Perspectives | 19 June 2019
A raft of recent consultations on Ibor reform indicates that we may finally be making some progress. We have seen the International Swaps and Derivatives Association (ISDA) issue another round of consultations for Inter-Bank Offered Rates (IBORs) trying to solve the issue of the spread and term adjustments in fall-back for derivatives referencing IBORs and pre-cessation trouble before the end of 2021.
In addition, the International Accounting Standards Board (IASB) published its first Exposure Draft, “ED/2019/1 Interest Rate Benchmark Reform”, proposing amendments to IFRS 9[1] and IAS 39[2], which was shortly followed by the European Financial Reporting Advisory Group’s (EFRAG) draft comment letter. With the proposed ED, the IASB focused on the IBORs pre-replacement issues and tackles, in particular, the forward-looking hedge accounting requirements.
Whilst local regulators do not seem similarly concerned about the lack of progress, recent developments will be welcomed by the financial services industry which has been waiting for the IASB to provide a first “signal” even a draft position on accounting matters.
One of the main concerns for the financial services industry was the ability to maintain hedging strategy based on “highly probable” conditions. Given the uncertainty around existing benchmark rates and their replacement during the transition periods, the forward-looking analysis required as per the accounting principles would have systematically failed, resulting in the discontinuation of the hedging relationships. With the compulsory, albeit temporary, amendments proposed by the IASB and supported by the EFRAG, market participants can relax… but only for a very short while.
Indeed the amendments proposed are not comprehensive and a second phase is both highly expected and asked for by the EFRAG in order to address the remaining accounting issues that can arise from the IBORs reform. Such issues include, but are not limited to, the Derecognition, impact in Profit and Loss (P&L) of the contract modification; Hedge Accounting effectiveness, discontinuation, documentation, and recalibration of the hedging relationships; IFRS 9 SPPI criterion[3] and business model; and IFRS 17 – Interest guarantees in insurance contracts or the impact of €STER (EONIA’s replacement) on the collateralised derivatives.
US moving at a faster pace?
These issues arise from the accounting “translation” of the expected contractual modifications which will have many other impacts. As such, one can easily understand why the industry is currently focusing on the contractual fall-backs. In particular, although relevant fall-back rates have been announced in different countries, the US are moving at a faster pace than Europe to transition toward the Secured Overnight Financing Rate (SOFR) – the alternative Risk Free Rate (RFR) for the USD LIBOR. Indeed, public-private sector RFR working groups in the US, such as the Alternative Reference Rates Committee (ARRC), have consulted the industry and in April and May 2019 published templates for fall-back language. This included pre-cessation triggers that will apply to new cash products contracts such as bilateral business loans, floating rating notes, securitisation and syndicated loans.
Since April 2018, there are currently $46.3 billion[4] of SOFR-referencing US dollar floating rate notes available in the market already and the trading repo is averaging $843 billion volume per day, according to data compiled by the Fed Bank of New York. So while the European market is gradually making progress, overall one could see a higher liquidity and market maturity for SOFR in the US sector at the moment.
On the UK side, the Financial Stability Board (FSB) and the Official Sector Steering Group (OSSG) wrote to ISDA in March 2019 seeking further market opinion for the spread-adjusted fall-back rate for LIBOR. The Financial Conduct Authority (FCA) encouraged market participants to consider including LIBOR contracts pre-cessation fall-back triggers, in addition to fall-back triggers based on permanent cessation until the very last date of LIBOR publication. Dutch Central Bank and Netherlands Authority have also requested financial institutions to provide roadmaps and details for their transition, as per the example of the FCA’s and PRA’s “Dear CEO letter” sent to major banks and insurers in September 2018.
Preparation for pre-cessation fall-back ongoing
In response to FCA recent statements on the LIBOR transition, the progress made and the challenges ahead, working groups have started to prepare for pre-cessation fall-back. Some strategies include closing out as much of their exposures to an IBOR as possible to avoid potential cessations of the rates. Alternatively, some banks have decided not to offer contracts with maturities of more than 5 years, in the light of future heavy capital requirements and holding up to 75 times[5] more in Risk-Weighted Assets under the new Fundamental Review of the Trading Book (FRTB).
The ISDA Consultation on Pre-Cessation Issues for LIBOR and Certain Other Interbank Offered Rates released on 16th May, include possibilities for companies to continue using LIBOR rate after cessation. However, not only would this create legal and accounting issues, but regulatory authorities would also have no means to curb the unprecedented problems created. Hence, ISDA actively seeks opinion on publishing a protocol in pre-cessation and fall-backs to allow both counterparties to preliminary agree to include certain transactions only. Furthermore, and simultaneous to the pre-cessation issue, a separate consultation is currently ongoing with regard to the spread and term adjustments applied to fall-backs in derivatives contracts. While high level directions have been agreed, technical issues to determine length of forward spread curve, duration period of historical static look back period and methodologies of spot spread calculations are to be further developed by the industry.
Regulators in Asia-Pacific region are also seeking to work and strengthen the contractual fall-backs for their interest rates. Already Australia’s Bank Bill Swap Rate (BBSW), Japan LIBOR and Tokyo IBOR (TIBOR) have been included in the 2018 ISDA consultation and it is very likely that Hong Kong IBOR (HIBOR) and Singapore Swap Offer Rate (SOR) will follow.
Work on strengthening benchmarks not without problems
Considerable work is being undertaken to strengthen benchmarks and build robust fall-backs, all making sure that the alternatives comply with the new European Benchmark Regulations so they can be used and cleared within the European Union.
Yet while progress is being made, the liquidity of the new RFRs remains an issue. As noted earlier, while SOFR trading is encouraging the liquidity trend of other RFRs seems slower. As at the end of March 2019, the monthly traded volume in listed futures aggregated across all products shows that only 102,488 contracts have started using SONIA, while 3,949,283[6] contracts continue using GBP LIBOR. Similarly, London Clearing House Group (LCH) has seen the SONIA interest rate swap clearing volume double to £45 trillion[7] but, at the same time, LIBOR-related product trading volume rose by around 50%. These figures clearly show that habits die hard and, partly fuelled by the uncertainties surrounding the alternatives rates, that the market is not yet ready to let the LIBOR go.
All eyes are now set on the financial services industry which is expected to lead the transition. But it should not be forgotten that for each transaction there is a counterparty, whether it be corporate firms or investors. With time marching on, it is of the utmost importance that all market participants are equally informed and educated on transition issues. Broader and louder communication now might be the key towards a smoother transition.
Article written by Michelle Kwok (Quantitative Analyst, Mazars UK) and Pauline Pélissier (Senior Manager, Mazars UK).
[1] IFRS 9 Financial Instruments
[2] IAS 39 Financial Instruments: Recognition and Measurement
[3] Solely Payments of Principal and Interest
[4] https://www.housing.org.uk/latest-updates/update-on-the-libor-sonia-transition/
[5] https://www.risk.net/regulation/6614631/fund-linked-structured-products-face-extinction-under-frtb
[6] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/newsletter-april-2019.pdf?la=en&hash=9EF34E504DFBE4C27411AA292C5354E8F23BC786
[7] https://www.marketsmedia.com/sonia-swap-clearing-volumes-double-at-lch/
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