It has been more than two years since Andrew Bailey, Chief Executive of the FCA, announced the need for the market to transition away from LIBOR before the end of 2021. Regulators and insurers are focusing more closely on this transition as we get closer to this date and the various financial markets converge on fallbacks to IBOR term rates.
The FCA said in July 2017 that it would no longer compel panel banks to submit rates to enable the LIBOR calculation and the market should not rely on LIBOR being available beyond 2021. This affects a number of currencies and tenors, including USD, Sterling and Swiss Franc. EURIBOR is being reformed but will (in the short term at least) continue.
Financial markets must find replacements for LIBOR. The FCA and other regulators have made it clear that markets should not expect a legislative solution to the problem or rely on the continuance of LIBOR or other IBORs. Even if those benchmarks continue to be published, it seems likely that with a dwindling number of contributors, those rates will become unrepresentative of real borrowing rates.
Central banks and other regulators have looked to drive markets to find suitable alternatives to LIBOR. The Bank of England and the FCA established the Working Group on Sterling Risk-Free Reference Rates (RFRs) which has recommended using the SONIA benchmark as the preferred RFR for sterling markets. RFRs have been identified for all of the affected currencies.
Replacing LIBOR is a huge task for the market as a whole. We discuss some of the challenges briefly below. There are specific challenges for insurers. Solvency II requires insurers across Europe to value liabilities using “risk-free” discount rates. These rates are typically derived from LIBOR. Changes to the interest rate benchmarks used by EIOPA (or the PRA) to derive risk free discount rates will impact the “best estimate” of an insurer’s liabilities (which is used to calculate technical provisions) and its Solvency Capital Requirement (SCR). This will have a corresponding impact on the assets held by an insurer to meet those liabilities.
In addition on the asset side of the balance sheet, movements in LIBOR are reflected in the swaps used by insurers to manage interest rate risk, which is particularly important for life companies.
More broadly, while the FCA and other regulators are encouraging market participants to move to new RFRs for new transactions, RFRs are not term rates and are not known in advance. In particular in the loan market, there has been some reluctance to move away from forward looking term rates, because market participants are accustomed to the certainty of knowing cashflow requirements in advance of interest payment dates.
There has been general market inertia – in particular in the loan markets – with each participant being reluctant to be the first mover, and market concerns about the mechanics of the proposed replacement rates. That said, bond and derivatives markets have seen a large movement to RFRs in recent months and since the end of 2019, there has been a real push by regulators to accelerate the pace of the transition away from LIBOR.
Another looming challenge for the market will be to amend and convert legacy contracts to provide for these new rates when LIBOR ceases or becomes unrepresentative. Some newer transactions have robust fallback provisions, but older contracts often do not have these. Fallbacks in older bond documentation, for example, would be to convert floating rate bonds to fixed rates – possibly leading to winners and losers, unless the documentation is amended.
The task of amending all existing transactions with maturities beyond the start of 2021 is enormous and even with the best will in the world, for many transactions (such as bonds with hundreds or thousands of bondholders whose consent could be required for an amendment) such a project may be next to impossible.
The derivatives market is a leader in presenting a solution to LIBOR fallbacks. An IBOR fallbacks protocol is expected to be finalised and published by the International Swaps and Derivatives Association, Inc. (ISDA) in the first quarter of 2020, allowing market participants to efficiently amend vast numbers of derivatives contracts. The fallback rates will be compounded overnight rates plus a spread (based on the historical median between the risk-free overnight rates and LIBOR, which has built-in bank credit risk).
In the loan and bond markets, the remediation exercise is expected to be more laborious and thus far we have seen only a small number of transactions being amended.
The financial services regulators’ perspective
The FCA and the PRA have said that they will step up engagement with firms on LIBOR transition in 2020 through their regular supervisory relationship. They will review management information and collect data to assess firms’ progress. The first set of management information from firms was due by 31 December 2019 and this information is now being analysed and discussed with firms. The information received will be a key input to the FPC’s consideration in mid-2020 of whether sufficient progress is being made to avoid the use of supervisory tools.
In January 2020, the PRA and the FCA wrote a joint letter to the CEOs of major banks and insurers setting out their initial expectations of firms’ transition progress through 2020. That letter set out the following targets:
The FCA and PRA expect LIBOR transition plans to include these targets in project milestones and ensure that management information is available to track progress. As a guide, the PRA and FCA consider that action in the following areas is key to delivery, and should feature in firms’ planning from Q1 2020:
The European Market Infrastructure Regulation (EMIR) established a set of rules that became effective on 1 March 2017 and required the users of uncleared over the counter (OTC) derivatives to put in place risk-management procedures to ensure the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts. Having been dormant for a while, new EMIR mandatory initial margin requirements for uncleared OTC derivatives are now being phased in. Phase 5 on 1 September 2020 and Phase 6 on 1 September 2021. All financial counterparties with aggregate gross notional amounts of uncleared OTC derivatives at a consolidated group level over €50 billion (for Phase 5) and €8 billion (for Phase 6) will be required to post initial margin to each other.
Unlike previous variation margin requirements, initial margin must be posted two way, cannot be netted and must be held in a segregated account with a third-party custodian. Those insurers who fall within the scope of the initial margin requirements because of the size of their OTC derivative portfolios will need to put in place a suite of custodian and security documents that is significantly more involved than the previous variation margin documentation.
Many insurers will receive requests for information from bank counterparties who will need to carry out due diligence to assess whether their (insurer) counterparties fall within scope of the initial margin requirements and whether, as a result, repapering of the relationship will be required.
Insurers should by now have in place working groups to identify their LIBOR exposures and remediation plans. There are technology solutions available to help make this process more efficient, though this is far from an end-to-end solution. Consideration of the interaction of complex financial contracts will still be required, for example, and legal advice needed.
Insurers within the scope of the EMIR initial margin requirements should be actively looking at how they will implement those requirements because there is a significant amount of work to be done if the Phase 5 and 6 deadlines are to be met.