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LIBOR’s Shallow Grave

The final day of 2021 marked the passing of LIBOR, simultaneously the world’s most important number and most disgraced benchmark. Perhaps inevitably, the funeral has turned out to be more ambiguous than most, the attendant wake promises to be a drawn-out and slightly messy affair. Following over 4 years of preparation and an estimated $10bn in expenditure by banks, this endnote to our Eyes on IBOR series note will briefly assess the current status of the transition.

The picture is clearest in respect of new transactions. From 1 January 2022, there have been no LIBOR rates published across all tenors in GBP, EUR, JPY and CHF, comprising 24 of the previous 35 rates. Along with a nuanced prohibition on new USD LIBOR transactions, there are exceptions for new USD trades that seek to reduce legacy exposure, the funeral date does mark the end of new references to LIBOR. The rates will for the most part no longer exist or participants are forbidden from using them, except in limited circumstances. While all change presents a challenge, this will not prove to be a problem. The vast share of LIBOR exposure is in the derivatives market, recent volume/liquidity data has been overwhelmingly in favour of RFR-referencing trades.[1] In respect of other asset classes, at least in the sterling market, there has been no issuance of LIBOR-linked bonds since October 2021 and negligible LIBOR loan activity since March.

Unsurprisingly, the situation is more complex for legacy transactions, comprising an estimated $265 trn. notional at the start of 2021. In a slightly belated recognition of the legacy challenge (capitulation to reality), in November 2021 the FCA clarified the application of synthetic LIBOR rates to tough OTC legacy contracts. Synthetic GBP and JPY LIBOR, calculated using RFRs plus a spread rather than submissions from panel banks, will continue to be published throughout 2022, with at least the option to extend. The FCA is disinclined to delineate which contracts the “zombie” LIBOR is applicable to, effectively allowing its use for all contracts currently uncatered for by the Fallback Protocol or bilateral amendment. Challenges remain in the less commoditised LIBOR-referencing asset classes, the FCA confirms that 1/3 of LIBOR-linked bonds remain to be transitioned via the solicitation process, with a similar estimation for the mortgage market by year-end. While loans, particularly syndicated, present their own bespoke problems, significant and similar progress has been made.

In terms of systemic risk, the derivatives Moby Dick is largely slain; ISDA’s Fallback Protocol having approx. 15,000 adherents to date, equating to 91% of legacy LIBOR exposure. While the two-step “amend the Supplement Definitions and then reference those via a mass application Protocol” is brutally elegant and effective, it does raise its own issues. To allow time for payment, the Protocol triggers fallbacks as relevant reset dates occur, mandating an “observation shift” of two retrograde business days in the interest period. By contrast, clearing house conversion trades delay payment by two days; as the fallbacks fall due over the next few months, the inevitable OTC-cleared basis risk will have to be addressed. Basis risk will also sequentially apply as the OTC hedges for structured products, bonds and loans convert to their RFR fallbacks. The staggered USD LIBOR interment adds to the party, cross currency swaps may reference USD LIBOR (for 18 months) on the one leg, while having to reference an RFR on the other. It remains to be seen what effect the CFTC’s December SOFR First “encouragement” will have; as always liquidity will likely prevail. Other material issues remain, such as market-wide inconsistency among swaption amendments, necessarily bespoke-ish by falling outside the Protocol.  However, attendance at the basis risk ball will be a much more muted affair than the LIBOR cessation Götterdämmerung previsioned by some (Consultancy) fearmongers. If not entirely deceased, LIBOR is now deeply necrotic, accompanied by a sort of Facebook page which will still be regularly updated for some undetermined time and some issues with the will still to be resolved. There remains a lot of work to do, particularly in the building of SOFR liquidity. However, recognition that it could have been a lot worse should be a cause for distanced celebration by all those involved.

[1] GBP Swaps November 89%  referenced SONIA, DTCC figures for the week ending 3 December showed CHF swaps 96% referencing SARON and JPY swaps 94% referencing TONA

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