In the past six months, “the end” of several things has been predicted: humanity, global capitalism, or at the very least, a bull run in global markets that lasted well over a decade. Though the impacts have been severe and a lot can still happen, so far the results have not been quite as dramatic as feared at some points. One thing for sure is that the end of LIBOR is nigh.
Contrary to the tragic human death toll, many people thought that another perverse effect of the virus would be to delay the death of LIBOR. Because of all the disruption, several pieces of regulation affecting financial institutions were delayed. With doubt about the 2021 deadline already lingering in some parts of the market before the virus reared its head, a lot of people assumed that the end of LIBOR would be delayed as well.
We have consistently warned that LIBOR cessation will not be delayed and now that we are halfway through 2020, two things are clear to us:
Zoom meetings are here to stay for some time as we are not out of the woods yet when it comes to the virus.
The end of LIBOR is nigh.
Skeptics of the demise of LIBOR by 2022 got (another) wake up call by the recent speech from Mr. Schooling Latter of the FCA in which he said that an announcement about the discontinuation of LIBOR from the end of 2021 “could come as early as November or December this year”. As spread adjustments for LIBOR to alternative rates, such as SONIA and SOFR, are calculated over 5-year historic data starting from the day of the announcement, the moving up of this announcement compared to market expectations had an effect on the basis between LIBOR and its alternative rates and also an effect on the GBP and USD 3m vs 6m (3s6s) basis. The 2y 3s6s basis barely moved due to all of the fixings (4 lots of 6m fixings) occurring before the end of 2021 but from 3y onwards when LIBOR will cease all these spreads showed a sharp jump.
Chart of the 3s6s basis in USD where the green lines are the 5y and 10y 3s6s basis which both jumped, whereas the 2y 3s6s (the orange line) remained unchanged.
Markets moved accordingly, indicating that this new timescale is now the majority view. In terms of fallbacks we have now seen the final 6m LIBOR fixings that will be used to calibrate fallback spreads. Anybody that still doubts the FCA announcing the death of LIBOR by year-end, or early 2021, can put their money where their mouth is by trading against the recent basis moves.
UK Parliament soon followed the news. It plans to introduce a legislative solution for the transition, providing the FCA with appropriate legislative powers via amendments to the Benchmark Regulation. The focus of this legislation will be to help with so-called “tough legacy” contracts.
However, the UK Parliament, the Bank of England, and the FCA made it very clear that this does not mean the transition away from LIBOR can be paused by firms. Several very valid reasons were given, which can be found here. Suffice to say “active transition of legacy contracts remains of key importance” and the use of the legislation should be limited to “an irreducible minimum” and “only those contracts that genuinely have no or inappropriate alternatives”.
Finally, for a while, LIBOR cessation only seemed to be taken seriously for GBP with most of the market progress made in SONIA. However, the ARRC – overseeing the same efforts for USD LIBOR cessation – has increased its sense of urgency significantly in the past six months as well. One interesting piece of the SOFR puzzle was the updated fallback language for syndicated loans it published on June 30. We highlight two things.
The first is the replacement of the compounded SOFR rate, calculated in arrears, by the simple average SOFR for these loans. This is noticeably different from conventions in the derivatives markets but allows for daily accrual of interest, which was seen as critical for syndicated loans.
Derivatives are used for hedging purposes and this decision means that a perfect hedge with standard derivatives will likely not be possible. However, the ARRC noted that in practice the differences will be minor and that the simple average SOFR rate “is still hedgeable.” Our take: the wait for perfect solutions is over and practicalities are taking priority in order for the industry to make the deadline.
The second thing that caught our eye in the announcement was that its Best Practice recommends that USD LIBOR syndicated loans should begin using the new hardwired fallback language no later than September 30, 2020. That is exactly three months after the ARRC released it. Our take: “Get a move on!”
With each day there are more reminders of the transition work that firms must take on. Be it the latest letter from HKMA to authorised institutions referencing the ASIFMA transition guide, or the ARRCs summer series of webinars and their own 57-page transition guide. Only this week Bloomberg hosted John Williams (FRBNY) and Andrew Bailey (BoE) together with the chairs of the UK RFR working group and the ARRC on a webinar. Whether it's into its last 18 months or 536 days, the end of LIBOR is nigh.