Global IBOR Reforms

In mid-2017, the CEO of the British markets regulator, the Financial Conduct Authority, took markets by surprise and announced an official target date for the demise of LIBOR. After the announcement that LIBOR would be phased out by the end of 2021, LGIM established a working group composed of members of our Legal, Portfolio Management and Client Strategy teams globally who are leading our efforts around the transition. This group is focused on managing the transition process as well as monitoring the developments in the replacement rate markets.

Here in the US, the Alternative Reference Rates Committee (ARRC) chose SOFR (Secured Overnight Financing Rate), a volume-weighted median of borrowing rates from the US Treasury repo market, as the replacement rate. In May 2018, the market began construction of SOFR derivatives, a necessary infrastructure to establish comfort in the pricing and liquidity of the reference rate for end users. Ultimately, market participants hope to see the SOFR derivatives market liquidity continue to be bolstered such that a smooth and cost-efficient transition can occur.

To our clients, perhaps the most relevant LIBOR use is through derivatives instruments, mainly fixed-floating interest rate swaps and related options. LIBOR is also the reference rate for total return swaps (e.g. on Treasuries, equity indices, and high yield indices), Eurodollars and various corporate floating-rate loans. For clients who trade over-the-counter total return swaps, we continue efforts to reference alternative non-LIBOR funding rates, such as Fed Funds, where practical. We continue to evaluate the risk and reward of the evolving opportunity set to ensure the existing positions affected by the change continue to age gracefully.

As our Working Group monitors and assesses all aspects of the transition process, we aim to keep you updated with important information. To that end, below is a Q&A around various relevant questions.

Update for all investors

The countdown is on to the cessation of LIBOR rates; GBP, EUR, JPY and CHF on December 31, 2021 and LGIM has been helping clients and preparing funds for the transition to alternative risk free rates.

An international initiative was launched to reform interbank offered rates (“IBORs”) and to develop more robust alternatives in 2017. This move was prompted by the widely publicized LIBOR manipulation scandal. IBORs are important because they were frequently used as a benchmark or target return for many funds, as well as underpinning various financial instruments and products and potentially other non-financial contractual arrangements.

Regulators around the world have been engaging with market participants, including banks and asset managers, to consider how best the market was to transition to new alternative risk free rates (“RFRs”). Legal & General has participated in various market work streams led by the Bank of England to help all aspects of the transition away from IBORs.

The transition has represented a significant market challenge, particularly for banks, asset managers and financial services firms across the industry. Estimates of the amount of IBOR-related activity in the banking and financial sector vary, but all pointed to global exposures in the hundreds of trillions. A significant amount of work across all market participants has therefore been required to ensure a smooth transition.

Despite the impacts from COVID-19 the market initiative to transfer away from certain currency IBORs has continued to make significant progress. The UK Financial Conduct Authority (FCA) along with the Bank of England have held several roundtables and published further guidance to ensure the market stays focused on the target date for cessation of GBP, EUR, JPY and CHF LIBOR.

Transition from LIBOR | FCA

When will this happen?

The FCA has confirmed that all LIBOR settings will either cease to be provided by any administrator or no longer be representative:

  • immediately after December 31, 2021, in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
  • immediately after June 30, 2023, in the case of the remaining US dollar settings 

On the respective rate cessation dates, banks will no longer be compelled to submit quotes to determine the London Inter Bank Offer Rate (LIBOR), effectively discontinuing the rate. As a consequence, substantial shifts in global trading and transition activity to alternative RFRs has been taking place and is expected to continue throughout Q4 2021 as we approach the December 2021 deadline.

This has very much been a market-led transition that has depended heavily on the developments of market participants, which have been enabled by numerous industry groups. LGIM has monitored these developments closely and taken action where appropriate in the interest of our clients. The UK has been the global leader in transition progress. The widely accepted GBP LIBOR fall-back is the alternative RFR, SONIA, which has been well developed in the derivatives market since its reform in April 2018, and subsequently developed across cash and loans markets.

How will it affect your investments with us?

We have made significant progress in identifying and addressing our clients’ investment exposure to IBORs and have an established governance structure around our transition activity. We have also been working in partnership with our parent company Legal & General Group PLC, who also have an established strong governance structure with a central co-ordination oversight, supported by divisional delivery.

This has allowed us to share project management and legal expertise to ensure an effective and controlled transition pipeline ahead of the December 2021 deadline. To date we have been working closely with clients and key stakeholders in our business to ensure the risk mitigation of transition to the investments we manage.

What are the risks?

The FCA has reiterated that market participants should not depend on LIBOR beyond 2021. The transition has involved involves a two-way path: (i) establishing multiple new products, and (ii) changing existing IBOR-referenced products. It also affects products across different jurisdictions which are transitioning to different alternative rates at different times.

Risks are therefore associated with:

  • Transfer of economic value when moving IBORs to RFRs
  • Operational process changes
  • Amending legal agreements
  • Liquidity risks of terminating IBOR instruments and replacing these with alternative RFR instruments

LGIM has always supported a transition first approach therefore we have managed to significantly reduce the risks to LIBOR within our business. This has allowed us to efficiently prepare our business for the cessation of LIBOR rates and further mitigate the above risks associated with transition.

Key 2021 Initiatives

Financial market players and organizations have been gradually taking steps to mitigate the impact of the transition from IBORs to RFRs. One of these steps included the publication by the International Swaps and Derivatives Association (“ISDA”) of the ISDA 2020 IBOR Fallbacks Protocol (“ISDA Protocol”) which market participants have been encouraged to adopt as part of their existing trading documentation since the beginning of 2021. Over 14,000 entities have now adhered to the protocol.

What is the ISDA Protocol?

ISDA are an organization who facilitate and set market standards in the trading of financial derivatives, usually traded under ISDA standardized Master Agreements. These instruments are often traded using IBOR rates. Notwithstanding ISDA’s primary role of being a global sounding board for derivatives transactions, given its global reach and influence in financial markets, ISDA has, in certain occasions created industry-wide protocols that have a wider scope than derivatives and ISDA-owned master agreements. With that in mind, in October 2020, ISDA published the ISDA Protocol with the aim to amend the terms of a wide range of market standard trading agreements such as ISDA Master Agreements, Global Master Repurchase Agreements, Global Master Securities Lending Agreements and International Foreign Exchange Master Agreements, to name a few, to ensure that on the permanent cessation of an IBOR or when an IBOR is deemed no longer representative a fallback rate is in place to provide for the continuation of the relevant IBOR linked trade and/or commercial provision.

The fallback rates have been determined via a market consultation and are now published as the selected currency RFR + a spread to ensure minimal value transfer on the removal of each relevant IBOR.

Further information on the Protocol and its expanded scope can be found here: ISDA 2020 IBOR Fallbacks Protocol – International Swaps and Derivatives Association.

LGIM, acting as agent, has adhered to the Protocol as well as adhering all Clients that have provided us with consent to do so.

LGIM have further been working with our clients, counterparties and the London Clearing House to ensure we are able to transition positions to fallbacks as required.

‘Tough Legacy’

The FCA has also announced new regulatory intervention powers to support what are deemed ‘Tough Legacy’ where there is no practical way to transition an existing IBOR exposure. The regulator recognizes a potential need to support such positions past the discontinuation of IBOR in the interest of Consumers. The FCA are currently undertaking a number of consultations in order to finalize such provisions and establish a ‘synthetic’ LIBOR which such ‘tough legacy’ contracts can continue to reference post LIBOR cessation.

Progress is also being made too across the pond with the US Transition body ARRC, who are also taking similar steps previously taken in the UK to promote the Secured Overnight Financing Rate (SOFR) as the new RFR to USD LIBOR. This is positive for the Global transition effort and will ensure the market is fully prepared to meet its obligations.

ARRC_Press_Release_Term_SOFR.pdf (newyorkfed.org)

At LGIM we continue to monitor the transition steps required and the associated risks, working closely with the FCA and the PRA on behalf of Legal & General and our clients. We are pleased to confirm that COVID-19 has not impacted our efforts and our transition program remains on target for Q4 2021.

Do you need to do anything?

Currently, you do not need to take any action with respect to your investments with LGIM. We will be in touch regarding your investments as appropriate, so please do look out for communications from us on this matter. However, if you are potentially impacted by the transition in other ways, please seek appropriate legal advice and guidance. You can also contact your usual LGIM representative if you would like to discuss this regulatory change and potential impact on your investments in more detail.

Further information can be found here:
https://www.bankofengland.co.uk/markets/transition-to-sterling-risk-free-rates-from-libor (link is external)

What are IBORs?

IBORs (Inter Bank Offer Rates) are financial benchmarks showing the average rates at which major banks can borrow in the interbank market. They are forward-looking, unsecured rates and range from overnight to 12 months.

IBORs also act as reference rates to hundreds of trillions of dollars in notional derivative exposure, for example interest rate swaps, and trillions of dollars in bonds, loans, mortgages, securitizations and deposits across institutional, corporate and retail market participants.

IBORs exist in different currencies. For example, GBP LIBOR is the rate at which UK banks can borrow from one another in sterling, and USD LIBOR is the rate at which banks can borrow from each other in US dollars.

What are the alternatives to IBORs?

Alternative Risk-Free Rates (“RFRs”) are being established across the different IBOR jurisdictions. In the US, the Federal Reserve convened a group of private market participants known as the Alternative Reference Rates Committee (ARRC) to manage the transition from LIBOR. The ARRC has recommended that SOFR (Secured Overnight Financing Rate) be used as the dollar near risk-free reference rate and has promoted its adoption as an alternative to USD LIBOR.

Alternative RFRs are intended to be more representative and robust. In addition to the manipulation scandals, the number of transactions underpinning the rates set by IBORs has been declining; as a result of post-financial crisis reforms, banks often now favor secured lending through deposits, repos and bonds. This means that IBORs are no longer a true reflection of the markets they are designed to represent.

How will the move from IBORs to RFRs happen?

The widely accepted LIBOR fallback has been the UK alternative RFR, SONIA, which is already well developed in the derivatives market, with early transition activity within the cash and loans markets.

With respect to derivatives, the International Swaps and Derivatives Association have also been working to establish common ‘fallback’ terms and a new Protocol listing fallback options for all available IBORs is expected to be published at some point in early 2021. This will assist derivatives market participants in their transition to RFRs.

What role is LGIM playing in the transition?

LGIMA, along with LGIM UK and our parent company Legal & General, have been engaged in the market transition at various levels with the Bank of England and other leading industry organizations, including the Securities Industry and Financial Markets Association (SIFMA), since 2017. Through these forums and our engagement with our counterparties and clients, we have been able to plan our transition away from IBORs ahead of the December 2021 deadline.

The global impact

Global impact of IBOR
Working Group Alternative Ref
Rate Name
Administrator Collateralizations Description
Alternative Reference Rates Committee (link is external) Secured Overnight Financing Rate (SOFR)(link is external) Federal Reserve Bank of New York Secured Secured rate that covers multiple overnight repo market segments
Working Group on Sterling Risk-Free Reference Rates (link is external) Sterling Overnight Index Average (SONIA) (link is external) Bank of England Unsecured Unsecured rate that covers overnight wholesale deposit transactions
The National Working Group on CHF Reference Rates (link is external) Swiss Average Rate Overnight (SARON) (link is external) SIX Exchange Secured Secured rate that reflects interest paid on interbank overnight repo rate
Study Group on Risk-Free Reference Rates(link is external) Tokyo Overnight Average Rate (TONAR)(link is external) Bank of Japan Unsecured Unsecured rate that captures overnight call rate market
Working Group on Risk-Free Reference Rates for the Euro Area (link is external) Euro short-term rate (€STR) (link is external) European Central Bank Unsecured Unsecured rate that captures overnight wholesale deposit transactions

Source: Financial Conduct Authority

 

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