Dantum Consulting has argued on various occasions this year that a delay to the LIBOR cessation should not be expected. We were right … sort of. Although an 18-month delay to the cessation of the most widely used USD LIBOR tenors provides some welcome extra time to the market to deal with some of the most challenging issues in the whole LIBOR cessation, it is also clear that the delay is limited in scope and that there is only a year left to prepare for the demise of all the other LIBOR currencies, as well as some of the lesser-used USD LIBOR tenors.
When ICE Benchmark Administration (IBA) announced on 18 November 2020 that its consultation would not include USD LIBOR, market participants became suspicious that a delay was on the cards. And indeed, on 30 November the FCA and IBA announced an 18-month delay to the cessation of the most widely used USD LIBOR benchmarks (1, 3, 6 and 12 months) to 30 June 2023. Does this mean market participants can now relax? Or should they still be panicking that there is only a year left to prepare for the demise of all the other LIBOR currencies, as well as some of the lesser-used USD LIBOR tenors?
So how did the market react to the announcement? Shortly after the announcement from IBA and FCA, the Eurodollar futures contract rallied more than 5bps reflecting the fact that they would be still be referencing USD LIBOR rather than SOFR. The 2 year forward starting 3s6s basis (the difference between 3 month and 6 month LIBOR) narrowed from 6.25bps to 3.88bps reflecting the delay to LIBOR transition.
Eurodollar future contacts rallied more than 5bp, reflecting the fact they will continue to reference USD LIBOR rather than SOFR.
As much as the FCA would like the end of 2021 deadline to remain, it does make sense to delay this deadline for those USD tenors, given the current lack of liquidity in SOFR. The last thing the regulator wants is a disorderly market. Even with a doubling of traded volumes since the SOFR discounting switch, this is still a drop in the ocean compared to the volumes still being transacted in USD LIBOR.
Given the many remaining issues concerning loans, consent solicitation on bonds, and the transition of ‘tough legacy’, the delay is a welcome reprieve for many. This could now allow enough time for a ‘term rate’ (more closely aligned to LIBOR) to be constructed once liquidity finally accelerates in SOFR. At the same time as the consultation announcement from IBA, the FCA also announced a consultation on ‘synthetic LIBOR’ to help with tough legacy. The Benchmark Regulation (BMR) will be amended by the Financial Services Bill to empower the FCA to approve ‘synthetic LIBOR’. But what does this mean? The FCA can designate a benchmark as ‘critical’ (to be called an Article 23A benchmark) and will permit some or all legacy use of the benchmark by supervised entities. They can also (under Article 23D) impose requirements on the administrator of the Article 23A benchmark, including as to how the benchmark is determined and the input data and, more importantly, get them to continue to submit. All of this will help toward ironing out some of the more problematic issues with LIBOR transition.
Interestingly the FCA’s Head of Markets Policy, Edwin Schooling Latter had made strong suggestions that an announcement on the cessation of LIBOR by the FCA could come as soon as November or December. This would effectively fix the spread adjustment to be added to the ARRs to the 5-year median of the LIBOR-ARR spread. This now looks less likely to happen in 2021 for USD LIBOR but could still occur in the first quarter of next year. If so, this triggers the fixing of the LIBOR-SOFR spread adjustment that is to be added at the date of cessation to all ARR currencies. Pushing the actual cessation of USD LIBOR out by 18 months would mean that the actual spread would trade around in the market for a further 18 months. The results of the IBA consultations are due in January, and it will be interesting to see if this coincides with an announcement from the FCA on the cessation of LIBOR.
In our opinion, this delay to USD LIBOR transition is very different from delays to recent and current regulations such as MiFID II, SFTR, or FRTB. Especially the MiFID II delay saw many institutions effectively taking a year off, which subsequently resulted in a mad rush to try and get everything over the line and a hiring frenzy. Even with USD LIBOR extended by 18 months, the other LIBOR currencies will still have to transition to their subsequent ARRS; ESTR, SARON, SONIA and TONAR.
The recommendations by ARRC have also been very clear that no new USD LIBOR trading is expected after 2021. In essence, this delay gives the market more time to deal with some of the transition issues and particularly ‘tough legacy’ contracts which were causing headaches. The FCA’s new legislative powers are a nice safety net to help deal with any remaining tough legacy. USD LIBOR liquidity is also likely to drop sharply towards and in 2022 as market participants will be forced to start embracing the SOFR benchmark. It really is a case of welcoming the delay but not taking your foot off the pedal!