Market struggling to wean off Libor

The UK’s Financial Conduct Authority (FCA) Q1 2021 deadline for the end of new Sterling Libor based contracts is closing fast but firms are still issuing and signing Libor contracts.

“The vast majority of banks are offering Sonia, alternative loans, as well as Libor,” says Serge Gwynne, partner at Oliver Wyman. “Where the client is keen on Libor, then they are still being issued at the moment, but this will need to change to meet the industry deadline of no new LIBOR loan issuance after Q1.”

The market is somewhat split in its preparedness for the new risk free rates (RFR): a survey conducted by SDL found that 60 percent of firms globally having been preparing for the transition to RFRs for at least one year. For the other 40 percent, 32 percent have been planning for less than a year and the remaining eight percent haven’t started.

“If you haven’t started your transition efforts already, it may sound like it’s impossible,” says Julien Rey, global lead for Libor transition at IHS Markit. “The problem is every firm should have started to look at this long before.

“There is way more proactive discussion at every firm we are dealing with, from both the buy and sell side. Even my colleagues in private equity are talking about the Libor transition, although it’s a minimal or minor component in what they do.”

In the UK, any new Sterling Libor contracts being issued with a maturity date beyond December 2021 should have fallback language to other rates such as Sonia. Gwynne says this is the case for most new Libor contracts.

“To avoid storing up new problems for the future, most banks and corporates have adopted new fallback language to make that transition easier. The clear expectation is that everyone should do everything they can to proactively move away from Libor before the end of the year.”

The FCA confirmed earlier this month the Intercontinental Exchange (ICE) Benchmark Administration (IBA) would stop publishing Libor rates for Sterling, Euro, Swiss Franc and Yen at the end of this year and for US dollar at the end of June 2023.

Though US dollar Libor can continue to be issued until December, the US Federal Reserve has been strongly encouraging firms to make the transition to RFRs as early as possible. Last week, to demonstrate the urgency of the transition, the Fed published a letter stating that they would examine the Libor transition plans of financial institutions ahead of the December 31 deadline. Even without the Fed’s further encouragement, there are already other incentives to switch to RFRs.

“From a hedging standpoint, like the lifecycle of the trade costs, the liquidity in US dollar Libor after the end of 2021 will decrease dramatically anyway,” says Rey. “There’s all of the incentive in the world to move away.”

With a little more than nine months until the end of US Libor, the Fed has stated firms could face “actions” if they cannot demonstrate preparedness for a post-Libor world.

In the letter addressed to all firms supervised by the Fed, they wrote, “Supervised firms that are not making adequate progress in transitioning away from Libor could create safety and soundness risks for themselves and for the financial system. Accordingly, examiners should consider issuing supervisory findings and other supervisory actions if a firm is not ready to stop issuing Libor-based contracts by December 31, 2021.”

Synthetic Libor and Credit Add-ons

The IBA will continue to publish a “synthetic” US dollar Libor until June 2023. No new Libor contracts can be issued using synthetic Libor but the 18-month extension of US dollar Libor rates will allow many “tough legacy contracts” to mature naturally, without the need to renegotiate fallbacks.

In the UK, the FCA will consult with the IBA on the possibility of publishing a synthetic Sterling Libor rate to be used in a similar fashion in the second quarter of this year.

“A synthetic [Sterling] Libor rate would make sense because it will act like a safety net,” says Rey.

“If it is confirmed that a synthetic rate is going to be published then the UK will be in the same sort of situation as the US.”

Looking ahead to the adoption of the RFRs, market participants in the US have been calling for a credit-addon to Sofr. Bloomberg has already started publishing their rate, BSBY, this month. IHS Markit also plans to launch their own rate, the USD CSA starting in April.

“What we intend to do with the CSA benchmark is fill the gap for firms that are issuing loans which need a benchmark that is sensitive to credit. We think the use case will be on loans, but it could also potentially be on other products.”

Unlike in the US, there is less demand for a similar product for Sonia in the UK.

“There’s been quite a push from both US and European banks to get to get that credit spread add on for US dollar rates. Whereas in the UK, there is much less demand from the banks,” says Oliver Wyman’s Gwynne. “It’s primarily a need that will be bank driven because it helps them to hedge their funding cost.”

There are a number of reasons the demand for a credit-addon in the UK is lower than in the US. These include, Sonia being more similar to Libor than Sofr, the market’s greater familiarity with Sonia and that the UK lending market being more centralised under larger banks.

Both Bloomberg and IHS Markit have said that extending their credit-addon for Sterling would be possible, but not an active consideration.

“This is something we could do, but it is not something that we have been working on as extensively as what we do in US dollars,” says Rey.