IBOR Transition: Regulatory and industry-led market developments in April 2021

The transition from Interbank Offered Rates (IBOR) to Alternative Risk-Free Rates (RFRs) has an impact on all financial and non-financial institutions operating with the impacted floating reference rates. It affects a wide range of financial instruments on the derivative and cash markets.

This blog edition highlights notable developments made publicly available by the global regulatory community, industry working groups and/or infrastructure providers over the month of April 2021. You will find more detail in our monthly EY IBOR Transition Newsletter, to which you may subscribe through the following link.

Over this last month, we have seen substantial efforts to provide methodologies supporting the transition away from LIBOR and fostering the adoption of the RFR products.  

The London Clearing House (LCH) published a circular “Rates Reform: LIBOR Fallback and Conversion Fees” which details the structure, fee and timeline for both fallback and conversion. The fallback fee applies to cleared contracts for which an index cessation event has occurred. LCH will apply a conversion fee to contracts which cannot otherwise be converted and so will be converted by the LCH conversion tool. LCH aims to encourage early transition before the conversion processes are run and to consider proactively transitioning away from fallen-back benchmarks. The conversion processes in 2021 will encompass CHF / EUR/ JPY LIBOR (3/12/2021), GBP (17/12/2021) and EUR EONIA (15/10/21) contracts.

Moreover, the Working Group on Sterling Risk-Free Reference Rates (GBP RFR WG) published a paper considering how a sterling structured products market could be designed using compounded in arrears SONIA, and to support the transition of legacy structured products where GBP LIBOR is in use. As many structured products are pre-packaged structured finance investments with a derivative component, the paper builds on the work to date on transition in areas relating to the bond market and derivatives market:

• Five Banking Days Lookback without Observation Shift (also known as “observation lag”) was used for over 230 SONIA-linked floating rate notes (“FRNs”) and securitizations with a total nominal value of approximately £105 billion. If the role of the derivatives element is relatively limited, it may be more appropriate to follow the applicable FRN convention for structured products.
• Five Banking Days Lookback with Observation Shift (also known as “observation shift”) was used in some recent issuances of sterling FRNs in order to, amongst other reasons, facilitate reconciliation of interest amounts between market counterparties.
• No observation lag or observation shift is a market standard sterling SONIA swaps. If the derivative is driving the structured product pay-outs, for example where the issuer hedges by way of SONIA swaps, it may be more appropriate to follow the more commonly used convention in the derivatives market.

By providing these guidelines, the paper aims to support issuers, manufacturers, distributors and investors in their plans to meet the GBP RFR WG’s milestones set out in its roadmap and priorities for transition by end-2021.

The legislators are also looking into the legislative tools to allow for an orderly transition away from LIBOR, especially where the contractual solution is unlikely to be successful (so called, tough legacy).

In April, the Alternative Reference Rates Committee (ARRC) commended New York State Governor for signing the LIBOR legislation into law and for taking this critical step in minimizing legal uncertainty and facilitating a smooth transition away from LIBOR. The LIBOR legislation establishes a targeted solution for tough legacy contracts and will significantly reduce operational and legal risks for many market participants, helping them to seamlessly transition to SOFR.

The Chair of the GBP RFR WG recently wrote a letter to HM Treasury, seeking an update on the UK Government’s approach to safe harbour provisions following its recent consultation. The letter highlighted the GBP FRFR WG’s support of the inclusion of safe harbor provisions in the Financial Services Bill, stating that such provisions are vitally important to avoid potential market disruption and that a number of industry bodies broadly support the proposed approach to their use.

EY Perspectives

The ISDA’s “Transition to RFR’s Review” has highlighted the increase in referenced SOFR and SONIA contracts for Q1 of 2021 in comparison to the last quarter of 2020, as the number of contracts which are transitioning away from LIBOR settings and onto RFRs have increased. 

However, the market referencing SONIA is doing significantly better than the SOFR market. With only 8 months left until the expiration of majority of the LIBOR settings, the USD market needs to progress the transition away from LIBOR. If there is no larger shift over the future months, we may will see markets favouring other alternative reference rates. Indeed, some users believe that Ameribor is much less volatile that SOFR. This is despite the ARRC’s assurances that SOFR is the most suitable alternative rate for institutions of all sizes.

The firms need to be ready to use alternatives to LIBORs (including the US dollar LIBOR) for most new trades by end-2021. Ultimately, the liquidity in SOFR and other alternatives to US dollar LIBOR should steadily increase as we approach the 2021 deadline. 

Transition milestones set by the working groups will likely help. As a reminder, the next milestone to watch out is the end of June with the following expectations:

• The ARRC expects to stop of new use of US dollar LIBOR in derivatives, business loans and most securitizations that mature after the end of 2021.
• GBP RFR WG expects to:
  • Progress active conversion of all legacy GBP LIBOR contracts expiring after end 2021 where viable and, if not viable, ensure robust fallbacks are adopted where possible 
  • Cease initiation of new GBP LIBOR non-linear derivatives that expire after end 2021, except for risk management of existing positions 
  • Cease initiation of new GBP LIBOR exchange traded derivatives that expire after end 2021, except for risk management of existing positions
• FINMA expects to:
  • Implement system and process changes 
  • Mitigate risks for remaining “tough legacy”
  • Write new contracts in general based on RFR

For more information on these topics, please contact us directly.

You will find below the list of key developments in the IBOR transition over the month of April 2021, the detail of which can be found in our monthly EY IBOR Transition Newsletter.

Swiss highlights:

• Developmentof SARON

Eurozone specific highlights:

• EIOPA published consultation paper on IBOR transitions

International highlights:

• QUICK Corp. announced publication of Tokyo Term Risk-Free Rates
• GFMA developed IBOR transition document
• Bloomberg confirmed its BSBY short-term credit sensitive index adheres to IOSCO Principles
• LCH published circular “Rates Reform: LIBOR Fallback and Conversion Fees”
• ISDA published paper “Adoption of RFRs: Major Developments in 2021”
• ISDA held Benchmark Strategies Forum
• ISDA published its March 2021 ISDA-Clarus RFR Adoption Indicator
• ISDA announced introduction to the 2021 ISDA Interest Rate Derivatives Definitions
• ISDA published “No Delay for USD LIBOR”
• ISDA published “Implementation of the 2021 ISDA Interest Rate Derivatives Definitions”
• ISDA published paper “Transition to RFRs Review: First Quarter of 2021”

UK specific highlights:

• FCA and BoE encouraged switch to SONIA in the sterling non-linear derivatives market
• GBP RFR WG published a summary of responses to its consultation on successor rate to GBP
• LIBOR in legacy bonds
• LSTA published simple RFR multicurrency concept document
• GBP RFR WG updated its priorities and roadmap for transition by end-2021
• GBP RFR WG published paper “Transition from LIBOR in Sterling Structured Products”
• IBA launched ICE SONIA Indexes to assist UK lending markets transition to SONIA
• FMSB published spotlight review on LIBOR back book transition
• GBP RFR WG Chair wrote a letter to HM Treasury about IBOR transition safe harbor
• LMA updated RFR referencing loans’ list
• GBP RFR WG issued statement on active transition of legacy GBP LIBOR contracts
• GBP RFR WG published paper “Operational considerations for fallbacks in uncleared derivatives”

US specific highlights:

• ARRC endorsed decision to sign New York State LIBOR legislation into law
• ARRC announced key principles for a forward-looking SOFR term rate
• ARRC announced the “SOFR Symposium: The Final Year