Ending reliance on LIBOR: Overview of progress made on transition to overnight risk-free rates and what remains to be done

Speech by Megan Butler, Executive Director of Supervision – Investment, Wholesale and Specialists at the FCA, delivered at the Investment Association, London. 

Speaker: Megan Butler, Executive Director of Supervision – Investment, Wholesale and Specialists
Event: Investment Association, London
Delivered: 21 February 2019
Note: this is the speech as drafted and may differ from the delivered version

Highlights:

  • Firms need to end their reliance on the London Inter-bank Offered Rate (LIBOR) by end-2021.
  • We have seen 15 sterling bond issues that have referenced compounded The Sterling Overnight Index Average-based (SONIA), with a total value of about £8.7bn, so far in 2019.
  • We are seeing evidence of progress, but there is work that remains to be done.

As you know, in two years the production of LIBOR is likely to end. Presenting asset managers with the non-trivial task of managing their LIBOR exposures.

How you respond to this deadline will be of fundamental importance to your firms and your customers. So thank you for participating.

I know that some of you are from businesses that are already managing down your LIBOR-linked derivatives books, moving portfolios across to SONIA-based swaps.

As you might imagine, we see this as the smart play. LIBOR is an anachronism. The markets for which it was originally built have, as Andrew Bailey described last year, changed beyond recognition.

The unsecured interbank lending market has dwindled. And the eurocurrency markets no longer exist as a distinct entity. Meaning LIBOR is essentially measuring the rate at which banks are not borrowing from each other.

On top of this, if you lay the transaction volumes underpinning the LIBOR and SONIA reference rates side by side, the difference is striking. Overnight cash transactions supporting the calculation of SONIA average £50bn a day. Transactions feeding into the calculations of three and six-month Sterling LIBOR average £187m and £87m a day respectively.

It is therefore essential that firms plan for a future in the absence of LIBOR. And we’re pleased that in many cases that’s precisely what is happening.

Issuance improving

When Andrew delivered his speech on LIBOR last July, cash markets were still at an early stage in transition. The European Investment Bank (EIB) had recently completed a SONIA-referencing bond issue. Demonstrating the feasibility of issuing a floating rate note referencing SONIA.

But firms at the time were raising concerns over the system changes required to manage bonds and loans that calculate interest payments at the end of reference periods.

The market has performed a bit of a ‘180’ since then. To the point that large floating rate bond issuers referencing SONIA, rather than LIBOR, have become commonplace.

So far this year, we’ve seen 15 issues (from banks, sovereigns, and supranationals) that have referenced compounded SONIA, with a total value of about £8.7bn. This already exceeds the £6.9bn issued in the six months prior.

By way of context, this is a market where 12 months ago we were told some issuers had categorically ruled out using compounded SONIA in floating rate bond issuance. Now, it seems to be gaining traction. Quite the turnaround.

Moreover, I think it’s worth noting that more than 130 investors purchased that £15.6bn issuance. Demonstrating progress on buy and sell side.

In derivatives, the picture is also positive. On a non-duration adjusted basis the monthly average of SONIA cleared OTC derivatives was £2.1tn in 2017. That grew by more than 100pc last year. To £4.2tn a month in 2018. And the notional traded monthly in SONIA, cleared, over-the-counter derivatives is now broadly equivalent to that of Sterling LIBOR.

This is all obviously very encouraging. Albeit it’s important to remember that there is still heavy use of LIBOR, including new contracts. There’s currently £60bn in bond issuance that references sterling LIBOR, and matures post-2021. A reminder of the fact that the LIBOR challenge we face is both large and, in some places, growing.

CEO feedback

As well as monitoring carefully the development of markets using the new risk free rate benchmarks, we and Prudential Regulation Authority (PRA) have also been giving increasing supervisory focus to firms’ readiness for the end of LIBOR.

In September last year, we and PRA wrote to a number of large banks and insurers. Seeking assurance that firms are: getting ready to transition to alternative rates, and have governance frameworks in place to oversee the work.

In that letter, we were clear that we expected firms to carry out a ‘comprehensive risk assessment of the potential prudential, and conduct impacts, associated with transition’. We also asked firms to quantify their LIBOR exposures and detail how they are managing the risks they identify.

Just before Christmas, we received assessments back from firms. We are still in the process of analysing the responses in detail. But we can share some early observations.

The top line is essentially this. Firms among UK banks and insurers are in different states of readiness for LIBOR transition. The majority of firms have provided good evidence about the work they are doing in order to prepare for transition. However, in some cases our letter has been a catalyst for action. So to give you some context here. Some firms held their first transition leadership meetings after receiving the letter.

Some were unable to provide a lot of detail about the action they’ve taken to protect the continuity of contracts.

And others were not yet able to describe their progress on adoption of the new RFRs; their presence in the SONIA swap and future markets; and the governance they are creating for new products. 

Let me immediately remind firms of their responsibility. Billions of dollars-worth of financial contracts needs to move on to a new benchmark rate. If this transition is chaotic, it could have serious repercussions. It is therefore an imperative that we take preparations for 2021 seriously. 

Billions of dollars-worth of financial contracts needs to move on to a new benchmark rate. If this transition is chaotic, it could have serious repercussions. It is therefore an imperative that we take preparations for 2021 seriously.

And to that point, let me thank firms that replied to us confirming that they have already taken action. Including those who are already using the new rates in new contracts, or have updated the fall-back language used in new issuances. And others who confirmed they have carried out due diligence regarding fall back arrangements for existing contracts.

Likewise, we were pleased to see that the more advanced firms were able to describe progress on adoption of the new RFRs. And nearly all business that we wrote to have identified their Senior Managers responsible for implementing their transition programmes. A very significant and important point.

And nearly all business that we wrote to have identified their Senior Managers responsible for implementing their transition programmes. A very significant and important point.

Buy-side 

I am conscious that a number of firms in this room will also have these bases covered. But some will not. So to that second group, I should make clear that although we wrote to the sell side to ask them to manage these points, we need you to do the same.

There will be some already of you who know all this already. But we hear that the profile of transition is lower on the buy side than on the sell side. And the scale of the challenge is high.

We are at a point where the back book is becoming a real focal point now. Around US$170tn of the interest rate swap contracts cleared by LCH, reference LIBOR. And a little under one-third of these, by notional, mature after end-2021.

A lot of asset managers will have exposure to LIBOR in multiple areas. Two of the most obvious and extensive areas are hedging strategies using LIBOR-referencing interest rate derivatives, and investments in bonds or other securities in which interest payments reference LIBOR.

In terms of floating rate notes, we have seen industry estimates that – looking across all five LIBOR currencies - there are around US$870bn in outstanding bonds that reference LIBOR and mature after end-2021. Reducing this stock of outstanding bonds is not straightforward.

Looking first at derivatives markets some of the reasons we’ve heard for delay do merit challenge.

Some firms want to wait for liquidity to develop. A reasonable position. But the numbers I quoted earlier show that liquidity is now available in key new markets. And the fact that firms can benefit from liquid markets in LIBOR-rates at the moment, also means you reduce the dealing cost of closing out. That liquidity in LIBOR markets may not be sustained. For late movers, those costs may not be so low.

On top of this, a number of business have suggested waiting for term rates to be produced based on the new overnight RFRs, which both UK and US working groups are looking at. 

But we’re also conscious that a lot of the market believes that in the future, liquidity will be concentrated around the overnight rates. This is already the case for SONIA-based swaps and futures. It is also the case for SONIA – and indeed Secure Overnight Financing Rate (SOFR)– based bonds. Waiting for term rates is not, in our view, a reason to delay transition.

Finally, we have heard that dealing costs are a deterrent to transition. The FCA has certainly been clear on the importance of controlling and seeking value for money in such costs.

But firms looking at these costs could choose to unwind LIBOR derivatives and put on RFR derivatives in their place as part of their day-to-day adjustment of hedges or positions. The less frequent such adjustment is, the more important it might be to start using those opportunities.

Likewise, buy-side firms will have an important part to play as the holders of legacy bonds that reference LIBOR after end-2021.

We understand that there is wide variation in the types of clauses these bonds have to deal with the cessation of LIBOR. Some may have none at all, or simply revert to a fixed rate. Others may have clauses suggesting the rate would instead be set by polling a number of banks for quotes.

Assuming banks are not prepared to provide such quotes for LIBOR, it seems doubtful they would be available here either. Meaning that as the end date for LIBOR approaches, or even uncertainty about the date of the end increased, an uncertainty premium could impact the value of such bonds.

Where fall back clauses are not robust, you can envisage the risks of legal disputes increasing. So to ensure continued access to cost-effective hedging, and to avoid such legal disputes, issuers of such bonds may seek to convert them to the new RFRs whose availability can be assured.

For bonds issued in the UK, the majority of consent thresholds for such changes might be doable. But identifying noteholders and collecting consents on an issuer-by-issuer, and note-by-note basis, is likely to be a costly process. Industry co-ordination could help to ease that process. Similarly, the good work of the administrator of LIBOR, ICE Benchmark Administration, should be highlighted. Who continues to do to produce and oversee the rate before end-2021.  

Conclusion

So my main message to you today is this: do not make the back book problem worse than it needs to be. Get to it right now. Inertia remains the biggest obstacle to a smooth transition. 

Do not make the back book problem worse than it needs to be. Get to it right now. Inertia remains the biggest obstacle to a smooth transition.

Do you know what you’ve got in terms of LIBOR exposures? Have you looked at your inventory? Where is LIBOR in your books? Is it hidden? Is it on the front page of the instrument?

Do your due diligence so that you know what you have got.

Firms that are worried about the costs of transitioning their portfolios across, might want to weigh this up against the impact of a potentially costly re-papering exercise in a few years’ time.

We strongly encourage asset managers to transition their hedges and positions over to SONIA before LIBOR disappears, and before liquidity in LIBOR-derivatives begins to decline.

Firms can adopt different approaches to scenario planning and reviewing or re-papering contracts. There is nothing wrong with this. We’re not prescribing how you do it. But you need to do it.

And this brings me to my final point this morning. If the reason you are not acting is because you think we are going to change course. I’m afraid you are wrong.

You need to be prepared for an end date for LIBOR in 2021. Whether your exposure is to sterling LIBOR or one of the other LIBOR rates, you will hear the same message from central banks and regulators in other jurisdictions, as you hear from FCA and the Bank of England today.

We co-ordinate closely with our counterpart authorities around the world. And you will see many similarities between the initiatives being taken in different currency areas.

That co-ordination will continue through the Financial Stability Board’s Official Sector Steering Group (OSSG). So, as Andrew explained last year, you need to plan for LIBOR to discontinue at the end of 2021. Across all of its tenors and currencies.

The absence of ways to remedy the current underlying weakness in LIBOR the lack of transactions to underpin the rate, and the unattractive prospect of LIBOR limping on with fewer panel banks, all lead to one conclusion.

The best option is to actively transition to alternative benchmarks. And today is an important opportunity to talk about any barriers that you face to achieving this. And to discuss the steps you need to take.