US Libor extension vital as fallback adoptions remain limited

While market participants have been preparing for the cessation of Libor at the end of this year, the ICE Benchmark Administration’s (IBA) expectation to push the dollar Libor deadline to 2023 has sparked relief as the adoption of fallback mechanisms remains limited for US counterparties.

“The US Libor was so widely entangled in the professionals and non-professional market, and its usage is so massive, that to undergo a full transition under old timelines is too much,” Jaap Kes, global head market risks & execution group treasury at ING.

“They had to come up with some kind of delay because professional market participants would have been ready, but this would likely not be the case for the non-professional participants of the marketplace, especially with coronavirus.”

Whilst two deadlines make the process more complex, the extension of the dollar Libor is necessary for market participants to amend the significant amount of US Libor based contracts.

US Libor – by far the most used of all Libors – amounts to $200trn worth of financial contracts, according to the Federal Reserve, equal to half of all Libor contracts across the globe.

With two sides to a financial contract, Kes says institutional market participants will also rely on the readiness of their counterparties and clients when amending contracts.

“Even for fixed-rate contracts the pricing is derived from derivatives that embed a fixed and a floating leg and, in that sense, these fixed-rate contracts are also derived from interest rate benchmarks,” he adds.

Anne Beaumont, partner and head of Libor transition at Friedman Kaplan Seiler & Adelman LLP, believes the proposed delay is crucial to tackling the tough legacy issue, which involves transactions that either have no Libor fallback language or bad fallback language, such as the last print of Libor that is turned into a fixed rate.

Pushing the deadline to 2023 also means many financial contracts under dollar Libor would have reached their end date.

Kenan Maciel, director of strategy at Lab49, says an extension of the deadline until contracts have reached their maturity will not be feasible due to the long-term nature of many contracts.

Despite the IBA’s delay of the US Libor deadline, Beaumont says market participants could face risks if they fail to transition away from the benchmark.

“For corporate treasurers, the risk is having something you think is a floating rate but turned into a fixed rate and not being prepared for it,” she says.

Asset and investment managers also risk being stuck holding products they cannot sell due to liquidity in instruments having bad fallback language.

“It’s already affecting pricing,” says Beaumont. “You’ll have value changes that you haven’t been tracking all along, but that you’ll realise when you have to try and sell.”

Whilst the adoption of fallback mechanisms remains low, a forward-looking Secured Overnight Rate (Sofr) variant – which operates similarly to Libor – would facilitate the benchmark’s transition and therefore minimise risks.

“These [alternative benchmarks] are still under development,” explains Kes. “The backward-looking variants are now there, but the forward-looking variants, which are easier to deal with for the non-professional market participants are still under development and are not ready for use yet. That’s what holds it [Libor transition] back.”

In September last year, the Alternative Reference Rates Committee (ARRC) released a Request for Proposals (RFP) in which it sought an organisation to publish forward-looking Sofr term rates. The ARRC aims to publish these in the first half of 2021 if liquidity in Sofr derivatives markets are sufficient.

Tougher regulatory intervention within the Libor transition could also boost the adoption of fallback mechanisms, according to Beaumont.

“They [market participants] don’t have to do it as long as Libor continues – they are not forced,” she says. “It’s an expenditure with no obvious benefits. Yes, financial stability is an obvious one, but it’s not easy to describe to shareholders or directors.”

Beaumont says a lack of understanding of Alternative Reference Rates (ARRs) is contributing to the transition’s difficulty.

“One is a mixture of nobody wanting to be the first person to adopt it, because they don’t understand how Sofr is going to behave. Despite all the promotion that’s been done, people don’t feel comfortable with Sofr – that coupled with the fact that there are not necessarily good matching hedging products.”

In the UK, 85 percent of the uncleared derivatives market is now ready of the cessation of Libor, with 12,500 firms signing the ISDA protocol, according to the FCA.

The FCA, along with the Bank of England (BOE) and the Working Group, still rely on the majority of sterling markets to have adopted Sonia by the end of the year. On January 25, the new International Swaps and Derivatives Association (Isda) language on fallback mechanism also became effective.

But while the FCA reaffirmed its readiness for the discontinuation of Libor this year, the IBA’s intention to extend the US deadline to June 2023 seems very likely considering the vast quantity of US Libor based financings.