Keynote speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, delivered at UK Finance's Commercial Finance Week on 5 July 2021.
Speaker: Edwin Schooling Latter, Director of Markets and Wholesale Policy
Location: UK Finance's Commercial Finance Week
Delivered on: 5 July 2021
Note: this is the speech as drafted and may differ from the delivered version
- This month marks 4 years since Andrew Bailey told financial markets they needed to prepare for a world without LIBOR after 2021.
- For the LIBOR panels ending this year the central challenge in the next months is ensuring that all legacy contracts that can be converted are converted.
- The next Working Group on Sterling Risk-Free Reference Rates' milestone for progress on this in sterling markets is end – Q3.
- We all want a good strong finish, not to fade or stumble in the home straight.
It is in some ways remarkable how marathon events – whether in London, New York, Chicago, or Tokyo – have become so popular. Completing a marathon is a feat that takes dedication; a lot of time and effort, and sometimes even some pain. You aim for something good from all that investment, in the preparation and in the completion. For the marathon of LIBOR transition, where we are closing in on the finishing line, that aim is fitter, stronger financial markets.
This month marks 4 years since Andrew Bailey told financial markets they needed to prepare for a world without LIBOR after 2021 – 4 years since we embarked on this marathon transition together.
Many thought the challenges of LIBOR transition would be insurmountable. We heard that 'liquidity is highest in LIBOR, so markets won’t move to new benchmarks'. We were told that 'cash products need forward-looking rates, not overnight rates'. We were asked 'how will you reach agreement on fair conversion?'. We were warned 'the value transfer issues will be too complicated' and that 'some contracts simply can’t be converted'. We were even asked 'you don’t really mean it, do you?'.
4 years on and those challenges have been overcome. In sterling markets, for example – where LIBOR used to be deeply embedded – liquidity has moved from LIBOR to overnight SONIA. That happened first in bonds. Then in securitisations. Then in linear swaps. Then in loans. Then in non-linear OTC derivatives. It turns out that most of those products did not need forward-looking rates. Overnight rates, compounded over the interest period, worked well. In fact, they worked better. International Swaps and Derivatives Association (ISDA) did find a consensus – wide consensus – on a fair replacement formula. And Parliament gave the FCA new powers to help maintain continuity of those legacy LIBOR contracts that can’t be converted.
You all now know that we really did mean it.
Success in numbers
To put that success into numbers. We’ve calculated that over 85% of outstanding uncleared sterling LIBOR derivatives have 2-sided adherence to ISDA’s protocol. From the data reported into UK trade repositories on US dollar markets, that figure is somewhat higher, at a little over 90%.
Adding in the conversion to SONIA and SOFR that will take place at central counterparties (CCPs), that means the vast bulk of this once LIBOR market will have converted to SONIA and SOFR when the LIBOR panels end. So it’s clear where swap market liquidity will end up. Indeed, even 6 months before the end of the sterling LIBOR panel, close to 3/4 of new cleared sterling swap activity is now based on SONIA, as is almost half of cleared sterling notional outstanding.
In the cash market, bonds have been the pacesetter. New issuance in sterling markets has been based almost exclusively on SONIA since 2019. And we have now seen a little over 1/3 of outstanding sterling LIBOR bonds – by value – converted, through consent solicitations, to overnight SONIA compounded in arrears.
Loans were slower off the mark, but the shift to overnight SONIA has been decisive – following the Working Group on Sterling Risk-Free Reference Rates' (RFR) end-Q1 milestone to stop new business based on LIBOR.
Like a marathon event, this has involved a significant amount of people undertaking the challenge together. We thank all those involved for their efforts.
What you need to do now
We’re not yet over the finish line.
For the LIBOR panels ending this year – so sterling, yen, swiss franc, euro – the central challenge in the next months is ensuring that all legacy contracts that can be converted do convert by year end.
The next RFR Working Group milestone for progress on this in sterling markets is end- Q3. That is less than 3 months away.
The end-Q3 date is there for a good reason. It will help avoid risks of getting caught in a pre-Christmas rush – where we could see a squeeze in IT, legal or other resources, or would simply have too little time to adjust to unexpected hurdles.
There are good reasons why you might choose for the actual change of rates payable to take effect only at the end of 2021, particularly for example if using SONIA plus the ISDA spread as the future rate. But we encourage you to put in place plans that mean arrangements for this change have been completed in good time, in line with the Q3 milestone.
Whether it is some form of active conversion, or use of fallbacks, you need to make an informed decision on when and how to transition your contracts. There is a lot of information out there to help you make those decisions – on the FCA, Bank of England and RFR Working Group websites, and through your trade bodies and advisors. But our key message is that you really need to have your active conversion plans in place in the next 3 months.
US Dollar market transition
As you know, the US dollar panel, and the 5 more commonly-used US dollar LIBOR panel-bank settings, are going to continue a little longer than the other LIBOR panels and panel-bank settings. But only until end-June 2023. And only for use in legacy transactions.
US authorities have published clear supervisory guidance on stopping new use of dollar LIBOR – across all asset classes – by the end of this year. In other words, to the same end-2021 timetable. The international regulatory community has aligned with that. Both IOSCO, the FSB, EU and other authorities have published supporting statements. And, in the UK, we will be consulting on using our new powers under the Benchmark Regulation (BMR) to provide further legal backing to this position. So you need to be taking steps now to move your new USD interest rates business to SOFR.
Some market participants and commentators point out that liquidity in SOFR is building only slowly. But that is going to change. A key date ahead is 26 July. The US authorities, and major dealers and interdealer brokers in the US and the UK, are putting their collective weight behind a ‘SOFR-First’ initiative on that date.
From 26 July, interdealer brokers are asked to replace trading of US dollar LIBOR linear swaps with trading of SOFR swaps. The FCA and Bank of England support this initiative fully, and urge those of you that do business in dollar swaps to be a part of it. A successful 'SOFR-first' initiative will be a valuable step in meeting the end of the year deadline for stopping new use of dollar LIBOR.
I also want to underline that the US initiative is SOFR-first. And the Alternative Reference Rates Committee's (ARRC’s) mandate is of course to help ensure a smooth transition to SOFR across both derivative and cash markets. We don’t want to see transition to new so-called 'credit sensitive' rates such as Bloomberg’s Short Term Bank Yield index – known as BSBY – that some have suggested as a possible successor to LIBOR in some contracts. Authorities in both the UK and US have warned publicly about the risks embedded in these so-called 'credit sensitive' rates.
They share many of the same flaws as LIBOR. That’s because they are derived largely from transactions in Commercial Paper (CP) and Certificate of Deposit markets. Yet liquidity in those markets has not proved robust to stress, as we saw vividly in March last year, when liquidity in CP markets dried up, and yields spiked. By contrast, the markets supporting SOFR, and SONIA, did prove robust.
That has real economic consequences for users of these so-called 'credit sensitive' rates. The spread, or interest premium, over risk free rates widened to 1.4% for LIBOR, 1.2% for BSBY, and 1.54% for IBA’s index in late March 2020. Yet in February 2020, this spread averaged less than 14bps. And it has since returned to those lower levels. There is a wide consensus that this spike was not due to declining perceptions of bank credit quality. What we observed was rates that are 'liquidity sensitive' rather than 'credit sensitive'. And this occurred just as monetary policy interventions sought to ease interest rate and credit conditions in the real economy. So these rates may look relatively benign in 'normal' market conditions. But there can be a painful sting in the tail for borrowers at times of stress.
Because of this we would be concerned about significant use of such rates in UK markets. It is hard to see how it would be suitable to use them in products aimed at less sophisticated borrowers who might not understand the complex and relatively opaque risks they present. We ask that any regulated UK market participants looking to use these so-called 'credit sensitive' rates in UK-based business consider the risks carefully, and raise with their FCA supervisors before doing so.
But the good news is that the bulk of outstanding dollar swap market positions are going to be moving to SOFR, not these risk-laden alternatives.
When running a marathon, you want to know your running shoe is going to last for a long race and survive a variety of possible stresses on the road ahead. And you don’t want to be changing footwear halfway. Looking at a long race in which the running shoes are interest rate benchmarks, overnight lending markets and compounding look to offer a more robust footing than Commercial Paper markets.
What the official sector has left to do
Finally, I will turn to what we as the 'race officials' need to do.
Let’s look first at sterling and yen LIBOR. For most of the LIBOR rates, the end of the panels means an end to LIBOR publication altogether. However, as set out in our 5 March announcement, we think there is a case to propose a different path in relation to 1-month, 3-month and 6-month sterling and yen LIBOR settings.
On 24 June, we opened a consultation on using our new powers to implement synthetic LIBOR rates for these 6 sterling and yen LIBOR settings, at the end of the year. In line with our published policy framework, we are proposing that these synthetic LIBOR rates would be based on forward-looking term RFRs, so SONIA for sterling, plus the relevant ISDA spread adjustment.
But we’ll also need to confirm who will be permitted to use these rates. We’ve already consulted on our proposed policy framework for determining this. We will publish our final policy once we have considered the feedback.
We will then consult on a specific application of this policy to the 6 sterling and Japanese yen LIBOR settings. That is, precisely which legacy contracts will be permitted to use any sterling and yen synthetic LIBOR rates. We are aiming to confirm our final decisions on that as soon as we can in Q4 this year.
While these new powers can help ensure there is a safety-net in place, they don’t remove the need for you to act. Any safety-net the FCA provides would only be for a time-limited period. Market participants are encouraged to amend their contracts where they can. There is no need to wait for our synthetic LIBOR decision before doing so. Moreover, synthetic LIBOR will not give you the benefits of converting to overnight rates compounded in arrears – the new centre of gravity of sterling interest rate markets, where liquidity is highest, and hedging costs therefore lowest. But you can get there by active conversion.
It’s July. Perhaps this is a little too early to look ahead to Christmas. The title of this speech is 6 months to go. But I doubt you really want to be crossing the finish line only on Christmas eve. You are even less likely to want to be unwrapping unwanted LIBOR contracts and repacking them between Christmas and New Year. So we encourage you all to use the next few months to get conversion done.
We’re down to the last 2 or 3 miles of this marathon. We all want a good strong finish, not to fade or stumble in the home straight. And that looks very achievable as I look at the data today. Moreover, our markets will have become stronger and fitter once this race is done.