11.22.2019

FCA: Next Steps In Transition From Libor

Speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, delivered at the Risk.net LIBOR Summit, 2019.

  • Highlights
    Key next steps in reducing the risks from continued use of the LIBOR benchmark include ending use of LIBOR in new sterling loans from Q3 2020, and making it standard to quote based on SONIA in sterling swap markets.
  • The FCA’s Director of Markets and Wholesale Policy describes how LIBOR could cease or fail the Benchmarks Regulation ‘representativeness’ test at end-2021, and how robust contractual fall back triggers can protect market participants from risks in both scenarios.

The need for transition away from LIBOR has been well rehearsed. The end-2021 date by which market participants need to be ready for life without LIBOR will be familiar to most, if not all in the room. Today, therefore, I would like to focus on some key next steps at this point in the transition from LIBOR to near Risk Free Rates (RFRs).

Progress made
I will pause only briefly to note what has already been achieved. We now have liquid markets for swaps and futures based on SONIA – the market’s chosen sterling Risk Free Rate. SONIA is now the norm in new issuance of floating rate sterling bonds and securitisations. There have been a number of other important new landmark achievements in the past weeks. These include the successful conversion to SONIA of £4.2 billion in previously LIBOR-referencing securities – with some of these consent solicitations achieving 100% investor agreement – as well as new firsts for the conversion to SONIA of a LIBOR loan, and a first SONIA swaption. The sterling RFR Working Group is working to publish a document that will share more widely some of the lessons learned in these conversions of ‘legacy’ LIBOR instruments.

There is no room whatsoever for complacency. There is much more to do. This week ISDA recorded the 1000th SOFR-swap transaction in the year to date, but SOFR swaps are still a very small part of the US dollar swaps market. And while we have seen some landmark firsts, beyond a handful of pioneering examples, we are yet to see loan markets move from LIBOR to the RFRs.

Key next steps in sterling swaps and loan markets

New sterling LIBOR public bond issuance appears to have ceased. But in sterling, as well as in US dollar, Japanese yen and Swiss francs, significant volumes of new LIBOR swaps maturing after end-2021 are still being struck. In sterling IRS (interest rate swap) markets, we will be encouraging market makers to make SONIA the market convention from Q1 2020. That does not, at this stage, mean no more sterling LIBOR swap transactions for those who have a particular reason to prefer LIBOR, but it does mean making it standard to quote and offer swaps based on SONIA rather than LIBOR. As infrastructure and liquidity to support SONIA swaps are already in place, this should be achievable with relatively little cost.

In the loan market, the task ahead is a bigger one. Looking at UK markets, we can draw some comfort that use of LIBOR is rare in new mortgages. It is getting even rarer as the handful of smaller lenders still using LIBOR have completed, or near completion of their transition programmes. Alternatives, including both fixed rates and alternative variable rates are already widely used. One of these is Bank rate (which past data show SONIA to have tracked closely).

Bank rate is also used for some variable-rate SME lending. But LIBOR continues to be common in corporate lending, including in syndicated loans. The sterling RFR Working Group has set a target of Q3 2020 to stop new lending using LIBOR. This will involve significant infrastructure and documentation preparation, customer communication and staff training exercises for some banks. The main IT system providers in this area have described to the Working Group their planned new product releases. One of the largest providers plans to make available its SONIA loans product on 29 November.

One message we have been keen to communicate is that delaying transition of new business away from LIBOR until the production of forward-looking term rates based on SONIA may not be the best approach. The loan market, like some others, has become accustomed to the forward-looking LIBOR benchmark. In those other markets, notably bonds and securitisations, we have also in the past heard arguments that forward-looking term rates are needed. But those arguments have largely evaporated in those markets, in the face of decisive shifts to overnight rates compounded in arrears. For similar reasons, including hedging costs and effectiveness, many expect to see this happen in large parts of lending markets too, particularly the wholesale end of those markets.

The often-heard argument that borrowers who value certainty of payments need forward-looking term rates often doesn’t hold much water. For those whose priority is payment certainty, fixed rates may be best. Other variable rate options, for example SONIA observed over an earlier period, can also provide payment certainty before the end of the interest period. Moreover, the benefit of compounding may mean such rates are less volatile than a forward-looking term rate polled from market transactions on a single day may prove to be.

The place for forward-looking SONIA term rates is the central issue in a forthcoming sterling RFR Working Group publication on term rate use cases. The Group expects overnight compounded rates to be the norm in derivatives, securities and wholesale loans. In some more retail markets, where simplicity or payment certainty is the key factor, fixed rates, or Bank rate may be preferred. There may, however, be some places where a forward-looking term rate is a good fit with business needs. Moreover, term rates may be particularly useful in calculating fair replacement rates for legacy LIBOR contracts that cannot be amended to work on overnight rates compounded in arrears.

The sterling RFR Working Group and its members are also working closely with counterparts in the United States and elsewhere to try and agree the final elements of common conventions that can best support an international syndicated loans market.

Further progress on transition in loans and swaps markets is the key task in the year ahead. The risks of continuing to rely on contracts that reference LIBOR beyond end-2021 are rising. The prudential risks are rising given uncertainty about the existence of the rate and how the properties of the rate (eg its volatility) or the depth of liquidity in LIBOR instruments will change as the end of LIBOR approaches. The conduct risks of striking new LIBOR-referencing transactions that endure beyond end-2021 are also rising. It is no longer credible for any regulated firm to claim it did not know LIBOR might not survive this date. This week we published some initial answers to some of the most commonly raised conduct questions. We will continue to engage with market participants on key questions as transition progresses.

The rest of the speech can be read here.

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