LIBOR Transition: Expert Views – Arif Merali

“We would encourage firms to continue to support their clients in switching to more robust alternatives, to ensure that infrastructure is aligned to the latest market conventions.”

Arif Merali

The Bank has recently updated its policy for collateral referencing LIBOR. What has changed and how are you treating U.S. dollar collateral, given the later date for cessation?

The Bank previously announced that it would implement scheduled haircut add-ons on LIBOR-linked collateral. Last month we updated our approach. In particular, we reserve the right to waive those add-ons where we are satisfied that a robust fallback or a future rate-switch mechanism (meeting certain conditions) is in place.

In response to the updated transition timelines for certain U.S. dollar LIBOR settings, the Bank is reviewing its approach to collateral referencing those settings and will communicate its decision in due course. In the meantime, such collateral will not be subject to the scheduled add-ons unless it also references other LIBOR rates. Consistent with U.S. authorities’ guidance on the use of U.S. dollar LIBOR in new contracts, the Bank will not accept new collateral linked to those U.S. dollar LIBOR settings if issued after 1 January 2022. Additionally, the Bank will only accept collateral linked to those U.S. dollar LIBOR settings that has been issued on or after 1 April 2021 and before 1 January 2022 if it is satisfied that a robust fallback or a future rate-switch mechanism is in place.

We have just passed the RFRWG end-Q1 milestone for ceasing new use of sterling LIBOR for most products. What are these, how successful have they been and how much focus is there on them from the Bank of England?

The Working Group on Sterling Risk-Free Reference Rates (RFRWG) recommended end-Q1 milestone is to cease initiation of new sterling LIBOR-linked loans, bonds, securitisations and linear derivatives (except for risk-management of existing positions) that expire after the end of 2021.

These milestones have certainly been successful in focusing attention and setting out a clear plan of action. And whilst it is too early to say yet whether they have been fully met by all, new issuance in sterling bond markets has been almost exclusively against the Sterling Overnight Index Average (SONIA) for some time now, and SONIA volumes in swap markets have continued to increase since the ‘SONIA first’ convention switch last year, such that most business is no longer on sterling LIBOR. Although lending markets were slower to adopt SONIA, we have seen a marked increase in new SONIA lending in the weeks leading up to the end-Q1 milestone.

There is very close supervisory focus on these milestones, as evidenced by the recent ‘Dear CEO’ letter from the Prudential Regulation Authority and Financial Conduct Authority (FCA), in which the authorities said that they expect all firms to meet the milestones of the RFRWG. They will be collecting information regularly from firms to assess progress.

“The transition away from LIBOR is a significant shift for the market. It is not a challenge to be underestimated, but with cessation now imminent it is clearly essential.”

Arif Merali

Whilst there has been good progress in SONIA adoption in linear derivatives, progress in non-linear derivatives and exchange-traded derivatives has been slower? Are you concerned by this, and what are you planning to do about it?

The RFRWG has a recommended end-Q2 milestone for ceasing initiation of new non-linear and exchange-traded derivatives (except for risk-management of existing positions). This reflects a sequenced approach, allowing the market to build upon the very strong liquidity that has developed in the core swap market. And although SONIA volumes in non-linear and exchange-traded derivatives markets start from a relatively low base, they have increased significantly in recent months as momentum begins to grow.

The Bank and FCA have recently announced their support for a ‘SONIA first’ convention switch for non-linear derivative markets on 11 May, and are currently considering steps to support a similar convention switch for exchange-traded derivatives towards the end of Q2. Regulated firms were also encouraged to support steps to build liquidity in these markets in the ‘Dear CEO’ letter.

Looking further forward, the RFRWG’s recommended timeline for market participants to cease initiation of cross-currency derivatives with a sterling leg is during Q2/Q3.

What advice would you give to firms who are yet to start active portfolio transitions to RFRs?

The RFRWG’s milestones on active transition recommend that firms should have identified all legacy exposures that can be actively converted by end-Q1 and progress active conversion where viable, through to completion by end-Q3. This message was reiterated by supervisors in the ‘Dear CEO’ letter and active transition is the primary way for firms to retain economic control of their contracts.

Following the announcements on the end of LIBOR on 5 March 2021, firms now have certainty about the cessation dates of panel-bank LIBOR and the fixing of the ‘spread adjustments’ by the International Swaps and Derivatives Association (ISDA) creates a clear economic link between sterling LIBOR and SONIA, providing a firm basis for discussions about active transition.

As such, we would encourage firms to engage with their counterparties as soon as possible regarding active transition, given the limited time available until the end of 2021; and where active transition is not viable, firms will of course want to ensure that robust fallbacks are in place.

For support with these discussions, firms can refer to various informative documents produced by the RFRWG, available via the RFR transition pages on the Bank of England website.

What would you say is the biggest obstacle firms are facing as they prepare for the transition away from LIBOR?

The transition away from LIBOR is a significant shift for the market. LIBOR has been used for decades across multiple currencies, embedded in market infrastructure and used as the dominant interest rate benchmark in a wide range of contracts. It is not a challenge to be underestimated, but with cessation now imminent it is clearly essential and thankfully most market participants realised some time ago the importance of ensuring they are prepared for life without LIBOR.

Progress has been good, with effective cooperation between public and private sectors in each of the relevant LIBOR currency jurisdictions, leading to selection of robust alternative Risk-Free Rates (RFRs). Following the excellent work of ISDA, there is a fallback in place covering approximately 97% of sterling interest-rate swaps.

Legislative solutions to support tough legacy contracts are being progressed in a number of jurisdictions, including the U.K. However, we note that further work remains. In particular, we would encourage firms to continue to support their clients in switching to more robust alternatives, to ensure that infrastructure is aligned to the latest market conventions, and, where feasible, to actively transition legacy LIBOR contracts onto the most robust forms of RFRs.