Beginning of the end of Libor as derivatives fallbacks take effect
Trillions of dollars worth of derivatives contracts are now fully prepared for the end of Libor following the implementation of so-called fallback rates this week, the latest milestone in the move away from the controversial bank lending benchmark.
Fallback rates published by the International Swaps and Derivatives Association will now replace Libor in derivatives trades should Libor cease to exist in the future, clearing the path for its removal from the market over the coming years.
Regulators across the globe have sought to rid markets of Libor, which is currently used in about US$260trn financial contracts, as soon as the end of this year following various scandals surrounding these interbank lending rates about a decade ago. The market-wide introduction of fallback rates could prove pivotal for helping corporate users of uncleared derivatives move away from Libor. Such users have generally been slower to drop the benchmark.
Over 12,500 firms across nearly 80 jurisdictions have signed up to an ISDA protocol adopting the fallback rates so far, including just over 85% of the roughly £4trn market in uncleared sterling interest-rate derivatives linked to Libor, according to the UK’s Financial Conduct Authority.
The FCA estimates 97% of sterling interest-rate derivatives are now subject to fallbacks when adding that coverage to cleared swaps and futures, showing how the vast majority of the market stands ready for life after Libor.
“The good news is that the industry – at least most of it – has risen to the challenge of this transition,” said Edwin Schooling Latter, director of markets and wholesale policy at the FCA, in a speech last week.
“The success of this protocol means a major reduction in risk faced by the 12,000-plus firms who have already signed, and for the system as a whole.”
UK regulators are at the forefront of the push to eradicate Libor from financial markets, pledging that they will no longer safeguard the benchmark’s existence after the end of this year.
ICE Benchmark Administration, the administrator of Libor, ended a consultation on Monday regarding plans to stop publishing all sterling, euro, Swiss franc and yen Libor, as well as one-week and two-month US dollar Libor, after the end of 2021 and the remaining US dollar Libors in mid-2023.
Clear progress
About 80% of the US$260trn in financial contracts linked to Libor are cleared interest-rate swaps or exchange-traded derivatives, according to Schooling Latter, while uncleared swaps account for a further 9% or so of that total.
Derivatives clearinghouses, which act as middlemen in trades between financial institutions, have played an important role in the transition away from Libor. In October, LCH and CME Clearing started valuing US dollar derivatives contracts totalling US$120trn and US$7trn, respectively, using the secured overnight financing rate, or SOFR – the benchmark US regulators want to replace US dollar Libor.
Progress has been slower among corporate users of derivatives. Companies don't tend to clear derivatives trades, meaning there isn't a handful of central hubs to coordinate and enforce trading norms across this part of the market. Treasurers have also been reluctant to make the switch as a result of Libor still being the predominant reference rate in large parts of corporate debt markets.
“Companies refinancing today still see their debt priced off Libor. Most companies are ready to talk about moving to SOFR for their derivatives when they see it on the debt side,” said Amol Dhargalkar, global head of corporates at consultancy Chatham Financial. “They don't want to do a SOFR derivative if they're still doing a Libor loan."
This is where the ISDA protocol will be crucial, acting as what the trade body calls a “viable safety net” if Libor is no longer available. From Monday, every new ISDA interest-rate swap contract linked to Libor will be subject to the fallback rates. They will also take effect for every old swap where both counterparties to the trade have signed the ISDA protocol.
At least one counterparty has signed the protocol in 99.7% of uncleared sterling derivatives trades linked to Libor, said Schooling Latter, while both sides have signed it in just over 85% of these contracts.
“Having a fallback based on a clear, consistent and transparent methodology will significantly reduce the risk of market disruption if [Libor] ceases to exist,” said Scott O’Malia, ISDA’s chief executive, in a statement.