FCA Consultation on Synthetic LIBOR - CP21/19 - June 2021
The demise of LIBOR has been well documented since July 2017 when Andrew Bailey, CEO of the Financial Conduct Authority (FCA) in the UK first announced possible cessation by the end of 2021. This set in train a number of actions by regulators and central banks globally to prepare for this momentous event.
On 5th March 2021, the FCA has made a pre-cessation announcement which will cause certain contracts to move to the fallbacks in the future. Specifically, the FCA announced the future loss of representativeness of certain LIBORs. The critical dates are 31st December 2021 for most LIBORs and 30th June 2023 for remaining USD LIBOR. The following diagram shows the timeline.
This announcement constitutes a pre-cessation trigger which is quite different to a permanent cessation of LIBOR. Only contacts with a pre-cessation clause will revert to fallbacks while those without the clause will continue referring to LIBOR (if it exists) or use their existing fallbacks.
The FCA intends to direct the current LIBOR administrator (using powers under Article 23D(2)) to continue to publish some LIBORs beyond December 2021 using a revised calculation methodology. This is often referred to as ‘synthetic LIBOR’. Contracts without the pre-cessation trigger look very likely to refer to synthetic LIBOR after December 2021.
Consultation CP21/19 was released in June 2021 and invites responses on the future of GBP and JPY synthetic LIBOR.
What is the FCA proposing?
The FCA are proposing a number of changes to GBP and JPY LIBORs. I will look at two of these in this blog:
1) The choice of rate; and
2) The choice of credit spread.
There are many other proposals in the consultation but these two have the potential to have significant impacts on anyone who remains on GBP or JPY LIBOR after December 2021 which will then be referring to synthetic LIBOR.
The choice of rate
The underlying rates are Term SONIA (provided by IBA) and TORF (provided by QBS). Both are forward-looking rates based on OIS quotes in the GBP and JPY markets each day.
Term SONIA is calculated from GBP (SONIA) OIS markets while TORF (Tokyo Risk Free Rate) is derived from the JPY (TONA) OIS market.
The FCA has already selected these rates and the consultation does not invite further discussion on this point.
The choice of credit spread
The FCA has made a recommendation as per the Table 1 below. Their preference is to align the credit spread with the ISDA spread adjustment published by Bloomberg (highlighted in bold).
However, the actual 5-year LIBOR - OIS credit spread (I added the the red box to highlight this) is quite different to the ISDA spread particularly for longer tenors. The choice of credit spread will have impacts on all users of synthetic LIBOR and needs to be carefully considered for a firm’s exposure and valuation.
While it is tempting to align the credit spread with ISDA (i.e. derivatives) this is not the actual, calculated 5 -year median of the LIBOR - OIS spread. By using ISDA, the implication is that the compounded OIS and the Term OIS are identical (i.e. OIS average settlement is zero over the 5 years) which is clearly not the case as seen in Table 1.
The fact that OIS trades do not settle at zero (averaged over 5 years) gives rise to this difference.
The choice of credit spread will have impacts on all users of syntheic LIBOR. Let’s look at a few example calculations.
Example calculations for GBP Synthetic LIBOR
The following table shows the impact for a GBP borrower using GBP 1 million and 1 billion notional.
Clearly, for a borrower using the ISDA spread is disadvantageous compared with the actual LIBOR -OIS spread. However, this analysis is based on the Term SONIA and the compounded daily SONIA being equivalent rates at the end of each period. This is unlikely and needs to be appreciated in the calculations.
Also note that the calculations are symmetrically opposite for the investors: there could be an advantage for these users.
Even with the caveats related to Term SONIA and compounded daily SONIA, there is a real risk of a transfer of value from borrowers to investors using the ISDA spread. Over the 5 years of calculation, the actual LIBOR - OIS credit spread could be regarded as a more appropriate measure of the adjustment required and therefore able to minimise the value transfer.
Many portfolios are much greater than 1 million or 1 billion notional so the final impact could be very substantial.
A short comment on revaluations
Another complication is the impact on revaluations which arises from the choice of credit spread. Forward rates are calculated from the relevant OIS curves which means Term SONIA and compounded, daily SONIA are identical (also for TORF and TONA).
If the ISDA and synthetic LIBOR credit spreads are different (i.e. LIBOR - OIS ) then the present value of trades linked to synthetic LIBOR and derivatives will be different if valued on the same curve. This would create a revaluation difference if the same curves are used for derivative and synthetic LIBOR valuations. Users should take care to separate the trades and assign the correct curve to each.
Summary
The FCA consultation will have impacts on users of synthetic LIBOR. There may be value transfer based on the choice of credit spread which could be substantial for some users.
I encourage everyone to look carefully at the proposals and analyse the potential impacts on your portfolios which may refer to synthetic LIBOR after December 2021.
Martialis has substantial experience in these calculations. We can assist you in this analysis and provide an independent review of your options.
New Developments in USD Reference Rates
The rise of new, credit sensitive benchmarks in USD presents users with a range of options which may better suit their purposes. As markets begin to move away from USD LIBOR there has been some resistance to using a single reference rate such as SOFR. The pricing challenges of switching from the familiar processes of LIBOR to a new rate with little (or no) credit and liquidity margin as well as the operational challenges of using a rate like SOFR (where the final reference is only known at the end of the relevant period) has presented many users with a good reason to delay transitioning away from LIBOR. The SOFR alternatives actually operate similarly to LIBOR and help solve many of the operational issues. They include:
Reference Rate Administrator Description (all forward-looking term rates)
Term SOFR CME Calculated from CME SOFR futures and possibly OIS, no credit spread
BSBY Bloomberg Calculated from bank funding in unsecured markets
CRITS/CRITR IHS Markit Calculated from USD CD and CP market (‘S’ is Spread and ‘R’ is Rate)
IBYI ICE Similar to BSBY and has been puiblished for over 2 years
AXI SOFR Academy Calculated from credit spreads out to 5 yeears which is then scaled to 1, 3 and 6 month
While all these alternatives have a term structure and most have a credit spread (except Term SOFR) they are all subtly different and some may be more appropriate for certain uses rather than others.
The advantage of all is that they are operationally similar to LIBOR (set at the start of the relevant period) and have a term structure. This makes them all easier to implement in current systems and processes and allows many users access to LIBOR replacements.
The markets will decide which reference rates dominate but these are significant contributors to LIBOR transition. Risk.net has a great article on the alternatives here.
Martialis is very experienced in managing LIBOR transition for many clients. These new reference rates may be appropriate for your needs and we can assist in assessing the options.