IBOR transition - fasten your seatbelt it could be a bumpy ride

As we wrote in February post an FCA speech, the ‘do nothing’ strategy of waiting for fallbacks could result in market chaos.

The Financial Stability Board (FSB) letter in March had Official Sector Steering Group (OSSG) members ask that ISDA also consult on including an additional trigger that would take effect in the event that the FCA found LIBOR to be non-representative in its capacity as the regulator of LIBOR.

So this could bring the date in which LIBOR ends even sooner after 2021 however adds further complexity to the process of agreeing what LIBOR falls back to and more importantly at what time and how does this align with the cash market?

When / what next?

We expect market outreach and feedback on open issues associated with the final parameters of the term and spread adjustments in Q2 2019.

Additionally in April there will be a further consultation covering the currencies such as the USD LIBOR.

It’s expected there will only be one protocol to incorporate the amended definitions for all benchmarks in Q4 2019.

Ensuring the language is incorporated into the documentation is key and somewhat expected. If protocol take up is not successful and an IBOR permanently ceases to exist, the fallback would be to reference banks which, will be notoriously difficult to obtain and would just create a whole heap of uncertainty. As a result there is a sizeable risk of falling back to contractual frustration, which won’t be in either parties’ interests. The loan market has a further fallback if reference banks fail which is to lender’s cost of funds. However that’s not ideal either because it’ll vary from lender to lender making it unlikely to reach a standard rate even within the loan market. The Bond market additionally falls back to the rate from the previous period which is far from ideal.

Rates	Existing fallback	Proposed fallback	Best fallback?
Derivatives	Reference bank quotes	Benchmarks Supplement (for all benchmarks) ISDA IBOR fallbacks (for IBORs only)	Benchmarks Supplement (for all benchmarks) ISDA IBOR fallbacks (for IBORs only)
Loans	Reference bank quotes Cost of funds	LMA Replacement Screen Rate clause	LMA Replacement Screen Rate clause
Bonds	Rate to fallback to interest rate from the previous period (which means the rate becomes fixed).	Attempts to include fallback provisions (such as nominating an independent third party to select a new rate) but very bespoke/transaction specific Legacy transactions difficult to manage as consent solicitation process usually requires majority/all lender consent	Market standard fallback provisions developed for inclusion in new issues Keep a 'zombie' LIBOR available for use in legacy transactions?

There seems to be a consensus view developing that the majority of outstanding LIBOR risk holders would be willing to wait for cessation triggers to activate the fallbacks in order to reduce their risk in a smooth fashion. We think it is naive to believe there will be no complications in this process and would still encourage transitioning where possible.

It’s likely that fallbacks across product classes won’t necessarily be aligned and that you could find yourself in a situation where LIBOR liquidity is significantly reduced resulting in wider bid/offer spreads in the market, negating any perceived benefit of waiting for the fallbacks. This could also potentially be catastrophic for products that are inherently connected, such as loan-linked derivatives. Aside from this, a scenario exists where Libor fixings are significantly more volatile as banks drop in and out of submission (especially if the FCA do not use the power they have to announce that a rate has become unrepresentative) leaving LIBOR holders extremely vulnerable to fixing risk, another complication that has been overlooked.

LCH have announced an intention to automatically include the ISDA IBOR fallbacks once available. If the market fails to incorporate them in bilateral transactions, the cleared and uncleared swaps market would be taking two very different positions, potentially leading to significant basis risk.

Are the cessation triggers across product classes the same?

No. The derivatives fallbacks ISDA have been working on currently only have one main trigger which is focused on the permanent cessation of an –IBOR. By contrast, in the cash market and the LMA’s replacement of screen rate language, there are a number of pre-cessation triggers.

For Floating Rate Notes and syndicated loans, the Alternative Reference Rates Committee have suggested three pre-cessation triggers (LIBOR stops unannounced for five days, administrator invokes the reduced submissions policy as a number of banks no longer submit, regulator says it’s no longer fit for purpose etc). It clearly makes sense for there to be some kind of cohesion across product classes on what the triggers are. The FSB’s OSSG have stated the importance of this.

So transition now or rely on fallbacks?

While there are always other, more urgent topics to focus on, transition early to avoid market ‘chaos’ has to be the message. Having a water tight insurance contract doesn’t mean you start to drive carelessly… and of course even with a seatbelt there’s always whiplash to think about.