Six months have now passed since publication of the Dechert OnPoint, LIBOR – Where Are We Now?, and in that period progress on benchmark reform and the development of alternative risk-free-rates (RFRs) has gathered pace. At a time when much discussion is focussed on Brexit and what March 2019 will bring, LIBOR, benchmark reform and the alternative RFRs have never been far from the headlines.

The message remains that the market needs to be prepared, and there has been comment as to lack of preparedness from the buy-side. The fear that firms are not giving the topic enough attention is highlighted by the recently published “Dear CEO letters1”, jointly issued by the UK Financial Conduct Authority (FCA) and Prudential Regulatory Authority (PRA) to certain large banks and insurance companies regarding firms’ preparation for the transition from LIBOR to alternative RFRs.

The problem that must be solved is how to develop alternatives for the long-standing, widely used family of inter-bank offered rates (IBORs), considering that the estimated notional exposure to the IBORs across financial markets is approximately $370 trillion.

Key Developments

12 July 2018 International Action

On this single day, there were three key developments: the first, a new LIBOR and benchmark reform-related speech by Andrew Bailey2; the second, a statement by the Financial Stability Board (FSB) on reforms to interest rate benchmarks3; and the third, ISDA’s long-awaited launch of an industry-wide consultation on aspects of fall-backs for derivatives referencing certain benchmarks4. The common message from Andrew Bailey and the FSB was that although there has been progress, in the period ahead discussions must continue and the path towards transition cleared.

ISDA RFR Fall-Backs Consultation

The ultimate product of the July consultation and ISDA’s related work will be amendment of the 2006 ISDA Definitions to provide fall-backs for LIBOR and the family of IBORs5. Once finalised, the amendments are expected to be implemented in existing contracts by the now commonly used ISDA protocol mechanism. For new transactions entered into on or after the date the changes become effective, the amendments will automatically apply. The consultation, to which market participants generally are being encouraged to respond, is intended to solicit feedback on an approach to addressing certain technical issues with the adjustments required to the RFRs if the fall-backs are triggered.

The consultation sets out ISDA’s intended way of introducing fall-backs to the floating rate options currently set out at Section 7.1 of the 2006 ISDA Definitions. The amendments are structured so that an objective trigger event must first occur. The new fall-backs, which comprise those RFRs already identified globally (see below), will be activated on the occurrence of that trigger, but will take effect only once the discontinuation actually occurs. In practice, there could be a time lag between the trigger occurring (for example, a public announcement) and the discontinuation of the relevant rate. The consultation focuses on the adjustment methods to be applied to the new RFR fall-backs so that they are comparable to the IBORs they will replace. The adjustments are to account for term (the IBORs are term rates, whereas the new RFRs are overnight rates), and spread (the IBORs incorporate a credit spread, whereas the RFRs generally do not).

Although the high-profile USD LIBOR, EUR LIBOR and EURIBOR have not yet been included in the consultation, it is expected that these (together with HIBOR6) will be covered in supplemental consultations, and that the results of the current consultation will be used as a guide. Timing for USD LIBOR will depend on data being collected on SOFR (the replacement rate already identified). With respect to EUR LIBOR and EURIBOR, timing is subject to further progress being made on the replacement rate, identified only recently in September 2018. It is expected that, in due course, the results of the first consultation will be used as a guide for the fall-backs to these IBORs. Following the end of the consultation in October (recently extended to 22 October 2018), no significant substantive developments or the new supplements are expected until mid-2019.

Industry Action

While ISDA continues to be at the forefront of derivatives-related activity, other industry bodies have also been very active. In May 2018, the Loan Market Association (LMA) published recommended replacement screen rate language. This was followed on 20 September with a second edition of a joint paper by the LMA and the Association of Corporate Treasurers (ACT)7, which provides an overview of the future of LIBOR and highlights the wider impact of LIBOR transition beyond the derivative, bond and loan markets. The LMA also recently launched a LIBOR microsite. In June 2018 a group of industry bodies8 published an IBOR Global Benchmark Transition Report9, which aims to help market participants understand and engage with the ongoing efforts of global regulators and their various working groups. In the United States, on 24 September, the Alternative Reference Rates Committee released a consultation for USD LIBOR fall-back language for floating rate notes and syndicated business loans.

Interaction with the European Benchmark Regulation (BMR)

European work on fall-backs and alternative RFRs (including with respect to timing) continues to be driven by the requirements of the BMR. The key BMR requirement for benchmark providers is the authorisation of benchmarks, as well as additional requirements for “critical benchmarks”. The BMR requirements create additional time pressure for benchmark providers since, post-January 2020, it will no longer be possible to use certain benchmarks (including EURIBOR and EONIA) unless the benchmark administrator has been authorised or granted an exemption from authorisation. This leaves only just over a year to get ready for the new rules and, to avoid market disruption, there are calls for a delay so as to ensure all is in order. EMMI10 has already announced that it will not reform EONIA to meet the BMR requirements.

For those benchmark users subject to the BMR, the key requirement of the BMR is to implement written plans regarding their “use of a benchmark” and to nominate alternatives should that benchmark materially change or cease to be provided.

On 19 September 2018, ISDA published the Benchmarks Supplement (Supplement). Although its primary intention is to serve those users of benchmarks that are subject to the “written plan” requirements of the BMR referenced above, given the global focus on contractual robustness, the Supplement may be used by parties not subject to the BMR who want to incorporate fall-back provisions in their contracts. The Supplement includes fall-backs as well as provisions regarding the consequences following a change to a benchmark for each of: the 2006 ISDA Definitions; the 2002 Equity Derivative Definitions; the 1998 FX and Currency Option Definitions; and the 2005 ISDA Commodity Definitions.

Global Progress on the Alternative RFRs

Global efforts to identify and develop replacement benchmarks continue. The most recent development was on 13 September 2018, when a European Central Bank (ECB) press release announced that the new euro risk-free rate would be the Euro Short-Term Rate (ESTER).

The table below summarises key information:

Region

Currency

Relevant IBOR

Alternative RFR

RFR Working Group

UK

£

GBP LIBOR

SONIA11

Working Group on Sterling Risk-Free Reference Rates

Euro Zone

EURIBOR/ EUR LIBOR

ESTER

Working Group on Euro-Risk Free Rates

Japan

¥

JPY LIBOR, JPY TIBOR

TONA12

Study Group on Risk-Free Reference Rates

Switzerland

CHF

CHF LIBOR

SARON13

National Working Group on Swiss Franc Reference Rates

United States

US $

USD LIBOR

SOFR14

Alternative Reference Rates Committee

What to do Now?

Given the wide IBOR exposure, firms are more than likely to be, or will be, affected by these developments in some way. It is important to:

  • Assess:
    • Current exposure to the LIBOR and IBORs;
    • If and when any such exposure will run-off; and
    • If and how any relevant agreements provide for the discontinuance of LIBOR.
  • Consider participating in market groups, especially if the firm has significant exposure.
  • Monitor developments.