Four down, more to go…

December 31st could be described as a watershed moment in finance, though it could also be described as an effortless finale. While most of the planet partied, LIBOR benchmark rates that had served markets for over thirty years were consigned to the dustbin, at least almost. While GBP and JPY LIBOR rates continue to be published in a synthetic form, their daily movement is now a function of movement in underlying risk-free rates (RFR’s). That is: they no longer move in line with term interbank lending rates set in the City of London.

That delta is different.

In this blog we look at the cessation event for GBP, JPY, CHF and EUR LIBOR, and demonstrate that while a great deal happened, with around U$180 trillion worth of financial contracts impacted, the transition-event was perfectly kept out of the limelight. Financial markets continued to price, trade and distribute risk, functioning almost seamlessly throughout. In our view global regulators got the cessation right and should feel a sense of achievement at the overall result for such a complex endeavour.

The local post-cessation scene

Over the past three years we’ve had a lot of engagement with firms across Asia-Pac in the LIBOR-cessation field, in several cases been engaged consulting to major transition-projects. With the GBP, JPY, CHF and EUR-LIBOR cessation moment having passed we asked these firms how the transition up to and through cessation finally went.

The following Q&A has delivered some anecdotes worth sharing, and not simply for the sake of promoting FCA bragging-rights, but worth it given the world’s biggest LIBOR cessation moment is still to come: USD-LIBOR, on 30th June, 2023. It’s in this context December 31st could be considered a well-planned and executed dress-rehearsal.

Q1. Was there any disruption experienced in your markets and/or corporate-finance business over this first LIBOR-cessation event?

Answers were strongly uniform, with all respondents noting that the transition was a resounding success, and relatively minor disruptions were worth mentioning:

·       Very few firms reported issues with clients, though some client positions in corporate-finance (loan) deals remain outstanding, pending a transition prior to their next reset date.

·       The somewhat limited corporate/buy-side adherence to the ISDA Protocol proved no barrier to transition, which we take to mean that most firms managed to strike bilateral agreements in sufficient time.

·       The large stock of cleared derivative transitioned through CCP’s in early-December proved of significant benefit given this reduced risk at cessation, and gave important markers to risks at the actual cessation-date.

·       A majority of firms transitioned their internal trades, a surprisingly large stock in some cases, well prior to Dec 31st.

·       Interbank counterparties overwhelmingly elected to rely on CCP rules, or ISDA fallbacks to transition deals struck with other banks, a point we had predicted.

·       Some firms reported that a small sub-set of all-trades had to be manually handled to ensure accurate booking, reconciliation, and representation of risk.

·       Most firms noted that the need for pre/post-cessation trade reconciliations placed significant pressure on their operations teams at a difficult time of year (an issue we’d noted, but one that will not be so relevant in 2023).

To cap this off, from what we make of market moves across the year-end there wasn’t the slightest hint of market disruption.

Well laid plans came to fruition impressively.

Q2. Where your firm holds positions mark-to-market, did position-deltas, market risk-factors, and regulatory risk-gauges make sense in the immediate cessation aftermath?

Again, respondents reported no significant issues in their trading books, either in front office book management or risk management oversight:

·       Several firms noted minor booking adjustments were required, but were immaterial.

·       Revaluation processes and marks were not impacted.

·       Money-market brokerages continue to quote USD-LIBOR curves, and revaluation issues have not arisen.

·       Major risk systems providers were noted as having worked tirelessly to ensure IR trading systems could handle auto-transitions, and resulting risk-factors were well tested.

We credit this last point as being a helpful institutional feature of modern finance where standards tend to develop with a healthy degree of cross-pollination among major firms.

Q3. Was there a material reliance on Synthetic LIBOR?

Back in October I blogged about the FCA Consultation CP21/29, and how it had the potential (but not the intent) of opening floodgates on the permitted use of Synthetic LIBOR. I inferred that the FCA appeared to be going well beyond the market expectations of the time. I noted that the “proposed decision” (of CP21/29), as subsequently confirmed, “should not be read in isolation,” and that “significant practical constraints to reliance on Synthetic LIBOR remain.”

We still believe this is the case, so it was interesting to note firms had sporadic use-case examples of reliance on Synthetic-LIBOR.

·       Several firms mentioned customer requests for use synthetics in loan contracts.

·       Others noted modest requests for use in interest rate Cap & Floor trades, which in our opinion is quite understandable given the unique complexities of these products (versus swaptions).

·       Firms appeared to have spent considerable time ensuring that customers who retained an economic link to Synthetic LIBOR did so willingly and after developing a full appreciation of the risk reward trade-off of doing so.

Q4. Other anecdotes?

·       The late-year customer crush was definitely evident, but manageable for all.

·       All firms noted the extent to which use of fallbacks dominated the path for customers and interbank counterparts, most agreeing that this was larger than regulators and planning estimates had suggested.

·       Several firms noted the use of facility side-letters where customers elected not to do full-blown deal transitions for multicurrency facilities, a very reasonable approach where drawings in ceasing currencies were unused, and likely to remain so.

Q5. What happens next?

·       Most major firms continue to monitor the LIBOR-reform space closely and have ongoing project-team involvement, indicating this is likely to remain the case to around mid-year.

·       The end of free-use of USD-LIBOR for regulated firms is a point of high focus, with clear regulatory pressure for firms to cease all bar necessary customer hedging activity, and we note that since forward deltas for USD past June 2023 are an increasing function of forward SOFR, firms may start to more willingly accept basis-risk in hedges where that does not break hedge accounting relationships.

·       Firms expect to conduct project post-mortems, and a couple expect regulator engagement on this topic in the first half.

·       Local firms are closely watching developments with respect Canadian Dollar benchmark reform and the cessation horizon for CDOR, a market based on bankers’ acceptances.

And global markets didn’t blink

Since the first regulatory-hints that LIBOR reform may be necessary, regulators sought to avoid demanding anything that might result in market disruption. At every stage reform needed to keep markets calm. Typically, regulator fears were couched in terms related to the extent to which LIBOR is or was ubiquitous in finance: with over U$400 trillion worth of contracts likely impacted.

In our view this first major cessation event went particularly well; a credit to the no-disruption mantra, and we find no evidence of market disturbance across the classic FICC suite of markets, nor of course in global equities. All was as it should have been.

And the path of LIBOR-to-Synthetic rates through transition was smooth, though many will question why GBP LIBOR rates moved so much as they finally became synthetic (a function of Term-SONIA plus ISDA Credit Spread Adjustment):

3-Month LIBOR rates in basis-points, 31st December to 4th January

John Feeney touched on the possibility of a step-function over the new year in his blog of July 20th  The Potential Wall at Cessation — Martialis Consulting.

The reality is that while there was a one-day cessation step, and visually a seemingly high one given the incredible liquidity sitting in short-term GBP instruments, those market players whose risk-systems modelled the step accurately would have had no X-factor revaluation gain or loss across the new year. Our pre-Christmas checks showed the market got this right. In very simple terms, the step was priced (or mispriced if your system wasn’t up to handling it) well in advance.

What now?

So, what can we expect as we move further into 2022?

Our role is to consult, not play at forecasting. But having been so close to markets in LIBOR reform it’s hard not to ponder and posit some thoughts around trends that seem likely to prevail in the year ahead.

1.       USD LIBOR usage will not simply go away, and we see evidence of this with the ongoing ability for non-regulated participants to continue to trade in a range of venues. Discussing this with clients, it seems many continue to grapple with how to curtail all-bar essential customer-driven turnover. This will be an important consideration as regulated firms work at meeting the well-flagged expectations of the regulators.

2.       Though we note ISDA reports 2 GBP LIBOR trades actually dealt in the first week of January, GBP SONIA and its term variants are settling down very well as market standards for UK finance. We expect this to solidify through 2022 with SONIA cementing its place as the dominant benchmark in UK finance.  

3.       By comparison, we see significant evidence of a dispersion of interest and viewpoints in competing benchmarks across USD-finance. We expect an ongoing debate as to the desirability of credit-sensitivity, see SOFR Academy, FactsetFactset, and RiskRisk.net. With the availability of BSBY, compounding with an eighteen month lead time to full cessation, there is a lot of debate still to be had in US markets, which we expect will take more than 2022 to resolve (if ever). There is plenty of scope for more than one benchmark.

4.       Domestic markets are likely to start considering the benchmark reforms now underway in Canada, and the implication of post USD-LIBOR transitions in a market that is not unlike that for BBSW. This can be expected to be most pronounced with respect the 1-Month BBSW rate, where the lack of deep activity is already quite well-flagged.

Which brings us to the question of outcomes, and economics, and thus pricing.

Finally, the benchmark smorgasbord needs to be well understood

I’ve written previously about the range of benchmark choices available to market participants as we move past cessation.

Considering the situation in the US, the demise of USD-LIBOR has brought forth a real range of alternates beyond the regulatory favourite (SOFR, compound or simple interest in-arrears):

• Term-SOFR

• With/without a specific credit add-on – e.g., AXI

• SOFR-in advance

• BSBY

• Ameribor

What’s clear is that five or more replacements are vying for attention in US markets, and markets are unsure about all of them. As these evolve it’s hard not to see market auctioning processes leading to real changes in the spread-to benchmark for each variant. If it were possible to imply an absence of further banking system stress (it isn’t) credit sensitive benchmarks should closely resemble SOFR/Term-SOFR at point of price.

Thus, as we’ve made a point of saying: end-users really need to understand the nature of the benchmark they are contracting to. How it performs over the long-haul matters.