joined US and UK regulators in emphasising the importance of a continued transition to robust alternative financial benchmarks, i.e. RFRs, to mitigate potential risks arising from the cessation of LIBOR. Global regulatory bodies are concerned that some of LIBOR's historic shortcomings may be replicated through the use of credit sensitive rates that lack sufficient underlying transaction volumes - potentially impacting market integrity and financial stability. Regulators are also concerned by a decline in the underlying activity of some credit sensitive rates during periods of stress such as the COVID-19 pandemic.

To support a smooth global transition, there was a move of interdealer cross-currency swap market trading conventions to RFRs on 21 September. This was the second phase of the CFTCs' SOFR first initiative and was supported by UK regulators and RFR working groups/committees in Switzerland and Japan.

Sterling market developments

The UK's tough legacy solution is beginning to be put into place. On 29 September, the FCA confirmed that it will require the LIBOR benchmark administrator, ICE Benchmark Administration (IBA), to publish 1-,3- and 6-month GBP and JPY LIBOR setting using a synthetic methodology from 4 January 2022 and for the duration of 2022. The methodology the FCA will require IBA to use is:

• forward-looking term versions of the relevant risk-free rate (i.e. the ICE Term SONIA Reference Rates provided by IBA for sterling, and the Tokyo Term Risk Free Rates (TORF) provided by QUICK Benchmarks Inc., adjusted to be on a 360 day count basis, for Japanese yen), plus
• the respective ISDA fixed spread adjustment (that is published for the purpose of ISDA's IBOR Fallbacks for the 6 LIBOR settings)

However, as defined by the Benchmarks Regulation, these LIBOR settings will be permanently unrepresentative of their underlying markets. This may be a fallback triggering event for many, more recent, LIBOR contracts.

Also on 29 September, the FCA published a consultation on which legacy contracts should be permitted to use these synthetic LIBOR rates. The FCA proposes to permit the use of a synthetic LIBOR for legacy GBP and JPY products, apart from cleared derivatives, from January 2022. This will provide a much-needed safety net for users with LIBOR contracts and will be a relief to many market participants. However, whilst the regulator's proposals acknowledge the difficultly, complexity and scale of the LIBOR transition, the permitted use will be reviewed annually and so the pressure on firms to move away from LIBOR remains.

The Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks is consulting on the use of synthetic LIBOR in Japan, proposing that is could be used for loans and bonds. However, unlike the EU and the UK, there are no specific regulations in Japan on interest rate benchmarks, so the use of synthetic LIBOR will be a decision for the two contracting parties.

In its consultation, the FCA also proposes to prohibit most new use of USD LIBOR after the end of 2021, in line with US guidance and existing FCA and PRA supervisory expectations.

The UK Government has started legislating for a `legal safe harbour' by introducing to parliament the `Critical Benchmarks (References and Administrators' Liability) Bill'. The bill seeks to reduce disruption in the LIBOR transition from the potential risk of contract uncertainty and disputes where contracts have been unable to transition from LIBOR to another benchmark (`tough legacy' contracts). A legal safe harbour would reduce the action, liability or grounds for litigation between parties to LIBOR contracts.

In the PRA's feedback letter to the CFOs of selected deposit-takers on written auditor reporting, it reiterated the benefits of automated systems to support aggregate reporting of IBOR exposures and the importance of controls over manual processes. It also identified opportunities for:

• More active management of transition risks and for ensuring plans to mitigate these risks are kept up to date
• Greater use of independent review and challenge of RFR transitioning plans

With GBP LIBOR ceasing end-2021, IBA announced that it will stop the publication of GBP LIBOR ICE Swap Rate for all tenors immediately after publication on 31 December 2021 due to insufficient data for calculations. 

After consultation, ISDA has now published Supplement 82 to the 2006 ISDA Definitions, the addition of fallbacks to “GBP-ISDA-Swap Rate”. Transactions which incorporate the 2006 ISDA Definitions and are entered into on or after 6 August 2021 will incorporate the new triggers and fallbacks for the GBP LIBOR ICE Swap Rate. ISDA also published a Form of Amendment to enable parties to amend one or more existing confirmations to incorporate fallbacks for provisions in the 2006 ISDA Definitions that refer to or relate to the GBP LIBOR ICE Swap Rate.

Regulators' expectations are that the use of forward-looking benchmarks should be relatively limited. The FMSB has now published its final Standard on the use of Term SONIA reference rates. The Standard applies to participants in the sterling fixed income and wholesale lending markets, including sterling legs of multi-currency products. It outlines eight core principles across different products and types of firm.

Euro market developments

The EU tough legacy solution is also beginning to take shape. During August, the European Commission (EC) consulted on two statutory replacement rates which it can designate under the amended EU Benchmarks Regulation (BMR) when the cessation of a critical benchmark is likely to cause disruption to EU financial markets.

Given a sizeable amount of retail mortgages in the EU referencing CHF LIBOR and no plan for a synthetic LIBOR, the EC is proposing to designate compounded Swiss Average Overnight Rates (SARON) observed over a period directly preceding the interest period (“last reset”) as a replacement for CHF LIBOR.

The EC is proposing a fixed spread adjustment based on the historical median spread between CHF LIBOR and relevant SARON compounded over a five-year lookback period up to 5 March 2021 (published by Bloomberg).

EONIA is being discontinued on 3 January 2022. However, there are still several thousands of derivative contracts with direct EONIA exposures in the EU. Therefore the EC is proposing to designate the statutory replacement for EONIA as €STR, plus 8.5 basis points. This is the existing fixed spread adjustment between EONIA and €STR, thus avoiding value transfer in the transition.

The statutory replacement can be used in contracts that are subject to the law of one of the EU Member States and where all parties are established in the EU.

EUR LIBOR will cease on 31 December 2021. The FCA is not mandating a synthetic EUR LIBOR and the EC is not designating a statutory replacement rate for EUR LIBOR, so it is important that firms transition away from use of EUR LIBOR.

USD market developments

The Alternative Reference Rates Committee (ARRC) now formally recommends CME Group's forward-looking SOFR term rates. This follows the successful completion of a key change in interdealer trading conventions on 26 July 2021 and continued growth in SOFR cash and derivatives markets.

When using SOFR term rates in legacy fallbacks and new fallbacks, firms should follow the ARRC's best practices and may also find the frequently-asked-questions (FAQs) useful.

The ARRC has published a summary of its recommendations to date regarding spread-adjusted fallbacks for contracts referencing USD LIBOR. This is a useful document for firms when finalising fallback language. 

To assist in this effort, Refinitiv launched the prototype publication of the ARRC's recommended spread adjustments and spread adjusted rates for cash products. There are two versions of the Refinitiv USD IBOR Cash Fallbacks: one for consumer cash products and another for institutional cash products. The initial prototype will not have fallbacks based on the SOFR term rate, but Refinitiv will include them in a second iteration based on the ARRC's recommendation of the CME term rates.

Please contact James Lewis, Peter Rothwell, Leks Doyin-Salau or Kate Dawson for further information.

To find out more on how to manage the transition from LIBOR to RFR, visit our Evolving LIBOR insights hub.