In January 2022, Libor or not Libor?

Following several manipulation cases in 2012, central banks and regulators decided to discontinue Libors/Eonia as reliable benchmark interest rates as from January 3rd 2022 including some transitory regimes up to June 2023. They provided guidance on related transitions (alternative rates, Conduct Risk practices expected, benchmarks regulation, and for buy side, performance fees management…) and advised that risk-free rates (RFRs) to be based on transaction public data rather than solely on banks submissions, diminishing concerns raised over Libor rates’ representativeness, transparency, and questions regarding fair treatment of end investors.

This transition brought some degrees of complexity with broad impacts levels, given respective market references, locations, conditions (product impacted, liquidity) but also opportunities in which flexibilities were progressively introduced. Market associations therefore engaged consultations on specific topics, such as ISDA/fallbacks, ICE/Libors publication calendar, as well as ICMA, EIOPA and the like.

Central banks and regulators favour overnight risk-free rates. Market data providers proposed more options to this transition, such as alternative rates, especially in USD markets with credit sensitive components (BSBY by Bloomberg, Ameribor by AMX, CRITR/CRITS from IHS Markit), poised more adapted to specific transactions.

Considered by regulators as too similar to former Libors with underlying markets (commercial papers, certificates of deposits) and not “liquid enough” (cf commercial papers credit crunch in March 2020), those credit-sensitive rates are hence designed to complement SOFR rather than replace it.

As overnight RFRs are chosen by regulators as alternatives to Libors and EONIA, term structure considerations arose, with market participants using different tenors in their funding and investment activities. As a result, working groups have considered a forward-looking approach based on these RFRs. Established markets like GBP shall use an in-arrears approach for SONIA. Term SONIA has been recently introduced. Other markets like USD shall use both approaches (in-arrears and in-advance SOFR are respectively used for FRNs and consumer loans). The Financial Stability Board recently issued recommendations (extensive use of overnight RFRs) and will publish progress reports over Q4 2021.

To facilitate RFRs adoption, regulators launched several consultations related to RFRs adoption similar to the one for linear derivatives. Swaps are deemed to be strong drivers for other derivatives practices (cross-currency swaps, non-linear derivatives, future contracts…). The UK Financial Conduct Authority (FCA) recommended SONIA quotation for swaps from March 2020 onward. Despite the Covid-19 pandemic, an increase in SONIA traded volumes was observed as a SONIA adoption for derivatives and cash markets.

Regarding GBP and JPY Libors, the FCA opened a consultation on June 24th 2021 regarding 1-month, 3-month and 6-month synthetic Libors implementations starting January 2022. FCA’s final decisions on those rates will be taken during Q4 2021.

Regulators induced flexibility regarding transition timelines dependent on market constraints, namely specific Libors publication extension, synthetic Libors, ARRC, CFTC on SOFR initiatives, European Commission on EONIA statutory replacement by €STR + 8,5bp to address potential non-transitioned contracts.

The FCA announced an extension of publication of several tenors of GBP, USD and JPY Libors from December 2021 to 2022 or 2023 in order to give more time to amend documentation, contracts or to allow for short dated financial instruments to mature to reduce the scope of financial instruments to be transitioned. It also introduced synthetic Libor based on forward-looking term RFRs. Regulators and market players prefer to move to overnight rates compounded in arrears as they reflect the genuine interest rate for that relevant period of reference rather than a historic period or a projected given rate.

To strengthen USD to SOFR markets’ transition, CFTC’s Interest Rate Benchmark Reform Subcommittee recommended from July 26th 2021 to use Interdealer Swap Market Trading Conventions based on SOFR (from USD Libors ones). Related swaps traded volume doubled between July 26th and August 15th, like SONIA quotation for GBP swaps in March 2020, triggering a significant increase in derivatives turnover in SONIA. Monitored volumes will suggest adoption trends and transition pace for coming months.

Bonds showed a high adoption rate with SOFR and SONIA being used by issuers, even if the market is still tiny for floating-rate notes.

Further publications are still expected on synthetic Libors use (GBP, JPY), on transition progress from JPY Libor to TONA and from SOR to SORA and conversion of legacy Libor contracts to RFRs contracts or with insertion of robust fallbacks, impacting Conduct Risk management.

Although financial institutions initiated risk-free rates transition in 2019, ending in 2021 with its final phase, teams will be busy with client management and related contracts update and cross coordination with other projects and regulations, like SFDR, performance fees ESMA directive, … .

Whilst interconnected and in a global transition context of key market structuring elements, both sell side and buy side have their own pace of change and specific approaches.

On the Investment Banks’ side, Libor transition project teams aggregated cross asset class impacts through layers of RFR related financial instruments inventories to provide a comprehensive view of their respective book of impacted transactions, whilst asset managers had to deal with other issues such as specific product topics around money markets funds too, and also complex distribution channels for instance through the adaptation of their respective legal and marketing documentation. Multi-boutiques models, providing some marketing edge to competitors, or increased outsourcing operating models, and the use of externalized trading desks, increased the items’ agenda for an orderly transition, with different levels of impacts. The latter includes exposures, maturities to be considered at different group or related entities levels, multiplying the number of people to be engaged on very specific issues for a global transition.

On the sell side, more specifically, the three main pillars identified were:

As bonds, derivatives, loans, structured products are impacted, ICMA, ISDA, LMA, EIOPA consultations must be followed to have guidance on documentation updates. Bilateral negotiation will take place to amend master agreements and related repo/securities lending transactions.

Loans’ transition is still to be closely monitored. Various actors confirmed their needs to increase their effort to be engaged through a significant number of bilateral negotiations with options remaining on credit spreads to be agreed. EONIA/€STR spread is capped at 8,5bp suggesting smooth negotiations. USD Libor/SOFR suggests several approaches, with higher spreads (26,2 bp on 3-month tenor), involving credit sensitive rates. Phased approaches depending on currencies, tenors impacted can be designed (with some priorities by January 2022, and other USD, GBP, JPY loans to be amended over 2022, 2023).

Counterparties on derivatives (mostly swaps), cash and loan transactions shall enter negotiations to agree on transition choice (risk-free rate conversion, applicable spread, fixed rate conversion, prepayment…). This operational phase should be carefully managed as many uncertainties arise (negotiations length, counterparties responsiveness, repapering, business as usual at year-end…). Many institutions recently reinforced their set up with dedicated teams to address their legacy portfolios transitions to meet regulatory deadlines as they are suggested.

Buy side institutions shall handle legal documentation updates through their funds KIIDs and prospectus whereas identified RFRs benchmarks are based on Libors, EONIA. A change of index leads to a modification of the KIIDs and prospectus for investment funds (magnitude of impact assessment is needed for collective investment vehicles) or an amendment of mandates and agreements after proper liaison with clients given the nature of the changes to be made.

These updates shall also involve some of asset managers, management companies’ external providers such as custodians, fund administrators, reporting engine providers, adding substantial workload in critical periods (end 2021, end of quarters, annual report date) while considering impacts from other regulations (SFDR, ESMA performance fees directive…).

In general, initial assessments and set up, led investment firms to map, first, their operational impacts: IT systems, front-to-back processes, risk engines (quantitative models using Libors, EONIA must be adapted), and secondly, their connectivity and flows with settlement services providers.

The review of the KIIDs and prospectus includes an analysis of the type of reference index, the presence or absence of performance fees and the nature of the fund, whether it is an open-ended, a dedicated, a money market or fund of funds… Complexity of implementation varies depending on the nature of the funds.

Master agreements, repo, securities lending transactions should be reviewed as well, with bilateral negotiations and/or protocol adherence helping the transition.

On product side, Libors, EONIA can be mentioned at investment funds levels, as a benchmark for comparison purposes or for performance purposes, particularly when the investment objective is to outperform the latter. Investment management mandates and agreements can also use Libors, EONIA.

Particular focus shall be made on funds with performance fees, money market funds. Possible switch dates range might be smaller compared to other funds. To manage only one performance calculation model, the accounting cut-off date could be preferred. However, ESMA 34-39-992 directive on performance fees calculation and disclosure must also be considered and can suggest alternative switch dates. For money market funds, impacts of change on performance fees must be identified along the different processes (performance fees calculation matrix, liaison with customers) and choice of spread. In addition, a bearer letter could be used for client communication, under specific conditions.

From an operational point of view, especially for fund administration, performance fees computation may remain a challenge, especially for daily and weekly NAV funds. These require constant mobilisation of the accounting and IT teams.

One issue consists in the automation of performance fee calculations in IT systems, while at the same time offering the possibility of customised calculations. The latter option could entail significant development costs that could be approached also on a case-by-case basis. With Funds markets more and more concentrated with ever larger volumes of funds to be processed with multiple compartments, share classes, such automation therefore requires reviews of related workflows to integrate or digitalize these calculations.

This move towards standardisation is also part of a regulatory framework requiring more and more transparency, would question performance fees given funds types (money market, multi-asset, debt, equity, etc.).