BIERKENS As we all know, LIBOR could disappear any day after 1 January 2022 – or at least from that day onwards LIBOR rates will no longer be required to be submitted. The challenges are that we don’t know how we’re going to get there, when the date will be or exactly what the end state is going to look like. It’s possible that LIBOR will continue to be published in some form, perhaps in some markets but not in others.

It’s interesting to note that – although it may not be receiving appropriate attention from everyone as yet – the International Swaps and Derivatives Association (ISDA) expects huge changes in the market as a result of this development. More than US$300 trillion of contracts reference LIBOR and EURIBOR, most of them derivatives.

One of the things I emphasise to clients is that we would still be talking about SOFR and SONIA even if the market underlying LIBOR was more liquid and robust.

A key takeout from the regulatory discussion around benchmark reform – as articulated in the Financial Stability Board’s market participants report in 2014 – is that there was a clear need for an alternative reference rate that doesn’t include a credit component and doesn’t fluctuate in line with the market’s view of bank creditworthiness.

The market as a whole is increasingly ‘riskless’. In fact, well over 70 per cent of the derivatives which make up the bulk of LIBOR referencing contracts are now cleared or margined. To have them referencing LIBOR even though they are mostly discounted with another rate was never optimal. A risk-free rate was going to be adopted, regardless of what happened to LIBOR.

Another important point – and one that was emphasised by [Reserve Bank of Australia (RBA) deputy governor] Guy Debelle at the ISDA conference in Sydney in 2018 – is that this transition is not being driven by regulators. Although the regulatory framework around LIBOR submission is of course very relevant, it’s more a matter of the underlying market no longer being viable.

To demonstrate this you only have to look at how much actual trading goes on in the rate used by US$200 trillion of LIBOR-based contracts. Even though a lot of transactions would qualify, not many take place. The median number of daily transactions in three-month US dollar LIBOR – which is the most quoted – in Q2 2018 was seven. It was two in one-month LIBOR, and zero in one-year LIBOR.

We need to be ready to move to alternative rates – which, as I said, are needed anyway – if and when LIBOR dries up for good. Ideally we would have two rates, so the question becomes whether we can find something to replace LIBOR.

Andrew Bailey [chief executive of the UK Financial Conduct Authority (FCA)] gave a very informative speech on the future of LIBOR in July last year. He talked about the creation of a “synthetic LIBOR”, but said there is no compelling answer as to how we can create one-, three- and six- or 12-month bank credit spreads that can be reliably measured on a dynamic and daily basis. If we could do it we would have done so already.

What this means is that there is currently no alternative for LIBOR, in the sense of being a like-for-like replacement. In this context, we have to start moving towards the adoption of risk-free rates.

BIERKENS There are several risks. One is how quickly the market is able to adopt risk-free rates. SOFR is a new risk-free rate as designated by the New York Federal Reserve. Its futures trading activity and open interest doubled between October and December last year – but from a very low base. A more sobering statistic is that in Q3 last year there were 15 trades in SOFR swaps of which 13 were basis swaps.

SONIA is a little different because it is a pre-existing rate. But in general there is an open question about how the market creates sufficient liquidity to transition to a new rate.

Another issue is that LIBOR may disappear in some currencies but not in others. Intercontinental Exchange (ICE)’s LIBOR submission policy states that the rate will be published unless it receives submissions from fewer than five banks, for instance. If LIBOR exists in some currencies but not others it will create issues for cross-currency basis swaps.

For cross-currency swaps, if one leg has its fallback reference rate triggered, swap counterparties will probably want the other leg to be on its fallback rate too. It is my understanding that ISDA anticipates putting a protocol in place to facilitate this.

There are a number of risks specifically related to fallback rates, too. Much as we may try to get a net-present-value neutral fallback rate, anything that is effectively a risk-free rate with something added to make it look and feel like LIBOR is never going to be exactly the same. There’s an inherent risk to this.

Also, while ISDA’s fallback rates are only triggered if LIBOR actually ceases to exist, proposed fallbacks in other markets have what are called “pre-cessation triggers”. This means fallbacks may activate at different times and they can also trigger into a different rate – or to a differently calibrated rate.

One of the specific issues here is that the derivatives market will most likely be falling back to a backward-looking-coupon rate that compounds in arrears based on overnight risk-free rates, while the cash markets may use a forward-looking rate. Again, this immediately introduces basis risk into hedging.

The other major risk is that, even if we go to risk-free rates, globally these rates are not the same. Some are secured and some are unsecured. Even though they are all labelled overnight and risk-free they are not all going to behave the same way in times of financial dislocation, for example. This also raises risk in cross-currency swaps using risk-free rates, among others.

The market is increasingly looking at how it gets to the transition or phasing out of LIBOR. ISDA has said LIBOR will disappear when the regulators or ICE say it has – but it may be very illiquid even prior to this.

In this case, it is quite possible that supervised firms in the EU could only use LIBOR for legacy contracts but not for new business. This is because the EU benchmarks regulation (BMR) stipulates that a benchmark that is not reflective of an underlying market cannot be used in new contracts.

What could happen in this scenario is that effectively half of the market will not be able to hedge existing trades using new contracts. It brings in a lot of additional illiquidity risk.

The BMR itself states that from 1 January 2020, EONIA – which is not overseen by the FCA and is therefore technically different from LIBOR though it has the same problems of a thin underlying market – can no longer be used for new contracts. This means the market will have to switch to ESTER – but this rate will not be published until the second half of 2019.

The market has, in effect, three months to switch all its systems to adopt ESTER in all new contracts. The European Central Bank published a transition paper at the end of last year but it remains a big risk and a very, very short timeframe. There have been discussions about postponement and while I don’t have any inside knowledge this does at least seem to be possible.

The approaches being taken across jurisdictions are not all the same, either. While the US seems pretty adamant about adopting a risk-free rate, EU regulators are trying to salvage EURIBOR with something called “EURIBOR plus” that is BMR compliant.

This is partly because EURIBOR is used so much in retail exposures, particularly for mortgages. It’s doubtful that this will be successful, but it is still something that is being attempted.