Thomas Werlen and Jascha Trubowitz discuss the recently published IBOR Global Benchmark Transition Report, published by ISDA, AFME, ICMA, SIFMA and SIFMA AMG.
US and Swiss qualified PD Dr. Thomas Werlen is Managing Partner of the Swiss office of Quinn Emanuel and a P.R.I.M.E Finance Expert. Jascha Trubowitz was a trainee at the Swiss office of Quinn Emanuel from April 2017 to June 2018 and currently interns at the Office of the Attorney General in Switzerland.
A new report assesses the issues involved with benchmark reform and makes recommendations on steps firms can take to prepare for the transition from interbank offered rates (IBORs) to alternative risk-free rates (alternative RFRs). The report has been published by the International Swaps and Derivatives Association (ISDA) the Association of Financial Markets in Europe (AFME), International Capital Market Association (ICMA) and the Securities Industry and Financial Markets Association (SIFMA) and its asset management group (SIFMA AMG).
What does the report set out and why was it commissioned?
On 26 June 2018, a group of key trade associations—ISDA, AFME, ICMA, SIFMA and SIFMA AMG—published the IBOR Global Benchmark Transition Report (the report). The report sheds light on the issues surrounding the IBOR benchmark reform and includes recommendations on steps companies can take to prepare for the transition from IBORs to alternative RFRs. The results of the Global IBOR Market Survey (the survey) serves as the basis of the report’s findings.
While IBORs serve a critical function in the financial markets, in particular, as reference rates underpinning hundreds of trillions of dollars in notional amount of derivatives and trillions of dollars in bonds, loans, securitisations and deposits, their continued use appears to be in doubt. Following a significant decline in the liquidity in the interbank unsecured market, the limited number of actual transactions and the reluctance of basing rates on banks’ judgments, the sustainability of certain IBORs is doubtful. The relevant jurisdictions covering IBOR currencies—the US, UK, EU, Switzerland and Japan—have set up public/private working groups to study benchmark replacements for IBOR. These have collaborated with global regulators to identify alternative RFRs to serve as alternatives to IBORs. Alternative RFRs are described as being risk-free or nearly risk-free because they are based on secured borrowing markets or on unsecured borrowing by sovereigns with little default risk, and therefore do not contain a credit risk premium. Hence, these rates would be deemed credit risk-free or nearly so. To date, all of these jurisdictions except the EU have identified preferred alternative RFRs. For a brief overview of the LIBOR refor, click here.
The global scale of this reform reflects the fact that any transition to alternative RFRs is an undertaking surpassing the capability of a single private or public institution and thus requires coordinated, world-wide efforts in order to succeed (The report, p. 6).
Nevertheless, individual institutions have a responsibility to take action. Andrew Bailey, Chief Executive Officer of the UK’s Financial Conduct Authority (FCA), stressed that:
‘Market participants must take responsibility for their individual transition plans…’
The report calls on market participants to act now and for each company to determine the scale of its exposure to IBORs and formulate strategies to reduce it. This means that instead of renewing existing IBOR exposures they should be phased out. Such action will require market participants to develop new products that refer to alternative RFRs. It is essential that each institution play its part in demanding, designing, supplying and trading these products. The report was produced as part of the ongoing efforts of the key trade associations in to help market participants understand and engage with global regulators and working groups. The report provides an assessment on the readiness of market participants, identifies the necessary elements for a successful transition and offers recommendations market participants can take to prepare for the transition (The report, p. 6, 10).
Specifically, the report is intended to consolidate and summarise the results obtained from the survey gauging the view of over 150 market participants in 24 countries on the impact of a transition from IBORs to alternative RFRs. The survey’s primary aim was to assess the current state of market readiness for the transition, the potential challenges related to the transition and the potential solutions to enable an orderly, efficient and harmonised transition. The survey covered IBOR currencies of the most relevant jurisdictions—USD, GDP, EUR, CHF and JPY (the report, page 10).
How is the market gearing up for the transition?
Market participants show high level of awareness
For a successful adoption of alternative RFRs, global regulators and working groups have deemed it vital for market participants to be aware of the transition. Efforts in raising awareness seem to have been highly successful. The survey showed that 87% of the survey participants are concerned about their exposure to the IBORs and that a majority has familiarised itself with the objectives of the working groups established in the jurisdictions. There are also promising indications that survey participants are gearing up for transition. 76% of the survey participants have, even if only minimal, started internal discussions on the transition, while 78% have even stated they intend to trade alternative RFRs within the next four years (the report, page 12 et seq.).
Lack of concrete steps being taken
However, the high level of awareness is not translating into real action being taken to prepare for the adoption of the alternative RFRs. Merely 11% of the survey participants have actually allocated budget and resources to the transition, and only 12% have developed a preliminary project plan. Notably, close to a quarter of survey participants have yet to take any steps to organise a program to support transition (the report, page 18).
Possible reasons for this gap
Most of the communication emanating from working groups has only until recently very much been focused on the selection of alternative RFRs. As the selection process is well underway, attention has begun shift to questions about implementation. For instance, William Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, emphasised in a recent speech on May 24, 2018 that:
‘Because of…the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates, we need aggressive action to move to a more durable and resilient benchmark regime.’
the report, pages 8 and 10
Also, the survey indicated that a number of survey participants lack a full understanding of the systemic risk posed by the dependence on IBORs. 60% indicated that they would continue trading IBORs if they were published after 2021. 18% indicated that they do not plan to use alternative RFRs at all (the report, page 12).
What are the potential challenges for the market in making the transition?
Despite the presence of fallback clauses in many products dealing with the event that a referenced IBOR ceases to exist, such clauses would fail to provide the necessary clarity and certainty once IBOR is permanently abolished. The report shows that the transition will pose a challenge for market participants in relation to corporate loans, bonds, floating rate notes, securitised products, consumer loans and residential mortgages. As existing fallback clauses for these instruments differ considerably, a permanent cessation of a relevant IBOR could lead to an increase in the costs for borrowing or lending of corporate loans, disrupt the market for bond issuers and investors as well as affect liquidity. Also, changing the terms for these instruments may prove challenging, since most or all lenders, bondholders or noteholders will have to come to an agreement (the report, page 15 et seq.).
Some survey participants expressed concern about basis risk in transitioning to alternative RFRs. Such risk could emerge if derivatives and the cash products that are hedged by the survey participants transition to alternative RFRs in a time-phased manner. In this respect, the report acknowledges that there are ongoing discussions over whether derivatives should refer to term alternative RFRs instead of RFRs themselves. There are concerns that the alternative RFR term rates would not be robust enough to support the weight of the derivatives transactions. As for currency swaps, the report finds that the survey participants were concerned that timing differences in the transition for alternative RFRs in each currency could disrupt the market, because the alternative RFRs being selected in the various jurisdictions may not share a common methodology for their determinations. Also, concerns have been raised with respect to the valuation of cross-currency transactions in adopting some combination of secured and unsecured alternative RFRs (the report, page 21).
The amendment of legacy positions to reference alternative RFRs instead of referencing existing IBORs will require the parties to consent commercial terms to bridge the differences between the IBOR and the alternative RFR. There are concerns by some institutions that despite negotiating in good faith and at arm’s length, they may face a claim from a counter-party who will be able to see the what the outcome would have been had no amendment taken place. Amending such legacy positions to reference an alternative RFR may also involve regulatory, tax and accounting issues (the report, page 24).
How can a transition be done in an orderly and efficient manner?
In terms of approaching the transition, the report stresses the need to take immediate action. This is not only addressed to market participants but also global regulators and working groups.
Communication and coordination
In view of a successful transition, what has resonated strongly among the survey participants is the issue of communication and coordination. Global regulators and working groups should be encouraged to provide clear regulatory messaging, regular and coordinated information as well as coordinated implementation timelines in their support of the transition. This way market participants are able to adjust to the latest developments and can refer to a consistent and clear framework on the basis of which they can develop their transition plans (the report, page 27).
Regulatory guidance for legacy positions
It was deemed critical by survey participants that legacy contract amendments would be subject to specific regulatory requirements if transition of such positions is to start (the report, page 30):
- survey participants want to avoid subjecting existing positions amended to reference alternative RFRs or include fallbacks to the requirements such as margin requirements under the European Market Infrastructure Regulation (EU) No 648/2012 (EMIR) or Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
- consumer protection laws may have to be taken into consideration when determining which legacy contract can be modified to reference alternative RFRs (or to include as fallbacks) and how to approach this without violating consumer rights. This is of particular relevance to mortgages, since, as a consequence of the transition, a large number of homeowners may experience an increase or decrease in payments. Survey participants are seeking regulatory clarity and guidance in this respect as to assess whether they can amend the legacy positions, and
- clarity is also desired on the implications of any transition on capital and liquidity ratios in consideration of transition planning. Working groups are already studying these aspects and may soon receive further clarity from global regulators
Alternative RFRs cannot be identified without proper products
Survey participants have identified products that are critical for their institution’s adoption of alternative RFRs. Products such as liquid RFR futures and forward rate agreement market, cash products based on RFRs and RFR money market instruments were named. Furthermore, it is necessary to modify existing basis swap markets and to develop new ones (These could be modelled after the current basis market between GBP LIBOR and Sterling Over Night Index Average (SONIA)). In addition, because of the phased approach of the working groups, the cross-currency swaps would have pass through a multi-stage transition process. The working groups have explicitly heralded the need for basic products as a requirement. Key products have already been launched over the past year (the report, page 32):
- OTC derivatives: ISDA has published floating rate option definitions for Swiss Average Rate Overnight, reformed SONIA and Secured Overnight Financing Rate (SOFR) in order to support trading in the alternative RFRs in cleared and non-cleared derivatives.
- Cleared derivatives: London Clearing House to start clearing outright Overnight Index Swap and basis swaps referencing Secured Overnight Financing Rate by the third quarter of 2018. CME Group to commence clearing OTC swaps referencing SOFR in 2018.
- Futures: Intercontinental Exchange (ICE) released a one-month SONIA futures contract in December 2017 and to release a three-month SONIA futures contract in June 2018. CurveGlobal released a 3-month SONIA futures contract in April 2018. CME released one-month and three-month SOFR futures contracts in May 2018.