No turning back

LIBOR and its equivalent base rates are critical market infrastructure, forming the pricing foundations of trillions of dollars of contracts from banks’ wholesale debt to retail home loans. Most IBORs will be gone at the start of 2022, and the market likely needed all that time to develop and implement replacement base rates for new contracts and legacy instruments.

Australia’s position has always been slightly different. Its local IBOR – the bank-bill swap rate (BBSW) – is, unusually, still generally based on robust trading volume in the underlying interbank market. It should continue, with regulatory blessing, even after the global demise of IBORs at the end of 2021.

Even so, the global change is relevant in Australia. Market participants with cross-currency exposures – especially those issuing offshore – will be directly affected by the transition.

Domestically, there will inevitably be more scrutiny of the robustness of BBSW in future. The Reserve Bank of Australia has already repeatedly cautioned market participants to re-examine their use of one-month BBSW, which has notably less trading volume to support it than the more commonly used three-month rate. Issuers and investors are also expected to engage with the use of fallback rates in new contracts, to ensure the legacy issue is minimised should BBSW become unavailable in future.

COVID-19 has posed massive challenges to market participants’ preparation for the demise of IBORs. Their attention has, understandably, been focused on the near-term impact of the pandemic. The means by which the industry would normally workshop its response to a seismic shift of this nature have also been disrupted.

To take just one example, the International Swaps and Derivatives Association (ISDA) – perhaps the central global forum for transition discussion – cancelled its 2020 AGM, which had been scheduled to take place in Madrid in May.

Again, the situation in Australia is somewhat different – but arguably even more pernicious. While international markets are facing a hard deadline, by being one step removed it has been easier to put the issue of IBOR transition aside in Australia. The absence of the local major banks from wholesale funding has also had a big impact on the issue’s visibility.

By the end of 2019, all the big four banks had tested the waters for sterling-denominated issuance linked to the UK’s risk-free rate (RFR), the sterling overnight index average (SONIA). Commonwealth Bank of Australia (CommBank), meanwhile, became the first Australian credit issuer to print a new deal referencing the Australian overnight index average (AONIA) instead of BBSW when it priced the A$1.5 billion (US$1.1 billion) Medallion Trust Series 2019-1 residential mortgage-backed securities (RNBS) transaction in November last year.

The only Australian issuer to price AONIA-linked deals in 2020 is South Australian Government Financing Authority. CommBank says it would likely have brought a second RMBS with AONIA as a base rate had its wholesale funding need not evaporated at the start of the COVID-19 crisis.

IBOR transition has been the subject of fewer headlines this year. But it has certainly not dropped off the global radar. In fact, international market users say engagement with the issue should be – and in many quarters is – ramping up.

ISDA held a webinar on 16 July to update members and others on the path forward for IBOR transition. The clear message from the association and key market participants is that planning has continued even as other challenges have come to the fore. In effect, a challenge that clearly would have been the number-one focal point of the year had to stay on the agenda even as COVID-19 hit.

Scott O’Malia, ISDA’s London-based chief executive, said there was “strong recognition” among attendees at ISDA events in London and New York just ahead of COVID-19 lockdowns that 2020 “would be a pivotal year for benchmark reform and an acceptance that industry efforts would need to accelerate”.

Nothing significant has changed. O’Malia added: “Not surprisingly, there were some immediate questions about how [the pandemic] would affect preparations and whether the transition work would continue at the necessary pace. Fortunately, that work has not come to a standstill.”

All the indications are that crunch time is approaching, pandemic or no pandemic. Edwin Schooling Latter, London-based director, markets and wholesale policy at the UK’s Financial Conduct Authority (FCA), commented on the ISDA webinar: “While we know that LIBOR will continue to be published until the end of 2021, this does not mean the need to act is still more than a year away. Nor has the need to act on LIBOR transition been pushed back by the impact of COVID-19. In fact, the 4-6 months ahead of us now is arguably the most critical period in the transition away from LIBOR. Now is the time to act.”

A lot of work has been taking place in the background, that could primarily be characterised as laying the foundations for market users to build the necessary new infrastructure.

For instance, arguing that “taking our foot off the gas is no longer an option”, O’Malia pointed to ISDA’s preparation of the essential tools firms need to make a smooth and successful IBOR transition. In particular, this means finalising a documentation protocol for transitioning IBOR-based contracts to RFR basis. The association also expects imminently to publish final guidance on fallback benchmarks for derivatives linked to key IBORs.

In the UK, the sterling risk-free rate working group has progressed with plans to tackle so-called “tough legacy” exposures, while the FCA announced in June that it expects new powers to be legislated under which it can force a change to LIBOR methodology to allow a synthetic rate to continue to be published, in certain circumstances, for tough legacy contracts.

The US alternative reference-rate committee (ARRC) has published best practices for IBOR transition, laying out detailed timelines and interim milestones for derivatives and cash markets. It also recommended conventions for cross-currency basis swaps in January and has continued work on cash-product fallback rates. The New York Federal Reserve began publishing daily component averages for the secured overnight funding rate (SOFR) in March.

“This has been a very busy year for the ARRC, despite COVID-19,” said Subadra Rajappa, New York-based ARRC member and managing director and head of US rates strategy at Societe Generale.

The outline of fallback benchmarks is now established in most jurisdictions. For instance, the UK’s approach is to use a combination of the relevant overnight RFR, compounded in arrears, and a fixed spread to reflect the premium associated with unsecured lending at term.

“These two elements have been chosen carefully and, in my view, wisely,” Schooling Latter said. “The overnight risk-free rate represents the most reliable benchmark interest rate available, derived from markets that have remained active and reliable throughout recent periods of stress.”

The ARRC, among others, is still exploring the potential offered by a forward-looking calculation of SOFR. This could solve a number of operational issues by removing the problem of payment uncertainty and basis risk that comes into play when things like bond coupons can only be calculated in retrospect. The fundamental problem is that forward-looking rates need real underlying traded volume to be robust and reliable – the lack of which is the reason for IBORs’ demise in the first place.

The message now is that the time has come for the wide swathe of market participants to start acting on the guidance being provided by global regulators and bodies like ISDA and the ARRC. For instance, despite the host of background work done to establish and define RFRs and their deployment, Rajappa argued that the ARRC’s most important publication in 2020 was the best-practices document, which outlines the steps market participants should take to transition to new benchmarks by the end of 2021.

For this reason, she added, there is not a lot pencilled in to ARRC’s own deliverables calendar for 2021. By contrast, its best-practice timeline is very busy, which she said demonstrates that banks and other market participants will be immersed in working towards compliance with best practices.

Jack Hattern, ISDA board member and managing director, global fixed income at BlackRock in New York, added: “We have talked about education throughout the process, but education at this point is not just about general awareness of what is happening. It is about understanding all the details. This is the time to ‘sweat the details’: to understand what is happening through your portfolio at security level and the holistic impact of the transition.”

For the buy and sell side alike, Hattern explained, a great deal of internal preparedness is required – for instance upgrading systems and analytics. A lot of progress has been made but Hattern echoed the view that now is no time for complacency.

“We tend to talk about our own individual firms’ internal preparedness,” he claimed. “But we also need to ensure the entire market ecosystem comes along with us. Participants need a general awareness of what is going on but also to be in synch with efforts from ISDA and the like with respect to standardisation.”

There are some signs in market activity that the message is starting to sink in. But the confronting reality is that most traded volume globally continues to use IBOR reference rates. US Depository Trust and Clearing Corporation data reveal that notional value of SOFR swaps in the first half of 2020 was four-and-a-half times greater than the same period in 2019. US LIBOR-linked swap volume fell by 6.1 per cent.

O’Malia said: “We are clearly heading in the right direction. But when I tell you US$63 trillion of US dollar LIBOR was traded in the first half of 2020, versus US$490 billion in SOFR, you can see there is still work to be done.”

Hattern added: “To be trading SOFR, we all want deep and liquid markets. A lot of work has been done and a lot of progress has been made, but there are a lot of things we need to keep building on and work to be done – and all the while the clock keeps ticking.”

The impetus has never been greater, and the IBOR deadline is not the only reason. The turbulent market conditions sparked by the onset of the COVID-19 crisis demonstrated to at least some market users that RFRs now provide a more reliable basis for pricing. According to Rajappa, US front-end spreads were extraordinarily volatile around March this year. While SOFR saw a mini-spike at the time, and it experienced another one in November last year, clearly the biggest spike was in LIBOR.

“A lot of liquidity has been pumped into the market since November to the extent that SOFR has actually been trading below the interest rate on excess reserves,” Rajappa revealed.

To some extent, it was inevitable that the migration of volume and liquidity to new contract benchmarks would be relatively slow. Agha Mizra, managing director and global head of interest-rate products at CME Group in Chicago, commented: “We all wish for very deep and consistent liquidity such as we have in Fed funds and Eurodollar futures. This is completely understandable. But these products are decades old. SOFR, even as just an interest-rate index, is only two years old. We are very pleased with the infrastructure backing SOFR futures and they have debuted as one of CME’s most successful new products.”

Tom Wipf is an ISDA board member, chair of the ARRC and Morgan Stanley’s New York-based vice chairman, institutional securities. He described himself in the webinar as “naturally optimistic”, including on benchmark transition, and said he is confident in growth of trading volume in contracts using RFR benchmarks from the start. “If you are trading something with maturity beyond 2021, to some degree you are already trading SOFR – particularly when it’s something with fallback protocol in place,” Wipf continued. “It’s clear there hasn’t been enough takeup of SOFR, but nonetheless there will be plenty of liquidity when we get to the key point. A 10-year derivative includes eight-and-a-half years of SOFR – whether you like it or not.”