LIBOR Transition

Beyond LIBOR The world of interest rate benchmarks is changing. Here is what you need to know.

Investment Bank

This section of the LIBOR transition website is not intended for wealth management, corporate or institutional client nor asset management clients of UBS. The information below aims to give our clients an understanding of the LIBOR transition and highlights the practical considerations that should be taken into account.

ISDA: Final IBOR Fallbacks Protocol and Supplement

Following the ISDA launch date announcement on 9 October 2020 , the IBOR Fallbacks Supplement and Protocol documents are FINAL and posted on the ISDA website. ISDA will host a number of webinars to assist with the market participants.

ISDA and Bloomberg have also produced a number of additional resources on the IBOR Fallbacks (see below).

Bloomberg: Fallback Rate and Spread Publication

You can access these daily publication of IBOR Fallback Rates and Spread Adjustments via Bloomberg Terminal® on FBAK <GO>. The daily publication is also publicly available on the Bloomberg website on a delayed basis.

Information available on this site is provided for existing Investment Bank clients with existing LIBOR-referencing positions or products only.

Key highlights of the Practical Guide

Facts and Figures

Facts and Figures

Discounting Risk

Discounting Risk

Forecasting Risk

Forecasting Risk

Facts and Figures

  • 5 ARRs have been identified to replace the 5 LIBOR currencies
  • Each ARR is an overnight rate
  • The ARRs are backward looking rates
  • Adjustment methodology agreed to address the differences (term and credit) between LIBOR and ARRs.

Discounting Risk

  • Discounting rate and interest paid on collateral usually aligned
  • Switch in discounting rates to ARRs by CCPs is likely to be a key driver for increased adoption of ARRs across the industry
  • Any changes to the margin annex for a derivative contract should reference the new ARR to replace existing cash margin rate

Forecasting Risk

  • Updated ISDA definitions due to be published on 23rd October 2020
  • Differences in fallback methodology across different product types may impact hedge effectiveness across transactions believed to be linked
  • Evaluation of current contractual fallback provisions may lead to increased bilateral discussion

Practical considerations checklist

  • Understand what this change means for you:
    • Analyse the exposure you currently have to LIBOR and assess the potential financial impact
    • Ensure you know where you have transactions which you believe to be linked (see Forecasting Risk Section)
    • Review the fallback language in your Legal Documentation (see Forecasting Risk Section)
  • Review your readiness:
    • Evaluate whether you need to make any changes to your risk management systems
    • In addition, consider any operational processes you may need to update, for example ensuring all reference data sources are updated accordingly
    • Consider consolidating your LIBOR exposure to reduce the number of bi-lateral transitions required

LIBOR Transition background

The London Interbank Offered Rate (LIBOR) is calculated from submissions by selected "panel" banks1 of the rates they either pay or would expect to pay to borrow from one another.

LIBOR is a widely-used interest rate benchmark. Rates are determined daily by the LIBOR administrator, the ICE Benchmark Administration (IBA), for various currencies (USD, EUR, GBP, CHF, JPY) and tenors (Overnight, 1w, 1m, 2m, 3m, 6m and 12m).

Size of LIBOR* market in 5 major currencies

According to IBA, LIBOR is used to determine periodic interest payments for many hundreds of trillions of notional of financial products globally, and is used for example in derivatives, bonds, structured products, securitised products and loans.

Just over a decade ago, the market's perception of an increase in inter-bank credit risk inherently contained within LIBOR led to a widening of the basis between LIBOR and short-term interest rate futures. Financial institutions began to switch from using LIBOR to Overnight Index Swap rate (OIS) for discounting purposes, which was seen as being closer to a risk-free rate. At the same time, liquidity in the unsecured lending market, which underpins LIBOR, declined as banks became increasingly unwilling to lend to one another on an unsecured basis. The concern was that a lending rate, based on an increasingly less liquid market, was being used to reference many multiples of financial contracts. As a result, in 2017, the FCA announced that the market should transition to alternative reference rates based firmly on transactions, with panel bank support for current LIBOR agreed only until the end of 2021.

The end-2021 deadline has been reiterated by regulatory bodies around the world and, despite market-driven transition challenges triggered by the COVID-19 pandemic, the FCA2 has stated that the transition away from LIBOR still needs to happen by the end of 2021.

In response to these concerns on LIBOR, the Financial Stability Board's (FSB) review produced the basis for the 19 principles developed by the International Organization of Securities Commissions (IOSCO)3 . One of the key IOSCO principles was that a new "representative" benchmark reference rate should wherever possible be based on transactions and not expert judgement.

Since the initial FCA statement in 20174, national working groups (see Forecasting Risk section) have been set up with the support of regulators and central banks with broad industry and market representation. These working groups have recommended alternative benchmarks for each of the LIBOR currencies. These alternatives are viewed as more robust benchmarks, compliant with IOSCO principles and are underpinned by larger volumes of observable transactions.

 

Alternative Reference Rates

Different jurisdictions have developed different methodologies for their new ARRs, and as illustrated in the timelines in the appendix, these are all at different stages in terms of market liquidity and development. These ARRs are managed by different administrators, as outlined below.

Jurisdiction

Jurisdiction

Working Group

Working Group

Legacy Reference Rate

Legacy Reference Rate

Target ARR

Target ARR

Underlying transactions

Secured vs Unsecured

Underlying transactions

Secured vs Unsecured

Rate Administrator

Rate Administrator

Comments

Comments

Jurisdiction

US

Working Group

Alternative Reference Rates committee (ARRC)

Legacy Reference Rate

USD LIBOR

Target ARR

Secured Overnight Financing Rate (SOFR)

Underlying transactions

Secured vs Unsecured

Secured

Rate Administrator

Federal Reserve Bank of New York

Comments

 

Jurisdiction

UK

Working Group

Working group on Sterling Risk-Free Reference Rates

Legacy Reference Rate

GBP LIBOR

Target ARR

Sterling Overnight Index Average (SONIA)

Underlying transactions

Secured vs Unsecured

Unsecured

Rate Administrator

Bank of England

Comments

 

Jurisdiction

Euro Area

Working Group

Working Group on euro risk-free rates

Legacy Reference Rate

EONIA1

Target ARR

Euro Short Term Rate (€STR)

Underlying transactions

Secured vs Unsecured

Unsecured

Rate Administrator

European Central Bank

Comments

Reformed EURIBOR is expected to continue alongside €STR as a multiple rate approach. The European Commission has expressed confidence in EURIBOR for the medium term

Jurisdiction

Switzerland

Working Group

The National Working Group on Swiss Franc Reference Rates

Legacy Reference Rate

CHF LIBOR

Target ARR

Swiss Average Rate Overnight (SARON)

Underlying transactions

Secured vs Unsecured

Secured

Rate Administrator

SIX Swiss Exchange

Comments

 

Jurisdiction

Japan

Working Group

Study Group on Risk-Free Reference Rates

Legacy Reference Rate

JPY LIBOR

Target ARR

Tokyo Overnight Average Rate (TONA)

Underlying transactions

Secured vs Unsecured

Unsecured

Rate Administrator

Bank of Japan

Comments

Multi rate approach planned with TIBOR (but Euroyen TIBOR may discontinue)

The ARRs are structurally different from LIBOR and are not economic equivalents.

Components

LIBOR

ARRs

Methodology

Based on a waterfall methodology incorporating real transactions but also expert judgement

SOFR, SONIA, €STR, SARON and TONA are anchored in real transactions

Term

Published for 7 maturities from overnight up to one year

Currently only available overnight

Credit Risk Adjustment

Includes a risk adjustment to account for interbank credit spread and tenor

There is minimal credit spread adjustment as the ARRs are overnight rates and some ARRs are secured

Rate

The rate is set at the beginning of the period

The rate is based on daily observations and is only known at the end of the period

Settlement Conventions

Paid at end of period

There are a variety of conventions used in the calculation of cashflows dependent on backward looking rates:

  • Compounding of the overnight ARR over the payment period
  • Averaging of the overnight ARR over the payment period
  • Lockout
  • Backward Shift or Lookback

Please see Appendix Overnight Index Swap Industry Definitions for further information on the above

Some of the ARRs are secured rates, i.e. calculated from observed repos collateralized by government bonds. This applies to SARON for CHF and SOFR for USD. The others are unsecured like LIBOR, i.e. based on unsecured borrowing with no actual underlying security. LIBOR differs from these unsecured ARRs in that it is based not only on observed interbank borrowing transactions but also expert judgement.

The ARRs developed to date are overnight rates. There are several ongoing efforts by the ARR working groups looking to develop forward looking term structures for the ARRs (except for SARON). However, a forward looking term rate requires sufficient depth in the ARR derivatives market in order to be able to calculate the rate, so they may not be fully available for use by 2021.

An alternative to forward looking term structures is to provide the result of compounding a rate over a period (such as 30, 90, 180 days) and publishing these as indices. This may assist some market participants to adopt these rates as it can limit the amount of daily compounding calculations required.

In March 2020 both the Federal Reserve and SIX began publishing 30-, 90-, and 180-day SOFR averages (as well as a SOFR Index) and 1-, 3- and 6-month compounded SARON indices, (calculated in arrears) respectively. Such compounded indices for SONIA have been published by Bank Of England from 3rd August 2020. 

The initial focus has been on the five ARRs detailed above. In due course other alternative rates may be developed. See appendix Other IBORs Benchmark Rates for selected examples of those currently under review.

Discounting Risk

The derivative contracts portion of the hundreds of $trillions of contracts are held in portfolios of trades that were either executed bilaterally between market participants (under ISDAs and if collateralized with a Credit Support Annex (CSA)) or intermediated by Central Clearing Counterparties (CCPs). Many of these bilateral CSAs reference Effective Federal Funds Rate (EFFR) or EONIA as the benchmark used to determine the interest paid on cash collateral posted. The CCPs currently use EFFR to determine the margin interest rate (known as Price Aligned Interest5 (PAI) rate) for USD activity (and prior to a switch to €STR in late July 2020 used EONIA for PAI for EUR.

Whilst the expected value of LIBOR drives the expected payments referencing LIBOR, the cashflows themselves need to be discounted back to the present value / price for a contract or security respectively. In this case, the change in the discounting curve on the valuation is referred to as Discounting Risk. Prior to the financial crisis, in the derivatives market, the rate used to discount these cashflows was LIBOR. Subsequently many market participants adopted an approach that aligned the discounting rate used with the interest rate paid (cash margin rate) on the type(s) of collateral specified (known as Eligible Collateral) in the underlying CSA. Any change in the discounting curve will not only change the Discounting Risk but also create a value transfer.

To reflect the eligible collateral, the current overnight benchmarks for the major currencies are used to pay PAI. For example the EFFR is used as the PAI rate on the posting of USD cash collateral. This rate is generally used as the discount rate to value the trade. Similarly, when it comes to posting of EUR cash collateral, EONIA is the PAI rate and the discount rate. EMMI has announced that EONIA will be withdrawn at end of the 2021. CSAs referencing this rate can be updated before that date, for example, by replacing with €STR.

For CSAs where non cash collateral is used, e.g. government bonds, margin interest is not transferred between counterparties, therefore there is no need for any renegotiation to change the discounting rate used to value the trade. The discounting rate used to value the underlying derivative contracts of these CSAs is aligned to the funding rate for this collateral in the secured funding market. As an example, if US Treasuries are the only eligible collateral, this could currently mean that the discount rate used is EFFR for the CSA. This rate could change to SOFR once the secured funding market adopts SOFR as the funding rate instead of EFFR.

The CSA changes are likely to accelerate post the switch from EFFR to SOFR and from EONIA to €STR when the CCPs make the change in 2020. The switch in discounting rates is a significant milestone for LIBOR transition as it is expected that market participants will look to switch their discounting risk thereby establishing hedging and re-hedging requirements in transactions referencing these ARRs: a key driver for adoption of ARRs as the market standard floating rate.

LCH and CME have disclosed their plans to adopt SOFR in place of EFFR as the PAI rate and discounting rate for all USD discounted contracts held in the exchange. In order to minimize the resulting discounting risk basis, it is expected that some market participants will seek to renegotiate their CSAs referencing EFFR to SOFR as close as possible to the CCP timelines. For details on the switch from EFFR to SOFR as the PAI rate and discounting of USD activity at LCH and CME, please see the table below:

EFFR->SOFR

EFFR->SOFR

LCH6

LCH6

CME7

CME7

EFFR->SOFR

Date of
Change

LCH6

16th October 2020

CME7

16th October 2020

EFFR->SOFR

Scope

LCH6

All USD discounted products

CME7

All USD discounted products

EFFR->SOFR

Proposal Summary

LCH6

  • Cash and Risk compensating (EFFR/SOFR Basis) swaps for Members
  • Clients can opt for Cash only & an auction process will take place to ensure LCH remains flat risk/cash

CME7

  • All Participants take Cash and Risk compensating (EFFR/SOFR Basis) swaps

OR

  • For participants that do not want Basis swaps, CME intends to engage third party providers to facilitate an auction and/or transfer mechanism

In addition to the negotiations mandated by the "Margin requirements for non-centrally cleared derivatives" regulations8 (with the first phase effective 1st September 2016 and final phase due 1st September 2021), CSA renegotiations driven by LIBOR transition are expected to be a major exercise. Given the majority of OTC contracts referencing LIBOR are cleared, there is an expectation that market participants may want to ensure that both current regulatory mandated and non-mandated bilateral CSAs are in line with CCP discounting and PAI.

The industry has largely been through the transition from using LIBOR to overnight rates for discounting. The expectation is that the transition from current overnight rates (EONIA, EFFR) to ARRs (€STR, SOFR) will not be as challenging as the transition from LIBOR to ARR for forecasting. Forecasting changes will be discussed in the next section.

UBS commences CSA negotiations after the current CCP transition dates. For CSAs currently referencing EONIA, UBS opened negotiations to effect the change of PAI to €STR at the end of July 2020. Similarly once the switch from EFFR to SOFR is completed at the CCPs on the 16th October 2020, UBS aims to open CSA negotiations for those CSAs referencing EFFR. Please contact your Sales representative directly to start the process.

The change in CCPs’ PAI for cleared swaps has a corresponding impact on swaptions that reference the price of cleared swaps as the underlying instruments. Depending on the extent to which the swaption is in or out of money changes following on from switch in PAI benchmark, either party of the swaption contract may experience a significant windfall gain or loss.

In order to recompense market participants for a windfall gain or loss in the price of a swaption due to the change in the underlying price of cleared swap, both the ECB9 and ARRC10 recommended that market participants should exchange voluntary compensation with their swaption counterparties.

UBS agrees in principle with the ARRC's recommendation for industry-wide compensation for the legacy swaption contracts affected by the discounting transition from EFFR to SOFR and would support an industry-wide implementation of a process which ensures that the payment of compensation is widespread and includes counterparties both with net compensation payments and receipts. We are not yet aware of industry formal working group discussions taking place to determine the mechanics of implementing the Committee's recommendation, and note that voluntary compensation was not possible in the transition from EONIA to ESTR, however continue to speak to regulators and ISDA on this. If you wish to share your views on the matter, please contact your sales representative or alternatively, get in touch via UBS-IB-LIBOR@ubs.com.

Forecasting Risk

LIBOR is widely applied as the floating interest rate benchmark referenced in a derivative (such as a swap floating leg), coupon on a bond or used to determine the interest rate on a loan. The valuation of such contracts or securities is driven by the change in the expected value of LIBOR—this is expressed as Forecasting Risk.

Active LIBOR transition is where market participants switch out of LIBOR referenced contracts into ARR referenced contracts as market liquidity allows, rather than waiting until the end of 2021. This activity would see ARR forecasting risk gradually replace LIBOR forecasting risk.

The ARR forecasting curve is generally lower than the LIBOR equivalent.

For any contracts referencing LIBOR when it is discontinued, the parties will, in the absence of changes to the terms, have to rely on the contractual terms that exist to determine the post-cessation rate. The effectiveness and prevalence of these fallback provisions varies across products and markets. These provisions, depending on when drafted, may have the components listed in the following table. Market participants should review existing derivative contracts and current positions in all LIBOR-referencing financial contracts (that expect to be held beyond 2021) for provisions that determine the reference rate in the absence of LIBOR, or confirm the steps to be taken to frame an alternative. Various groups (specifically ISDA for derivative contracts) are coordinating inputs from the industry to arrive at fallback language for impacted financial products addressing permanent LIBOR cessation.

Term

Term

Definition

Definition

Term

Fallback Language

Definition

Fallback language refers to the legal provisions in a contract that apply if the underlying reference rate (e.g. LIBOR) in the product is not published (whether on a temporary or permanent basis).

Term

Fallback Rate

Definition

The reference rate replacing LIBOR upon the Fallback Trigger Event. There are multiple approaches adopted in existing contracts to calculate a fallback rate, including replacing a floating rate with the last LIBOR setting for all post-cessation fixings or referencing the lenders' costs of funds.

Term

Spread Adjustment

Definition

As noted LIBOR is different to the ARR applicable in each jurisdiction and there may need to be a spread adjustment applied to the ARR replacing LIBOR to account for differences in the construction of LIBOR and the ARR.

Term

Fallback Trigger Event

Definition

Set of events relating to the original reference rate which may trigger the fallback to a new Reference Rate.

Clients should consider the economic and financial impact of the fallback provisions in their own contracts.

For example, the Federal Reserve Bank of New York's Alternative Reference Rate Committee has published language for cash products like securitized products and loans. The Loan Market Association has also focused on fallbacks for loans. ISDA is due to publish an update to its definitional booklets which incorporate updated fallback language (known as the IBOR fallback) in Q3 2020.

The preference of the FCA11 is for market participants to pro-actively switch to new alternative ARRs as soon as possible (as a primary approach), rather than to rely on fallback language (acting, in effect as a ‘seatbelt’). However, there are various aspects which may hinder this process—for example liquidity in an ARR.

11 https://www.fca.org.uk/news/speeches/libor-preparing-end

There are different defined triggers and fallbacks for different products. In bonds, for example, a common fallback in existing documentation is to use the last available published rate. Thus in the event of LIBOR cessation, these securities would essentially become fixed rate products. In loans, a common ultimate fallback is to lenders' costs of funds. In a derivative, on the other hand, the alternative to LIBOR may be subject to calculation by agents (e.g. a dealer poll undertaken by calculation agent or to some other method).

For OTC derivatives, ISDA has consulted widely on updated Definitions to incorporate fallback language for implementation in derivative contracts, with the final form due to be published on 23rd October 2020. These changes will become effective for new contracts traded on or after 25th January 2021. These changes will become effective for new contracts traded four months after the publication date. These updated Definitions will include pre-defined ARR based fallbacks for LIBOR and certain IBOR replacement rates and new trigger definitions.

An alternative approach may be to implement ISDA's Benchmark Supplement12, which sets out a contractual process aiming to agree an alternative rate, but does not pre-define the actual rate. The Benchmark Supplement does not therefore provide economic certainty.

ISDA is currently scheduled to publish an IBOR fallback protocol on 23rd October 2020 that when adhered to by market participants, will apply to the updated Definitions to existing derivative contracts. The ISDA Protocol is expected to be drafted deliberately broad to cover transactions governed by ISDA Master Agreement or other forms of master agreement (e.g. Federation Bancaire Francaise, Swiss Master Agreement).

If market participants choose not to sign up to protocol or do not adopt the provisions through a bilateral negotiation then the existing contracts will remain on the current fallback provisions as stipulated in the contract which when written probably did not envisage a permanent cessation of LIBOR.

ISDA's Benchmark Supplement also provides the option to implement a contractual process for existing contracts. However, both parties to the contract need to elect to implement for existing contracts for this to take effect.

It is expected that regulated entities such as UBS would adhere to the protocol by the effective date of January 25th 2021.

It should be noted that even in ARRs where liquidity and volumes are most developed (i.e. SONIA), this is concentrated in linear derivatives such as swaps. For non-linear derivative contracts there is comparatively little liquidity and volumes currently e.g.in swaptions where an outright SONIA volatility surface has not yet developed. With respect to the ISDA IBOR Fallback protocol, reliance on this to achieve LIBOR transition may not provide the same level of economic certainty for non-linear derivative contracts that it does for linear derivatives. In a transaction, the replacement of LIBOR references with an ARR plus an adjustment spread may affect the moneyness of the transaction and affect its efficacy relative to when originally traded as a LIBOR referencing derivative.

CCPs have indicated they will look to apply the updated ISDA Definitions for all contracts (new contracts executed under updated Definitions as well as existing contracts)13.

It is hoped that products other than OTC derivatives referencing LIBOR may also include fallback language or other provisions aimed at easing the transition to the relevant replacement rate as and when industry standards develop.

Differences in fallback methodology across different product types have added more complexity to the transition for linked transactions. For example the hedge effectiveness of a swap hedging the LIBOR component of a bond or loan may lose some efficacy upon the triggering of differing fallback methodologies. Market participants may need to discuss any linked or hedged transactions and evaluate contractual fallbacks in place. The market uncertainty in entering into new contracts referencing LIBOR beyond 2021 are summarized by the Commodities, Futures Trading Commission (CFTC)14.

ISDA has consulted with the industry to determine a market consensus on the methodology used to calculate the adjustment spread to address the term and credit differences between LIBOR and the ARR and other factors such as liquidity and fluctuations in supply and demand.

These consultations15 have established that market participants prefer to use the compounded setting in arrears rate to address differences in tenor between IBORs and overnight RFRs, and the historical median over a five-year lookback period approach.

Note that Bloomberg has begun to publish these LIBOR fallback rates as per ISDA's agreed methodology as of 21st July 2020. The real time data can be accessed via FBAK <GO> on Bloomberg Terminals, and is publicly available on the Bloomberg website on a delayed basis.

ARRC published its best practices16 for completing transition from LIBOR to provide date-based guidance, including when no new LIBOR activity should be conducted.

Product

Product

Hardwired Fallbacks Incorporated by

Hardwired Fallbacks Incorporated by

IT/Operational Vendor Readiness

IT/Operational Vendor Readiness

Target for No New USD LIBOR (maturing beyond 2021)

Target for No New USD LIBOR (maturing beyond 2021)

Anticipated Fallback Rates to be selected by

Anticipated Fallback Rates to be selected by

Product

Floating Rate Notes

Hardwired Fallbacks Incorporated by

30th June 2020

IT/Operational Vendor Readiness

30th June 2020

Target for No New USD LIBOR (maturing beyond 2021)

31st Dec 2020

Anticipated Fallback Rates to be selected by

6 months before the first reset/fixing scheduled after LIBOR cessation

Product

Business Loans

Hardwired Fallbacks Incorporated by

30th Sept 2020

IT/Operational Vendor Readiness

30th Sept 2020

Target for No New USD LIBOR (maturing beyond 2021)

30th June 2021

Anticipated Fallback Rates to be selected by

6 months before the first reset/fixing scheduled after LIBOR cessation

Product

Consumer Loans

Hardwired Fallbacks Incorporated by

Mortgages:

30th June 2020

Student Loans: 30th Sept 2020

IT/Operational Vendor Readiness

Mortgages:

30th Sept 2020

Target for No New USD LIBOR (maturing beyond 2021)

Mortgages:

30th Sept 2020

Anticipated Fallback Rates to be selected by

Specific consumer regulations

Product

Securitizations

Hardwired Fallbacks Incorporated by

30th June 2020

IT/Operational Vendor Readiness

31st Dec 2020

Target for No New USD LIBOR (maturing beyond 2021)

CLOs: 30th Sept 2021

Other: 30th June 2021

Anticipated Fallback Rates to be selected by

6 months before the first reset/fixing scheduled after LIBOR cessation

Product

Derivatives

Hardwired Fallbacks Incorporated by

Up to 4months after IBOR ISDA Protocol and New definition are published

IT/Operational Vendor Readiness

Dealers to act to deliver a liquid SOFR derivatives markets to clients

Target for No New USD LIBOR (maturing beyond 2021)

30th June 2021

Anticipated Fallback Rates to be selected by

 

Cessation and Pre-Cessation Definitions

Terms

Terms

Definition

Definition

Terms

Cessation Event

Definition

Event whereby a reference rate is discontinued or unavailable permanently, triggering Fallback. A typical LIBOR cessation event would occur if there were no longer sufficient panel banks contributing to calculation of LIBOR

Terms

Pre-Cessation Event

Definition

An event which impacts the reference rate but does not prevent its publication. With respect to LIBOR, such an event could be where the FCA deems LIBOR unrepresentative per IOSCO principles (via EUBR legislation) thus preventing EU regulated market participants from entering into new contracts referencing LIBOR

ARRC17 recommended the industry to include Pre-Cessation as a Fallback Trigger event in the Fallback Provisions for Floating Rate Notes.

The forthcoming ISDA Definitions will include both pre-cessation fallbacks (based on a 'non-representativeness' determination) and permanent cessation fallbacks to apply to all new derivatives referencing LIBOR that incorporate the amended 2006 ISDA Definitions. For Legacy trades (i.e. those transacted prior to the effective date of the updated Definitions) these updated Definitions are expected to be incorporated via adherence to the ISDA Fallback Protocol.

On 23rd June HM Treasury18 announced that it intends to bring forward legislation to amend the Benchmarks Regulation (BMR) to give the FCA enhanced powers. These could help manage and direct an orderly wind-down of critical benchmarks such as LIBOR. The proposed changes will create a possible way of reducing disruption by enabling continued publication of a LIBOR rate using different and more robust methodology and inputs.

The legislation would allow the FCA to direct the benchmark administrator to change the methodology, if doing so would better protect consumers and the integrity of the market than cessation of the rate. By acting via the administrator, the LIBOR rate (including the screen rates) would be preserved and remain in place.

We will refer to this continued publication of LIBOR under a different methodology as 'Synthetic LIBOR'.

Regulators still expect the same focus and urgency from market participants to transition from LIBOR by primarily actively switching from LIBOR contracts into ARR contracts or failing that, to insert robust and workable fallback.

These new powers may allow the continued publication of LIBOR (including the screen rates) with a more robust methodology and inputs. However the exact format of Synthetic LIBOR is unknown and will be set with market input. It is expected to be based on some form of ARR and an adjustment spread.

The use of Synthetic LIBOR is also expected to be limited to what the FCA19 term as "Tough Legacy". These are contracts that have no or inappropriate/unviable alternatives and no realistic ability to be renegotiated or amended.

Also note that any continued publication of LIBOR is dependent on the proposed legislation being passed and that the FCA will exercise such powers, none of which is certain.

Prior to the HM Treasury announcement, the FCA outlined some scenarios to accelerate the transition from LIBOR to ARRs perhaps to address the counter-active effect that the possibility of LIBOR continuing may have on certain market participants.

These scenarios include the possibility of a pre-cessation or cessation announcement ahead of end 2021. This announcement would be in advance of the event or effective data but would have the effect of fixing the adjustment spread between LIBOR and the corresponding ARR which would apply at either pre-cessation or cessation date.

The GBP LIBOR market (at time of publication) is pricing such an announcement in early Q1 2021. It is not clear how such a cessation would fit with the enhanced powers proposed in the HM Treasury announcement.

Certain contracts which reference LIBOR (including bonds, structured products, securitized products, loans and a subset of existing contracts) may have characteristics that impede smooth transition such as product mechanics for material amendments, non-linearity, illiquidity or because they act as hedges to products with different fallback methods.

Non-Protocol Covered agreements and confirmations may need to be reviewed to determine an approach. Generally, this approach is likely to involve market participants being requested to sign documentation agreeing to the transition to the relevant replacement rate.

Due to the increased complexity introduced by the differences between asset class fallbacks and product amendment mechanics, the industry is expected to need to perform a significant review of contractual documentation before agreeing to change terms on their existing trades. Amendments to existing trades will be a challenging exercise if market participants have to amend a significant volume of trades across different products on a bilateral or multilateral basis.

The level of impact on value and Forecasting Risk will be driven by but not limited to the following:

  • The specific legacy reference rate
  • Whether term rates become available
  • The specific fallback trigger provisions in existing contract(s)
  • Fallback rate to include an adjustment required to reflect the credit and term differences agreed by industry groups
  • The maturity of the contract(s)
  • The date when changes are expected to happen
  • The type of product as there are potentially differing industry solutions

There is no industry consensus on how the change in the value of contracts between parties will be handled.

Contact us

Please do not hesitate to contact us if you have any further questions relating to the LIBOR Transition. Alternatively, please reach out to your usual UBS contact