Libor in depth

Special report 2019 Risk.net

Sponsored by

LID_OFC_0919.indd 89 15/08/2019 16:43 Opinion

Libor – How seven firms are tackling the transition Lukas Becker Desk Editor, Derivatives [email protected] t the law firm Fieldfisher’s offices near London Bridge in June, around 75 people gathered in a meeting Joanna Edwards Senior Director, Marketing Solutions A room for a seminar on Libor transition. [email protected] During the event, the audience of buy- and sell-side executives answered poll questions on their

Stuart Willes smartphones. The answers were not encouraging. Commercial Editorial Manager Asked: ‘How prepared are you for Libor discontinuance?’, two-thirds said they were just “starting to think [email protected] about it”. None had begun moving Libor positions to new risk-free rates (RFRs). Alex Hurrell, Commercial Subeditor Only one-quarter expected to transition all of their exposures away from Libor by the end of 2021, and [email protected] nearly half predicted they would only be able to get 50–80% of the work done in time. Antony Chambers, Publisher, Risk.net This was a small sample size, and the results should be taken with a pinch of salt. But polls at other industry [email protected] gatherings also give the impression that, despite clear warnings, Libor may disappear soon after 2021 – at

Robert Alexander, Sales Manager which point the UK Financial Conduct Authority (FCA) will no longer compel banks to submit quotes to the [email protected] various benchmark panels – market participants have done little about it, at least so far. There are exceptions. Risk.net spoke with a number of forward-thinking firms in a range of sectors – David Pagliaro, Group Managing Director [email protected] corporates, asset managers, insurers, regional banks, clearing houses and supranational issuers – about the progress they have made in transitioning away from Libor, and the findings have been aggregated into a series Ben Wood, Group Publishing Director [email protected] of seven profiles published in this report. UK-based firms appear to have made the most headway, and the series kicks off with LCH, which has a key Ben Cornish, Senior Production Executive [email protected] role, especially with secured overnight financing rate (SOFR) swaps. The clearing house found a way to safely accept the contracts for clearing without waiting for bilateral liquidity to build, as it does with most products. Infopro Digital (UK) Next year will see the discounting rate for US dollar Libor swaps changed to SOFR, a move that is expected to Haymarket House, 28–29 Haymarket London SW1Y 4RX boost demand for SOFR swaps. Tel: +44 (0)20 7316 9000 BMO Global Asset Management is a liability-driven investment manager based in London, which, as of Infopro Digital (US) June, has moved nearly 95% of its £10 billion ($13 billion) sterling Libor swaps portfolio onto the sterling 55 Broad Street, 22nd Floor overnight interbank average rate (Sonia). The firm targets pockets of liquidity from asset swaps and unwinds, New York, NY 10004-2501 Tel: +1 646 736 1888 and all of its new sterling swap trades are linked to Sonia. Associated British Ports is proof that corporates don’t need to be laggards in the transition. The company Infopro Digital (Asia-Pacific) moved more than £500 million of sterling Libor swaps onto Sonia late last year, and on June 11 met holders of Unit 1704-05, Berkshire House Taikoo Place, 25 Westlands Road its listed floating rate notes to convince them to switch the benchmark to the sterling overnight rate. Hong Kong, SAR China The European Investment Bank issued a Sonia-linked floating rate note last year – an oversubscribed Tel: +852 3411 4888 £1 billion bond – and, in the process, worked out the kinks of using the compounded-in-arrears methodology Cover illustration to calculate coupon payments. It is now trying to take the formula to the US, and beyond. Richard Osley/NB Illustration Toronto Dominion Securities was bookrunner on the EIB’s first Sonia issue, as well as on some early US SOFR deals. It helped create the standard structure in the UK, where coupons are calculated by compounding Published by Infopro Digital © Infopro Digital Risk (IP) Limited, 2019 the overnight rate in arrears, but has found that a lack of consistency in SOFR deals has held back progress in the US. For other markets, progress has been a little slower. US insurer Prudential Financial is still testing the pipes with some SOFR swap trades, and getting accustomed to some of the technical differences inherent in the new products. Hartford, Connecticut-based Webster Bank, meanwhile, is preparing to repaper legacy loan and swap contracts, and implementing the client education process that goes along with that effort. Included in the series is an interview with Cornelia Holthausen, deputy director-general in the directorate All rights reserved. No part of this publication may be reproduced, stored in or introduced into any retrieval system, general market operations division of the European Central Bank, who speaks to Risk.net about transitioning or transmitted, in any form or by any means, electronic, from Eonia to the euro short-term rate, and how long Euribor can really hang around. mechanical, photocopying, recording or otherwise, without the prior written permission of the copyright owners. Risk is Lukas Becker registered as a trade mark at the US Patent Office Derivatives editor, Risk.net

risk.net 1

LID_Intro_0919.indd 1 05/09/2019 12:53 Contents

4 LCH

LCH brings SOFR swaps into the fold

Central counterparty adapted its risk models to begin clearing the new swaps 6 BMO Global Asset and plans a quick switchover to SOFR Management discounting next year BMO – Setting the pace in Libor transition

As an early mover, BMO switches £10 billion of pension liability swap hedges to Sonia

8 Prudential Financial 9 European Investment Bank 12 Webster Bank

Taking SOFR for a test drive EIB sees prizes and pitfalls Webster Bank – Small lender in Libor reform eyes big SOFR challenges Test trades have allowed US insurer Prudential Financial to start getting The Sonia bond trailblazer wants a single The Connecticut-based firm is focusing used to a life without Libor bond template for all risk-free rates, but on client education and fallbacks found hidden devils in its debut

14 TD Securities 16 Associated British Ports 19 European Central Bank

TD Securities – The Sonia ABP crafts blueprint for ECB’s Holthausen on Euribor, FRN standards bearer corporate Libor switch fallbacks and Eonia’s end

Canadian bank TD Securities shows the US UK port operator embraces Sonia for The QE wind-down could boost Euribor, market can handle compounded coupons swaps, bonds and loans but panel bank expansion is unlikely

2 Libor in depth Special report 2019

LID_Contents_0919.indd 2 04/09/2019 14:10

LCH

LCH brings SOFR swaps into the fold

Central counterparty adapted its risk models to begin clearing the new swaps and plans a quick switchover to SOFR discounting next year. By Helen Bartholomew

s custodians of mutualised risk – A$375 trillion notional of it – clearing houses have strict guidelines governing how and when new products are brought into the fold. Derivatives typically need a track record of liquidity in bilateral markets and observable pricing on trading venues before they are even considered for clearing. Benchmark reform, however, has turned this premise on its head. In July 2018, just three months after the Federal Reserve began publishing the secured overnight financing rate (SOFR), LCH SwapClear cleared its first swaps linked to US dollar Libor’s risk-free successor rate. “It’s fair to say that the clearing rules and the framework set up to get products into clearing didn’t quite anticipate benchmark reform,” says Philip Whitehurst, head of service development for rates derivatives at LCH. “We managed to ensure that we were covering all of the risks attendant with clearing swaps linked to new risk-free rates [RFRs].” Given Libor may end after 2021, allowing Once the rate was selected by the industry-led US their tainted submissions-based predecessors. liquidity to build in bilateral markets before bringing Alternative Reference Rates Committee (ARRC) in “If a clearing house is holding enough margin SOFR swaps into the cleared world was not an June 2017 and the methodology was known, LCH to cope with a ‘less robust’ rate, then that should option. At the same time, new rules incentivising switched into development mode, using a backfilled give a greater level of certainty about the ability to clearing – via mandate and higher capital and time series to make the necessary assumptions effectively risk manage products linked to a similar, margin costs on bilateral trades –mean it’s cheaper around topics such as liquidity and likely behaviour. but more robust rate,” Horner says. to use capital-light cleared Libor swaps than the It’s easy to think that heavy reliance on assumptions new, regulator-endorsed RFR. So the clearing house rather than hard trading data translates into lower Discounting update had to bite the bullet and start clearing SOFR risk standards, but that’s not necessarily the case, as With speed-to-market a crucial factor, LCH opted to swaps anyway. LCH’s Whitehurst stresses. make some compromises at launch, accepting that “Launching a new contract directly into clearing “We’ve still got the same risk management in-flight updates would be required once the service is more challenging from a risk management standards, but we’ve had to go about things in a was up and running. and systems perspective,” says David Horner, slightly different way in terms of how we build the The biggest update – one that could arguably LCH’s head of risk for rates. “As a clearing house, case for a product being safe to clear, and the model bolster SOFR swaps liquidity – will come in the you have to make assumptions on the product’s being sufficiently robust,” he says. second half of 2020. At that point, LCH will use characteristics, and we err on the side of being Comfort was also taken from the fact that SOFR instead of the Fed Funds rate for calculation conservative, but there’s generally an established improvements intended to make the RFRs more of price alignment interest (PAI) – the rate paid on history of clearing similar derivatives, which robust than their Libor counterparts should also cash collateral – and as the discounting rate used to means there is some useful data on which to base mean they’re likely to be more resilient, less volatile calculate the present value of future cashflows on all those assumptions.” and stand up to unusual market events better than US dollar-denominated swaps it clears.

4 Libor in depth Special report 2019

LID_Feature_0919_LCH.indd 4 29/08/2019 16:45 LCH

The decision to launch SOFR swaps with Fed Funds discounting initially irked some buy-side firms, who argued that it added an unnecessary layer of future transition. Rival CME ceded to dissenting voices, launching its SOFR swaps clearing effort with SOFR discounting from the get-go. But LCH’s decision appears to have paid off. Just over $100 billion in cleared notional of the instruments has been registered to date, with LCH accounting for an estimated 95% of activity. “As a market infrastructure provider our job is to drive as strong a consensus as possible, but it’s fair to say there was not total unanimity on this issue. There were outliers but there was a strong consensus in support of our approach,” says Whitehurst. The discounting overhaul, which would apply to US dollar Libor as well as SOFR swaps both new and old, would put LCH ahead of the ARRC’s paced transition plan, which calls for CCPs to stop Philip Whitehurst, LCH David Horner, LCH accepting new swaps with Fed Funds PAI and discounting in 2021. In April 2017, the working group on sterling A decade after clearing its first Sonia swaps, The CCP is now working on a mechanism to RFRs – a committee convened by the Bank of outstanding cleared notional in the products now eliminate any value transfer resulting from the move. England – chose a reformed version of Sonia as the outstrips that for sterling Libor swaps on a notional The basis between Fed Funds and SOFR has ranged recommended successor for sterling Libor. This was basis. On a risk-adjusted basis, accounting for from 75 to –3 basis points this year, at an average followed three months later by a pivotal speech maturity, Sonia represents around 20% of the CCP’s of 3.5bp, so firms that benefit from the change in from Financial Conduct Authority chair Andrew sterling swaps risk, up from 10% in mid-2017. discount rate are expected to pass those winnings Bailey, which suggested Libor’s days were numbered In the middle of two contrasting experiences back to the clearing house in order to compensate beyond 2021. for sterling and dollar benchmark transition sits the losers. For many, it was the first true realisation that Saron – the Swiss Libor successor with a decade- The one-step move into a SOFR-only discounting Libor could disappear altogether. For the world’s long history but no derivatives market. LCH has world was the route of choice for clients, who biggest swaps clearing house, however, news that cleared Sfr300 billion ($302 billion) in cumulative preferred that to a piecemeal approach, which would the FCA would no longer compel panel banks to volume of Saron swaps since the October 2017 require US dollar swap portfolios to be discounted off contribute to Libor after 2021 simply cemented a launch. The rate now underpins around 10% of two different curves for a period of time. project more than eight years in the making. total Swiss franc swaps notional. “Words like ‘unprecedented’ are overused, but in “Andrew Bailey’s comments have removed a lot my opinion, this is the single biggest transformation of the ambiguity over a migration to alternative €STR timetable for the swaps market for 30 years – not just the step reference rates. It’s now clear that the risk-free There’s plenty yet to do. A new RFR for euro itself, but what it signals. It’s just one step, but it’s rates are being used to transition away from markets, the euro short-term rate (€STR), is set to vital in terms of supporting the adoption of SOFR as Libor,” says Horner. “As a core element of a CCP’s be launched in October. The CCP aims to match the alternative to US dollar Libor,” says Whitehurst. risk management, we plan and model for the its SOFR timetable in offering clearing for swaps worst-case scenario, so we were always interested linked to the new rate, suggesting a January 2020 Ahead of the curve in Libor reform and fallbacks from a contingency- start date. LCH’s experience of transition in sterling markets planning perspective. But it now seems much “We’re able to do plenty of the preparatory could hardly be more different. Part by luck, part by more likely that these plans could actually work for clearing €STR in the same way we did for judgement, it enjoyed a head start. be triggered.” SOFR as there are already a lot of statistics being In 2009, three years before the first fines The European Union’s Benchmark Regulation prepared, which enables us to determine the rate’s were even handed down to the first banks for – initially slated for implementation at the end of key characteristics,” says Horner. their role in manipulating Libor benchmarks, the 2019 but now delayed by two years – was another The direction of travel towards greater use of central counterparty began clearing interest rate factor driving LCH’s activities in the direction of RFRs is clear, but will there be a point when Libor swaps linked to a little-known rate – the sterling more robust overnight rates. swaps cease to exist at LCH? overnight index average (Sonia). The benchmark The introduction of BMR was an important “It’s reasonably likely that LCH will ultimately was also selected as the PAI and discounting rate signal as it brought the production of benchmarks cease clearing Libor swaps, but that’s not for all sterling-denominated swaps at the central under tighter regulation. When a regulation imminent and it will be a challenge for the market counterparty in 2010, after the market recognised such as BMR was in the pipeline, it was clear to complete its migration by January 2, 2022,” that cash-collateralised swaps should be discounted that benchmark design was going to change says Whitehurst. ■ at an overnight rate instead of Libor. fundamentally,” says Whitehurst. Previously published on Risk.net

risk.net 5

LID_Feature_0919_LCH.indd 5 29/08/2019 16:45 BMO Global Asset Management

BMO – Setting the pace in Libor transition

Early mover switches £10 billion of pension liability swap hedges to Sonia. By Lukas Becker

iability-driven investment (LDI) funds are known the firm could to go to any of the bank liquidity Las some of the biggest and most sophisticated providers to close out the individual positions counterparties in the sterling swap market. and the trades would be netted down and Even so, senior bankers raise their eyebrows eventually compressed. in surprise when told that one fund has already If the portfolio was non-cleared, BMO would managed to move nearly all of its swap exposure off have either been reliant on the original dealers to sterling Libor and onto its replacement, Sonia. trade the offsetting Libor swap, or would have to The firm, BMO Global Asset Management, go to another bank – creating extra line items and has £50 billion ($64 billion) of pension fund increasing costs. liabilities under management, of which more It would also increase the risk that, should Libor than £10 billion were hedged with Libor swaps. cease, contracts behave differently, says Nabil The firm began the transition in April 2018. By Owadally, an LDI portfolio manager at the asset August 2018, it had managed to move the vast management firm. This could occur if not all banks majority of its clients’ back books to cleared signed the upcoming protocol that would amend Sonia positions. swap contracts en masse to insert so-called fallback “100% of those that have a transition plan are language. This will dictate the rate that will replace done or in the midst of implementing it. In terms of Libor should the benchmark cease. what’s been actually completed, it’s approaching “If you have no take-up of the fallback on 95%,” says Simon Bentley, a client portfolio one [swap] versus the other, you’re actually manager at BMO Global Asset Management “100% of those that have a starting to build basis risk into your Libor book,” in London. transition plan are done or in the says Owadally. For new interest rate swaps, the firm aims to Ahead of any movement, BMO ensured it had trade only contracts linked to the overnight rate. midst of implementing it. In terms the right permissions in place to avoid transition The success is no accident – BMO started of what’s actually been completed, being dragged out by having to wait for responses speaking informally with dealers on the Bank of it’s approaching 95%” from clients. First, the firm divided clients into three categories. England-convened working group on sterling risk- Simon Bentley, BMO Global Asset Management free rates (RFRs) as far back as 2016. The first included clients such as pooled funds where BMO historically has achieved good outcomes BMO had full discretion to move without having for clients by staying on top of the myriad changes to go back for permissions. The second category in the swap market and by being an early mover, After a white paper issued by the sterling included segregated clients where BMO had says Bentley. This is important as portfolios are never working group in June 2017 found broad support discretion, but there needed to be an element of static – clients often want to rebalance when they for adoption of Sonia as the RFR, and once LCH engagement with the client. obtain new liability data or enter a new insurance began clearing Sonia swaps out to 50 years at The third category needed some sort portfolio buyout – so the firm has to constantly the end of the year, it was time to put the plan of paperwork change, generally to amend gauge the effect of these changes on dealing costs into action. the rate used as the primary or secondary and act accordingly. The transition itself was a relatively simple performance benchmark. “We’re always looking at what’s going on in the procedure – the firm is generally a fixed rate “For clients whose primary benchmark was a background, whether it’s cash collateral or central receiver, so it would need to enter an equal and swaps benchmark, or the only benchmark was clearing, and more recently Libor and Sonia. So offsetting Libor swap and then a new receive-fixed a swaps benchmark, that set of cashflows was we’ve been engaged with it largely since day one, Sonia swap. designed assuming that we were going to hold but obviously looking for a sensible time to start BMO has been an enthusiastic adopter of Libor swaps. It needed restating to suit a portfolio taking action,” he says. central clearing, which made the process easier as that used Sonia swaps,” says Bentley.

6 Libor in depth Special report 2019

LID_Feature_0919_BMO.indd 6 29/08/2019 16:46 BMO Global Asset Management

“You can see where the demand to come out of Libor and into Sonia comes from naturally, because structurally, pension funds are that way around” Nabil Owadally, BMO Global Asset Management

Restructuring of clients’ legacy in-the-money more attractive gilt yields appeared relative to Libor swaps also provided some Sonia flows. If an Sonia swaps, all else being equal. This created asset manager receiving fixed, for example, wanted an inherent adjustment mechanism in the to take profit on a position, it would close out the switching process which allowed BMO to adjust position and restrike at the current market level. its allocation between gilts and Sonia swaps as This would require the bank to adjust its the basis moved. discount hedge. Sonia is the rate used to calculate In all, close to 95% of the sterling Libor swap the present value of future cash flows for cash book by DV01 – the sensitivity to a 1 basis point collateralised sterling Libor swaps. This means the move in underlying rates – has been transitioned to value of a Libor swap is sensitive to movements in Sonia. Plans are in place to transition the remaining the Sonia-Libor basis. proportion, though clients are holding off for a If a change needed to be made, BMO explained Using the earlier example, from the bank’s out-of- variety of reasons. Some have yet to sign the final this to the client. After a discussion with their the-money, fixed payer perspective, if Libor stayed paperwork, for instance, while others may be consultant, the client would sign a side letter to flat but Sonia fell, the value would move further overhauling performance benchmarks in preparation update the benchmark to Sonia, at which point against the dealer. Banks hedge this risk using so- for the shift. BMO could get on with the transition. In a handful called widener Sonia-Libor basis swaps, which see Some of the swaps also expire before the end of of cases, Bentley says, the client chose to use a gilt- them essentially receive Libor and pay Sonia. 2021, meaning they will roll off before Libor is likely based benchmark instead. So when the sterling Libor swaps are unwound, to end. the basis swaps are also removed by entering All new sterling swaps are now linked only to Sonia. Building liquidity the opposite trade. This creates pay-fixed Sonia Switching activity started at the end of the first flows, and gave BMO the opportunity to take the Trickier shift to €STR quarter of 2018. BMO couldn’t simply go out other side. The euro swaps book is another matter. BMO is and do the transition all at once, as there wasn’t Supply is also said to have come from hedge a relatively big user of Euribor-linked interest rate enough liquidity in the Sonia market. It needed funds that entered Libor-Sonia basis-widener trades swaps, with a number of clients in the eurozone. a supply of firms willing to take the opposite to profit from an expected rise in the basis after July But unlike Libor, Euribor has no end date, and position – that is, to pay a fixed rate on a 2017, when UK Financial Conduct Authority chief the nominated replacement, the euro short-term Sonia swap. executive Andrew Bailey said the regulator would rate (€STR), doesn’t exist yet. Bentley says the firm is Generally, corporates are a key source of pay- not compel banks to submit quotes to Libor panels on a “watching brief” at the moment. fixed swaps in the sterling market, but these were from the end of 2021. Even when €STR is available – it’s expected in expected to transition at a slower pace. As the funds took profits, they entered the October 2019 – transition faces complications. For “You can see where the demand to come out of opposite trade to close the position out, providing example, Dutch pension funds prescribe the discount Libor and into Sonia comes from naturally, because further opportunities for BMO. rate for pension liabilities, which is set to six-month structurally, pension funds are that way around. “From their perspective, they’re not necessarily Euribor, so moving these accounts pre-emptively It’s less clear, given the fragmentation of the paid looking to clip out of their trade, they’d be happy is difficult. side on Libor, where the supply was going to come just to target a specific level and then come out of Liquidity may take a long time to build in a from,” says Owadally. the trade entirely. Given the flexibility that we had new rate. With pension funds being inherently The firm had to wait for pockets of Sonia risk from our side, we had the ability to take on that conservative investors, it may be some time before to become available. One key source was asset liquidity in one go,” says Owadally. there is enough liquidity in so far non-existent swaps done off the back of fixed-rate bond Given the sporadic nature of the Sonia swap instruments for these clients to be comfortable syndications. Asset swaps are packages that see supply, BMO didn’t target any particular Sonia-Libor doing trades in €STR. a fund buy a fixed rate bond and simultaneously basis level, he says, but instead prioritised stability “So, for all of those reasons, what we’ve tended enter a pay-fixed interest rate swap. This enables of pricing, by keeping a keen eye on liquidity to concentrate on is just the education process. The them to pay away the coupon in exchange for a pockets and avoiding trades that would move good news is that close to 90% of our euro clients floating rate. the market. are already in clearing. So the infrastructure is there, Some market participants had already been BMO also reduced its sensitivity to basis it’s more about having the readiness to be able to accepting Sonia as the floating leg in asset swaps. moves by employing a systematic, relative deal with €STR swaps and the education process,” This created the opposite, pay-fixed positions BMO value framework to allocate between gilts and says Owadally. ■ needed to strike new, receive-fixed Sonia swaps. swaps. The wider the Sonia-Libor basis, the Previously published on Risk.net

risk.net 7

LID_Feature_0919_BMO.indd 7 29/08/2019 16:46 Prudential Financial

Taking SOFR for a test drive

Test trades have allowed US insurer Prudential Financial to start getting used to a life without Libor. By Robert Mackenzie Smith

or many industry participants, the fi rst seismic However, this has not stopped Prudential from Fshift in the move away from Libor came in July, doing test SOFR trades and highlighting issues that 2017, when the chief executive of the UK Financial may need to be resolved as the end of 2021 comes Conduct Authority gave a speech suggesting that into view. Libor’s days may be numbered after 2021. “The one thing we can do is prepare ourselves But for the global head of derivatives trading for the inevitability that Libor will end and, along at US insurer Prudential Financial, it was April last those lines, we can test systems and operational year – when US dollar Libor’s replacement, the processes. For example, we have done a very secured overnight fi nancing rate (SOFR), was fi rst small number of trades that have allowed us to published – that represented the turning point when walk through the process of trading SOFR swaps,” the changes that lay ahead for the business became says McAlister. very real. He declines to comment on the notionals “Building out a team to tackle this began the involved or the precise makeup of the contracts, day after SOFR was fi rst published,” says Chris but he says doing these trades has allowed McAlister, who has spent the past 25 years in the the business to become aware of the technical fi rm’s centralised derivatives subsidiary, Prudential differences between trading these swaps and Global Funding. regular Libor ones. “At that moment, we began to convene a For example, payment dates will probably be committee across a number of different functional delayed by one or two days when trading SOFR areas, with the fi rst step to go about gathering data swaps versus Libor equivalents, owing to the fact around our Libor exposure for the entire group,” the fl oating rate linked to SOFR is set in arrears. This he says. “The one thing we can do is prepare could create problems with hedges if the fl oating McAlister has put together a team of 15 people ourselves for the inevitability that and fi xed legs are paid at different times. across a swath of different areas within the wider “The market standard will likely gravitate towards fi rm, including risk management, auditing and Libor will end and test systems and something that involves a payment date being fi nancial reporting, to collate data about its global operational processes” at least a day or two after that fi nal rate being Libor exposures across several of its businesses, Chris McAlister, Prudential Financial published. It’s certainly something new for the such as investment management, insurance and market to deal with,” says McAlister. fi nancial planning. The test trades have also allowed the fi rm to Those businesses make up part of Prudential’s think through the curve construction of SOFR. This is $1.5 trillion in assets under management and In that respect, McAlister has nudged the fi rm in part hindered by the lack of SOFR swaps trading $4 trillion of gross life insurance in force across 40 into an infl uential position on the industry-led US in the market today, but Prudential has already countries, which means having a centralised view Alternative Reference Rates Committee, which has begun gathering data to help populate a curve. of the fi rm’s Libor exposure is particularly helpful, been co-ordinating the transition away from US “We’re continuing to monitor live liquidity and says McAlister. dollar Libor. Prudential has been represented on the you need robust data to populate that curve,” he “We have all the derivatives exposure centralised, main board since April and has seats at the table in says. “Time is on your side right now, so this is the so we have that data easily to hand,” he says. “The four subcommittees. time to spend on that.” key thing is to gather the relevant data and then Certain factors have held up the adoption of For new fallback language, Prudential contributed make sure we have the relevant people at the table SOFR, such as the limited volume in the swaps responses to the fi rst consultation published by Isda to tackle a situation like this, who own and monitor market, which year-to-date is roughly $91 billion for sterling, Swiss franc and yen Libor, among others, that risk.” in notional versus $58.6 trillion in US dollar Libor, last year. It also plans to offer its thoughts for the Given the fi rm’s size – Prudential is the biggest according to data published by the International latest consultation on US dollar Libor, Hong Kong’s life insurer in the US and tenth-largest asset Swaps and Derivatives Association. Hibor and the Canadian dollar offered rate. manager worldwide – Libor exposures range The lack of clarity around tax, accounting and “Answering the fallback consultation questions across many areas, including cash products such regulatory issues, which were discussed most allows us to think through issues that might crop up as mortgages, business and consumer loans, recently at a Financial Stability Board meeting as a result of adjusting contracts, and allows us to collateralised debt obligations, securitisations, and on April 10, have also created uncertainty and plan ahead,” says McAlister. ■ more complex fi nancial derivatives, such as swaps. dampened enthusiasm for adopting the new rate. Previously published on Risk.net

8 Libor in depth Special report 2019

LID_Feature_0919_ Prudential.indd 8 29/08/2019 16:49 European Investment Bank

EIB sees prizes and pitfalls in Libor reform

Sonia bond trailblazer wants a single bond template for all risk-free rates, but found hidden devils in its debut. By Duncan Wood

risk.net 9

LID_Feature_0919_EIB.indd 9 29/08/2019 16:53 European Investment Bank

lans to replace Libor are often framed as a way to end Leroy takes a dim view of both positions. Pa sordid chapter in the history of the rates market: the “I think a lot of market participants are hoping Euribor burial of a tarnished benchmark and the industrial-scale will survive and can be reformed. I don’t think that can be cheating it allowed. the case, for various reasons,” he says. But at the European Investment Bank, at least one The technical reason is that the transaction volumes person is hoping Libor’s demise can also be the start of that support Euribor are a fraction of the volumes a bright, new future. In this future, the arrival of a host underpinning the doomed Libor rates, but there is an of replacement risk-free rates (RFRs) gives issuers a overarching reason, too: divergence between markets will chance to establish bond conventions that are identical raise costs for participants, he argues. from one currency to the next, while also matching the “Anything is possible, but we’ve noticed regulatory accompanying interest rate swap market. The result will change in the US has made its way to Europe – and be a bigger pool of liquidity and lower costs. vice versa in some cases – because there is a need to This vision lay behind the structuring choices the EIB harmonise market conventions, to harmonise the way made when issuing a Sonia bond in August 2018, and banks operate. If the market needs to develop different a US secured overnight financing rate (SOFR) bond in models, different back-office systems, then it creates cost. November the same year – respectively, the sterling And if you have to cope with both backward-looking and and US dollar RFRs. The EIB is also considering bonds forward-looking rates – and swap between them – then referencing the new Swiss and Japanese benchmarks. it will create costs and frictions. Ultimately, people will If it goes ahead, it will copy the structure used in its “The one thing we can do move away from that,” he says. sterling bond. is prepare ourselves for the As things stand, this choice will be left to the market. “As a global issuer, we believe we can potentially inevitability that Libor will Speaking at a conference in Brussels in late April, the help harmonise all these rates. What we would like Belgian regulator said a reformed Euribor is expected to to do is push for exactly the same template in every end and test systems and be cleared for ongoing use. market – and I personally believe the Sonia template operational processes” So, which of the rival benchmarks would the EIB’s we designed is the best one to use,” says Xavier Leroy, Chris McAlister, Prudential Financial Leroy use – reformed Euribor or the European Central a senior funding officer working for the new products Bank’s soon-to-be-launched €STR benchmark? and special transactions team at the EIB’s headquarters “I would go for €STR. You can rely on real data. You in Luxembourg. don’t need any derivatives, don’t need anyone to intervene, to quote, to tell you Having spent a fraught year working on that first bond issue, perhaps he what they think they would quote – you use historical market data, and a rate would say that. But as the first Sonia issuer – and one of the biggest and most that is published by the central bank,” he says. frequent sterling issuers – the EIB’s stance also carries more than the usual weight. Birthing pains How much weight it carries in the dollar market remains to be seen. True The EIB’s journey towards a new family of benchmarks actually started back in to Leroy’s vision, when the EIB launched its bond – three months after the 2011, when Thomas Schroeder – still a colleague of Leroy’s today – decided debut issue from the World Bank – it stuck to its Sonia template, which notably Libor was not a reliable rate. This was after Risk.net first reported concerns that calculates the coupon by compounding the overnight rate, whereas the earlier the benchmark was not reflecting the interbank loan market, but before the first SOFR bonds had averaged those daily inputs. criminal investigations were revealed. “We didn’t copy the early issuance. The bulk of the demand for the Schroeder took it upon himself to establish an alternative, opting for Sonia early transactions was coming from US investors, especially money market because it was derived from actual transactions, rather than an amalgam of funds. Those investors are very familiar with Fed Funds, where the market bank estimates. convention is a simple average – but the reality of interest rates is that you Despite the arguments in its favour, the £300 million ($382 million) bond never have a simple average, so our bonds used compounding and a few was a flop. Demand did not materialise, leaving the bank underwriters holding others have done so since then. In the future, I think compounding will the debt – Royal Bank of Canada was the sole lead manager. Leroy believes the become the norm,” he says. dealers were eventually able to shift it, but only at a loss. So, how confident is he that replacing Libor will usher in a bond market nirvana? “Investors said the idea was interesting in principle, but from their perspective “Ask me again in five years,” he quips. “I’m not saying we’re going to win, Libor was working fine. Buying something denominated in Sonia would just but this is what we’re pushing for.” leave them with basis risk to the benchmark. And there was no push from regulators to change it,” he says. €STR blessing The push came six years later. In June 2017, Andrew Bailey, the chief executive One of the ironies here is that the EIB’s home market is currently the biggest of the UK’s Financial Conduct Authority (FCA), revealed Libor’s panel banks had blot on this vista of future harmony. While Japan, Switzerland, the UK and US agreed to continue supporting the benchmark until the end of 2021. The market have all chosen overnight rates to replace Libor, Europe has been following twin had four-and-a-half years to select replacement rates, bake them into new tracks – launch of a new overnight RFR, as well as reform of Euribor. In addition, instruments, and defuse the ticking timebomb of existing, Libor-linked products. the euro market is flirting with the idea of a forward-looking fallback rate that Leroy says the EIB immediately recognised two things: its obligation to could be used in existing contracts if Euribor reform fails – so, a rate that would support the mission of one of its member states, and the opportunity to define be known in advance, rather than a backward-looking rate that is only arrived at the structure for this new market. Soon after, the EIB engaged two structuring after compounding over the relevant term. advisers – NatWest Markets and Toronto-Dominion Bank.

10 Libor in depth Special report 2019

LID_Feature_0919_EIB.indd 10 29/08/2019 16:53 European Investment Bank

There were three challenges – coming up with a structure for the bond, “As Andrew Bailey made those follow-up speeches, people started to listen. testing demand for a product that had previously fallen flat, and making sure Initially, the attitude was that this was just wishful thinking from the regulator,” investors had the systems to book the new bond. Against all expectations, the says Leroy. “The FCA’s communications strategy was excellent and is why the last of these three elements would prove the most time-consuming. UK is leading the world in the adoption of RFRs – it’s at least a year ahead of Broadly, some of the choices in terms of structure were relatively the US, and maybe three years ahead of Europe. The communications and the straightforward. For example, the EIB and its advisers quickly chose to calculate determination have probably been stronger than we’ve seen elsewhere.” the bond’s floating coupon on a backward-looking basis – adding up the At this point, the EIB had a structure for its new Sonia bond, and it had a overnight prints published by the Bank of England (BoE) and producing a rate market. Now, all it needed to do was ensure investors could buy the thing. The at the end of the period. This may make it impossible to know the precise rate trials that followed were a lesson to the EIB and its banks and – Leroy says – a in advance, but it avoids the conceptual contortions of a forward-looking rate, warning for all rates market participants. which would have to be based on Sonia derivatives, rather than the overnight “We gave this feedback to the various public bodies – the BoE, the FCA. No-one rate itself. should underestimate the practical difficulties. You could design a new rate that “The market is abandoning Libor because it needs to use real data from makes perfect sense from a theoretical point of view, but when you go right down markets that cannot be manipulated. But if the replacement is an overnight into the detail of how it works for investors, it can be really complex,” he says. rate, then the only way to set it on a forward-looking basis is to take it from something else – forwards or derivatives – and then you’re returning to Libor Test-trade lessons through the back door,” Leroy says. These complexities were revealed by a test trade. The EIB sold a £1 million bond He adds: “If you go backward-looking, then you can only use the rates to each of its advisers, so they could try entering it into different books – trading published by the BoE. It’s as solid as it can be. If you wanted to manipulate a or treasury – as well as repoing between themselves and carrying out other tests. compounded three-month coupon, then you have to manipulate the market on “We were doing it to tick the box. I didn’t think anything would go wrong,” each of those 90 days. It’s not a fixing you can change whenever it suits you.” says Leroy. “Many things went wrong.” Derivatives markets will also be calculating rates on a backward-looking basis, There were two main sources of grief. First, Bloomberg uses the ticker and the EIB wanted the coupon calculation for its Sonia bonds to mirror the ‘Sonia/n’, but the forward-slash character is not recognised by many back-office cashflow calculations for interest rate swaps: “For many institutions, whether systems. Second, a daily compounding coupon that is calculated on a five-day liquidity is coming from bonds or swaps doesn’t matter – it can be a viable way lag is a pretty unusual – and possibly unique – feature. to raise money. So we wanted to create one pool of liquidity,” Leroy says. As a result, one of the two banks was unable to take delivery of its portion of So far, so simple. But the new bond soon hit its first snag: after an investor the test trade (Leroy declines to identify which one). has agreed to buy some paper, there is a five-day lag before it actually makes Attempts to fix the problem first focused on Bloomberg and dealer systems its payment and receives the bond in return. This period is used to draw up the vendors like Calypso and Murex. If Bloomberg could simply change the ticker – and complicated legal documentation that accompanies each transaction. the vendors issue some kind of patch – then everything would be all right. But At the initial launch of the bond, the backward-looking calculation would Bloomberg refused to change the ticker, and the vendors couldn’t offer a quick fix, not be a problem – the bond would be priced, booked, and interest would start either: although many banks use the same base system, each iteration has typically compounding, at the settlement date. But for a subsequent tap of the bond, a been subject to tweaking and tailoring that would make any patch redundant. new investor would need to pay a different price, reflecting the fact that there In the end, each of the banks had to produce its own workaround. It was a reduced time to the coupon payment and therefore less credit risk. This so- took months. called dirty price is based on the coupon rate itself, which would be impossible to “My hair turned grey,” says Leroy. “I was amazed that we could spend so calculate precisely at the outset of the five-day settlement period. much time on this. The problem is – this was outside the expertise of everyone One solution would be for the investor to use the last daily print of Sonia involved in the deal. I’m a funding expert; the banks are funding experts. If when pricing and booking the deal, and then to hold that rate steady you speak to them about rates, spreads, market conventions, then they know throughout the five-day settlement period – but, as new Sonia prints fed into everything. But they knew nothing about IT architecture – it was not their job.” the book on each of those days, it would create a mismatch with the fixed rate The test trade did the trick, though. The EIB and the banks learned about the that had been used to price the bond. The mismatch could be fixed manually, niggles in the bond, then sold slices of it to investors and were able to advise but would be a headache. The EIB tackled the problem by calculating the coupon them on how to fix the resulting issues. Still, at the time the full £1 billion bond using the Sonia rate from five days prior. launched on June 22, 2018, some buyers were still having to manually adjust “No matter what happens, if you use a five-day lag you can always use real their systems in order to participate. data – you don’t have to interpolate, don’t have to use derivatives, don’t have to With this experience behind him, Leroy is looking forward to launching more create fake rates,” he says. RFR issues – and an organisational change at the EIB means he will be involved Early in 2018, once these wrinkles had been ironed out, the prototype was in all of them. Until the end of 2018, Leroy had been responsible for sterling shown to the sterling debt market’s key official stakeholders – the BoE, FCA funding for the EIB. The four-person team he has joined came into existence at and UK Debt Management Office. Feedback was positive, and no changes the start of this year. were necessary. “We deal with anything new and innovative, and among the many things As the year wore on, the market started to warm to the idea of a Sonia-linked we have to deal with, all the new RFRs are with us. Not just Sonia, but SOFR, bond. In the weeks following Bailey’s July 2017 speech, investors had initially €STR – it means there’s less need to transfer knowledge,” he says. dismissed the idea – there was no urgency, the deadline would be delayed, Libor So, where will the EIB go now, as it pursues its vision of a debt market paradise? would survive. But Bailey and other global regulators repeated and reinforced Japan and Switzerland have both selected their RFRs – could they be next? their stance – the tone gradually becoming more strident. In 2018, the message “It’s something we’re looking at, but not yet,” says Leroy. ■ was not so much that Libor could die, but that it would. Previously published on Risk.net

risk.net 11

LID_Feature_0919_EIB.indd 11 29/08/2019 16:53 Webster Bank

Webster Bank – Small lender eyes big SOFR challenges

Connecticut-based firm is focusing on client education and fallbacks. By Duncan Wood

n Hartford, Connecticut, when it rains, it poos. And I no, that’s not a typo. Any time more than a quarter-inch of rain falls on Hartford and its neighbouring towns, it overwhelms the area’s antique sewer system – waste floods into basements and streets, as well as local rivers and streams. In total, this happens about 50 times a year, saturating the area with around one billion gallons of untreated sewage and rainwater. A $2.5 billion overhaul of the system is now in its third phase, overseen by Hartford’s Metropolitan District Commission, and for at least one of the commission’s board members, Denise Hall, it could prove an instructive experience. Having piloted this huge and costly plumbing refit in her volunteer role at the MDC, Hall now faces something similar in her day job as a derivatives salesperson at Webster Bank, a local lender. Like every other interest rate market participant, Webster and its clients will be affected by plans to retire the market’s Libor family of interest rate benchmarks in the cause of health and hygiene. So, the $27 billion- secured overnight financing rate (SOFR) – and, as Creeping doubts asset bank is now preparing for its own public an overnight rate derived from repo trading, it differs If these plans match up across the product sets, then works project. from Libor in some important respects – but the it may be possible to ensure that – for example – a “I’ve been in banking since the early 1990s, conversation pretty quickly gets down to brass tacks. loan and its accompanying swap switch to the same and there’s no standing still in this industry. Every “It goes like this: ‘OK, let’s say we do this replacement rate, at the same time, and that the time you turn around, there is another hurdle to transaction and we’re using Libor in the loan and economics of the original trades are preserved. But clear – and I don’t think everyone has yet digested Libor in the swap, and it runs past 2021, and in differences are already creeping in – for example, how big this one could be,” says Hall, a senior the meantime Libor is supposed to go away – how US syndicated loans will switch to a forward-looking vice-president of treasury sales with Webster at its do I know I get a perfect hedge?’ That’s their main SOFR rate known at the start of a given period, Hartford headquarters. “People are saying: ‘Well, concern. They don’t really care what we call the while swaps will move to a backward-looking rate OK – we’re going to have to switch rates,’ but you thing – they just want to know they’re going to end only known as the end of the period. don’t know whether that replacement rate will up with the same fixed rate,” says Hall. As an onlooker, Webster can only tell its clients preserve the economics of your transaction, so what At the moment, it’s impossible to say how those not to fret. do you do?” hedges will be preserved. Working groups for each “We’ll tell them there is some uncertainty, that a This is the question now being asked by the product set are currently drawing up proposals replacement rate has been identified but that it’s not bank’s clients. Most of her swap clients are floating that will determine how bonds, derivatives, an exact match for the rate we’re currently using – rate borrowers that want to fix their repayments, so loans and securitisations behave when Libor that it’s overnight instead of a one-month or three- as new loans and swaps are documented, Hall has dies – and, in the case of swaps, drawing up a month rate, it’s secured instead of unsecured – so been making them aware the Libor-based rate in protocol that would allow signatories to convert there will have to be a way to preserve the spread we their contracts could stop being published at some trades to a new rate en masse, before the end of agreed at the time we did the original transactions. point after the end of 2021. She tells them the likely 2021, assuming the parties on both sides of the They have our commitment that we’re going to make successor for US dollar contracts is the brand-new book agree. this work for them, however it comes out,” says Hall.

12 Libor in depth Special report 2019

LID_Feature_0919_Webster.indd 12 29/08/2019 16:56 Webster Bank

For banks like Webster – and their customers – In addition to the work already being done by huge, grey clouds of doubt hang over key elements the bank’s in-house and external lawyers, Hall of their business, while the debate about how to expects the transition work to fall heavily on the blow away those clouds takes place in New York, bank’s treasury and loan operations group, as well London, Frankfurt and Tokyo. as a project management team. In the former, The bank traces its history back to 1935, when portfolio managers will have the job of working Harold Webster Smith founded the First Federal out how much Libor exposure is in Webster’s Savings and Loan in Waterbury, Connecticut using loan and securities books, while the asset/liability money borrowed from family and friends. Today, it has management team will model the effect of $27 billion in assets and around 3,400 employees, switching to a new reference rate. but still talks up its community roots and values. The loan operations group, meanwhile, will have Its swaps customers range from small businesses to “make sure they are ready to modify the rates to commercial real estate developers and major on all existing loans that reference Libor; make sure corporates – Webster participates in the syndicated they understand the new index and how it works,” loan market to support the bigger borrowers in its she says. region – and the swaps range in size from half a million dollars to $100 million or more. Maturities Support network can go out as far as 20 years – the bank executed To support these efforts, Hall says Webster will have “four or five” such trades last year, Hall says. to engage in a “huge training effort” for everyone In all, the bank has around $8 billion notional of using the bank’s systems to book or manage interest customer-related swaps – counting both the client- rate products and risks. facing leg and the dealer-facing hedges – of which This kind of multi-pronged, multi-year project about 45% will mature before the end of 2021. isn’t easy for a smaller bank, so Webster will draw Webster will consider moving the rest of the book on support where it can – from industry groups, away from Libor prior to the rate’s death, Hall says “Many of our clients will only have external lawyers and bigger dealers. – it’s keenly awaiting the release of a protocol from done three or four smaller-size Hall also expects the bank to lean on its peers, as it the International Swaps and Derivatives Association did during a radical overhaul of derivatives regulation that will enable the entirety of a bilateral portfolio swaps, and while the big banks may in the years that followed the financial crisis. to be transitioned to a replacement rate if signed by also do those trades, they don’t “With the Dodd-Frank Act, we set up what was both counterparties. have a team locally who will walk almost a support group with around 10 other regional the clients through it and get them banks of our size. We’d get on the phone once a Loan fallbacks month and find out how the others were interpreting There is no equivalent solution for the loan book, comfortable” the text, or tackling the issues it raised. We really had however, meaning each loan would need to be Denise Hall, Webster Bank to rely on each other, and I’m thinking we may need to renegotiated separately. do the same for Libor transition,” she says. These disparate loan contracts pose a problem for Ultimately, though, while these kinds of networks any bank that wants to understand its exposure to may help Webster test and amend its roadmap, the Libor. Each deal contains some kind of fallback rate “The first thing we wanted to do was ensure new bank’s clients are its own – no-one else can help that would be used should Libor ever stop being loans include better fallbacks,” she says. here – and Hall feels the responsibility keenly. published, but the remedies are diverse and were “Most Libor fallback language only “Many of our clients will only have done three typically agreed as a stopgap – envisaging a brief, contemplated the rate being unavailable for a or four smaller-size swaps, and while the big banks technical hiatus in Libor’s publication – rather than short time period, not being eliminated altogether. may also do those trades, they don’t have a team to cover the benchmark’s death. New fallback language needs to address a number locally who will walk the clients through it and get “It’s easy to say: ‘Here are all our Libor-based of key points: the discontinuation of Libor being them comfortable. I see that as our job, and one of loans.’ The trick is making sure you know what’s published; Libor ceasing to be representative of our the benefits of working with a local regional bank” in every loan document, too – because you could cost to make the loan; specific events that would she says. have one that says if Libor ends then we revert to trigger the fallback; and the identification of a It’s a job that puts Hall and Webster on the front the Prime rate, and you could have another that specific replacement rate, including any adjustment line of the effort to replace Libor. Now, they’re falls back to something entirely different. So you to the spread, that will maintain the economics of just waiting for the information they need in that need to know what will happen in every single the deal for the bank.” fight, including evidence they can use to reassure case,” says Hall. For now, this is as far as Webster’s preparations their customers. On June 4, the Prime rate was around 300 basis have gone – educating clients about the change, “Everyone is going to be looking at the extent to points higher than the three-month US dollar and standardising fallbacks in new loans. In which SOFR is being utilised. We need to prove it’s Libor rate. total, Hall estimates no more than two dozen of really a good index to use, and be able to tell people To stop digging this hole, Webster Bank’s lawyers the bank’s staff have currently been involved in that we’ve somehow solved the issues with the have already drawn up uniform fallback language benchmark reform work. But that number is set credit and term differences,” she says. ■ that is being included in all new loans. to climb. Previously published on Risk.net

risk.net 13

LID_Feature_0919_Webster.indd 13 29/08/2019 16:56 TD Securities

TD Securities – The Sonia FRN standards bearer

Canadian bank TD Securities shows the US market can handle compounded coupons. By Helen Bartholomew

une 22, 2018 was a momentous day for J Sonia. It was the day when debt investors gave an overwhelming seal of approval to the first benchmark floating rate bond linked to Libor’s successor rate for sterling markets – a £1 billion ($1.27 billion) five-year issue by the European Investment Bank (EIB). For TD Securities – one of four bookrunners and two structuring advisers on the trade – it was the culmination of eight months’ work, chipping away at a new template that would quickly become the gold standard for Sonia issuance. It also marked the beginning of the end for Libor as a reference for triple-A-rated sterling floating rate note (FRN) assets. “There’s no other SSA [sovereign, supranational and agency] deal you work on for eight months and there probably won’t be again,” says Mark Byrne, director of syndicate at TD Securities in London. “All the work we did was in such a robust manner that once investors turned up on the day and bought the deal, we knew we could roll it out for others. It increased the workload tenfold, but Sonia transactions are now run-of-the-mill for the SSA and covered bond community,” he says. The benchmark transition journey for TD Securities’ debt syndicate desk got underway a year earlier, after a June 2017 speech by Andrew Bailey, chair of the UK’s Financial were already swapping fixed SSA bonds back bond in great detail. We took a blank canvas and Conduct Authority, put Libor’s future on the to Sonia. If you’re a mortgage-based institution asked, if you were to do a Sonia coupon, what chopping block. buying bonds, Sonia makes a lot more sense bond would you most like to buy? Then we looked than Libor, and these institutions were keen to at the implications for the issuer, the market and EIB tie-up show progress.” the infrastructure, and thought about the best bond In September of that year, the Canadian lender For those buyers, a direct Sonia-linked FRN format from the demand side. We looked more acted as duration manager on a new, sterling fixed issue was an obvious next step. By the end of closely at Sonia swaps as a base to start from,” rate issue for the EIB, acting as counterparty to 2017, the bank had canvassed a handful of says Byrne. syndicate members on swap hedges and switch investors on what a Sonia FRN might look like. The bank’s starting point was to take the Sonia orders, which see investors exchange old bonds EIB was a clear candidate for the inaugural trade. leg of a basis swap term sheet and tease the for new ones. The bank included Sonia on the Not only is the issuer one of the most high-profile backward-looking calculation out into a coupon – list of available hedges and was encouraged by names in the public debt arena, the organisation an approach which quickly won support from bank the take‑up. had already dabbled in Sonia back in 2011 with treasury desks. “Acting as duration manager, we got more a previous bond referencing the benchmark, At this point, EIB appointed TD Securities and Sonia hedging than we expected. It sparked a although the deal struggled to gain traction at NatWest Markets as structuring advisers on an as- conversation with investors and we quickly found the time. yet-unmandated bond – a trio that Byrne likens to a UK bank treasury and building society sectors “To be honest, we never really looked at that working group on Sonia FRN issuance.

14 Libor in depth Special report 2019

LID_Feature_0919_ TD Securities.indd 14 29/08/2019 17:07 TD Securities

Compounding-in-arrears solution Is it the end of Libor FRNs in the triple-A world? One of the key challenges when structuring bonds “It appears to be,” Byrne responds. “There are no linked to overnight rates is to create visibility on more roadblocks other than issuers’ internal system the coupon payment. Libor, as a term rate, allows and infrastructure.” payment amounts known up to 12 months in Since the EIB trade only the European Bank for advance. With no forward curve on the sterling RFR, Reconstruction and Development has referenced the banks settled on a compounded backward- Libor for sterling FRN issuance. The issuer has since looking rate, calculated with a five-day lag. This issued a Sonia bond. means the compounding begins five days before the bond starts and ends five days before the bond SOFR debut ends, ensuring each coupon contains a full 91 days As Sonia FRNs became business-as-usual, thoughts of fixings. quickly drifted to the US market, where the secured Coupon structuring is a marked departure from a overnight financing rate (SOFR) began publication syndicate manager’s typical day job, which typically in April 2018. As a brand-new RFR with only a involves updating issuers on demand and pricing fledgling derivatives market, syndicate banks faced dynamics and advising on the most appropriate an uphill struggle trying to wean issuers off US maturity for a new deal, according to Byrne. dollar Libor. “We were talking to operations people, lawyers “With SOFR, everything is being developed at the and central banks every day. I’ve lost count of the same time: derivatives, VAR models, curves to value number of drawings I’ve done of a coupon when liabilities. Every bit of plumbing is still being built,” speaking to the lawyers – then have them come says Byrne. back with it at 9 or 10 o’clock at night written into There was little consensus on what a legal language only for us to have to go back with standardised SOFR FRN would look like. Almost changes. That’s not a regular SSA syndicate job.” one year and more than $80 billion of SOFR As the EIB bond began to take shape, rumblings “If you’re a mortgage-based issuance after the first trade – a $6 billion three- of a forward-looking term rate on Sonia began to institution buying bonds, Sonia part FRN for Fannie Mae in July 2018 – that emerge at the working group for sterling RFRs, question remains unanswered. potentially scuppering any chance of the newly makes a lot more sense than TD acted as a bookrunner on the inaugural developed compounding-in-arrears structure Libor, and these institutions were SOFR deal, which followed the same template as becoming the market-standard. keen to show progress” standard Fed Funds-linked issues. Coupons were “The risk of a term rate coming in and being Mark Byrne, TD Securities calculated using a simple average, and a five-day the basis for the FRN market was real, but from lockout period plays a similar role to the five-day our diligence with investors it was incredibly lag in Sonia trades by providing advance payment clear that, first, they didn’t want a term rate, and visibility. With a lockout, however, some days are second, they didn’t see a forward rate as being such a development could have enticed another removed entirely from the calculation. This can a better alternative,” says Byrne, noting that issuer into a speculative Sonia debut – perhaps with be significant, as SOFR is a repo-based rate and overnight compounding is a better match for bank a structure that was not the culmination of rigorous typically spikes at the quarter- and year-end. As a treasury risk. due diligence. result, longer lockouts miss more of the spike to “If you have cash on deposit, what do you “We were very conscious of somebody else deliver a lower coupon. do with that? You go to the bank, put it on deposit jumping the gun and getting ahead. We wanted Adding to the lack of uniformity, EIB opted for overnight and it compounds naturally every day.” to be first, but we wanted to be correct. We didn’t a compounded rate for its $1 billion debut SOFR In March 2018, a trial run saw EIB issue a want to shout from the rooftops that we were bond, which followed in November. The US industry £2 million notional Sonia FRN under the new working on anything, but at the same time it was group overseeing Libor transition, the Alternative template. A critical test of the middle-, back-office important to have the fact that this bond would Reference Rates Committee, recommended in April and settlement stages, TD and Natwest – the two be considered eligible collateral by the BoE known that compounded SOFR “would more accurately structuring advisers – each took a clip onto their publicly to give bank treasuries some comfort,” says reflect the time value of money and allow for more balance sheets and traded dummy tickets back and Byrne. accurate hedging”. forth. Problems were quickly flagged. For example, Months of diligence finally paid off at the official “The simple average has seen more trades but the accrued interest wasn’t being calculated June launch. EIB gathered £1.55 billion of demand the lockout periods and how weekends are treated properly on trading platforms. Bloomberg responded for its £1 billion five-year issue. With more than 50 are all slightly different. If you’re trying to update by adding a new calculation type, but solutions to accounts placing orders, Byrne notes that critical your back-office systems, you don’t want to have to other niggles relied on manual adjustments. mass was reached with just that single trade. do it for six different coupon types,” says Byrne. Another crucial step went largely unnoticed, Covered bond issuers such as Lloyds and “In SOFR, we’re not quite there for FRNs to much to the relief of TD and its partners, who were Santander quickly followed SSA visionaries into really take off just yet. There isn’t the consistency in keen to keep their plans under wraps until launch. the Sonia debt market. Crucially, all stuck to the the FRN type that we see in Sonia and we’re still In April 2018, the Bank of England officially made EIB template, setting the compounded-in-arrears discovering what works best.” ■ Sonia-linked FRNs repo eligible. Any fanfare around formula as standard in the Sonia FRN market. Previously published on Risk.net

risk.net 15

LID_Feature_0919_ TD Securities.indd 15 29/08/2019 17:07 Associated British Ports

ABP crafts blueprint for corporate Libor switch

UK port operator embraces Sonia for swaps, bonds and loans. By Lukas Becker

n discussions around Libor transition, corporates are generally portrayed as After Bailey’s speech, Kennedy started looking into ABP’s own exposures Islow moving and out-of-touch with developments. and realised Libor exposure existed across many different instruments: But last year, London-based Associated British Ports showed what corporates swaps, US private placement notes, listed bonds and private debt. As an are capable of when they tackled the issue head on. The company shifted infrastructure business, these were all long dated, maturing well beyond more than £500 million ($633 million) of interest rate and cross-currency Libor’s guaranteed lifespan. Kennedy wanted to move these instead to swap exposure from sterling Libor to Sonia and is actively looking to switch reference Sonia. outstanding bonds and loans in the same vein. It’s no simple cut-and-paste. Sonia is a so-called backward looking rate – Shaun Kennedy, treasurer at ABP, says the firm started looking seriously at when compounded over a period, usually three or six months, the coupon is only the topic about 18 months ago, following the July 2017 speech by UK Financial known at the end of the period. Libor, on the other hand, is forward looking – a Conduct Authority chief executive Andrew Bailey. News the FCA would not user knows at the start of the period how much its coupon payment will be at compel banks to submit quotes to Libor panels from the end of 2021 prompted the end. a radical shift in thinking. Received wisdom is that corporates will baulk at using an interest rate “That was the first time we sat up and took notice. We responded to the Bank where the coupon is known only at the end of a period and prefer a forward- of England consultation that came out around that time, which is something we looking rate based on futures or overnight indexed swaps linked to the have not done before or even thought about. And things sort of spiralled a bit overnight rate. But Kennedy says ABP is happy with a compounded, backward- after that,” says Kennedy. looking rate.

16 Libor in depth Special report 2019

LID_Feature_0919_ABP.indd 16 29/08/2019 16:59 Associated British Ports

“I’m not bothered about term rates. I’m quite comfortable using Sonia compounded. For me, I look at what’s out there in terms of what sort of instrument would I want to use. I want the thing that’s the most liquid, the most stable and most transparent in terms of pricing.” Sonia has many benefits, he says, such as low volatility from its compounded methodology and an absence of bank credit risk. “If I’m doing a 15-year loan with a pension fund, bank credit risk is irrelevant to us. It’s got nothing to do with that lending. So linking it to Sonia makes a lot more sense,” he says.

Slow off the mark After responding to a Libor reform consultation from the sterling working group on risk-free rates, ABP was invited to join the group. Kennedy and a colleague have attended meetings since January 2018 as one of a handful of corporate representatives. ABP was already a step ahead of many financial institutions in its efforts. In the 12 months after the Bailey speech, Kennedy says only one bank flagged “Although there are Sonia bonds being done, they’re Libor transition as a potential issue for the firm. “There certainly wasn’t a lot in this sort of five-years-or-less bucket, and tend to be going on in that first 12 months after the speech. Very little happened – it was quite frustrating from my point of view,” he says. issued by financial institutions” The first priority was ABP’s syndicated revolving credit facility, which was Shaun Kennedy, Associated British Ports up for renewal in mid-2018. From February that year, Kennedy tried to begin conversations with relationship banks to use Sonia as the basis for the floating An alternative route was to trade a series of Libor-Sonia basis swaps with interest rate payments. He hit a brick wall. each swap counterparty. This involves entering a large number of basis swaps “I asked everyone for Sonia and they just laughed at me,” he says. “It in both directions, increasing the overall cost of execution. ABP does not just wasn’t on the cards at all.” ABP eventually had to renew the facility by collateralise its exposures, so adding new line items increases capital costs remaining on a sterling Libor basis. for banks. It was “a bit disheartening”, but not to be put off, Kennedy next targeted The company decided to bring in a single hedging bank, with which it ABP’s swap book, some of which had mandatory breaks coming up in 2018. executed a £288 million pay-Libor receive-Sonia basis swap to switch the These allow banks to cut the capital, credit and funding costs of the trade by interest rate swap. An additional £285 million basis swap in the other direction only pricing up to the point of the break. They also give banks a way out of covered the cross-currency swap. Pricing was based on the net position a trade if it becomes too painful and are often used by banks as leverage to between ABP and the hedging bank, which was £3 million net receive-Sonia renegotiate terms. from ABP’s perspective. ABP eyed these breaks as an opportunity to shift contracts from six-month The hedging bank then entered into new Libor-Sonia swaps at LCH with ABP’s sterling Libor to six-month compounded Sonia. Conversations with banks’ interest rate and cross-currency swap counterparties, effectively transferring the derivatives teams were completely different to those attempted with loans teams basis risk to them. straight off the bat. The basis swaps were then immediately collapsed against the interest rate “So, this is the interesting thing; you sit around in meetings with various and cross-currency swaps. ABP issued a new confirmation that the swaps were banks and they say ‘we’re definitely up for Sonia’,” Kennedy says. “Talk to the now both only referencing Sonia. derivatives guy and, certainly for a UK clearer, they’re all for Sonia. Talking to the As a final step, ABP amended the Sonia leg of its basis swap so that the loan syndicate desk, they said ‘surely we’re going to wait for some sort of term coupon was paid on a five-day lag. This meant the coupon period would begin rate structure’, or ‘we’re not really looking at it’.” and end five days later than the actual six-month Sonia reference period, creating a window at the end where the final coupon can be calculated and Switching swaps payment arranged. ABP has £1.31 billion notional of Libor-linked interest rate swaps expiring The maturity profiles of the swaps meant this netting position won’t last. The between 2036 and 2046. The trades were struck before 2006 when the cross-currency swaps expire in 2024, meaning the company will receive more company was taken private. Of these, eight swaps worth £288 million notional and more Sonia cashflows over time from the longer-dated interest rate swaps. had mandatory breaks in 2018, which were spread over six bank counterparties. But given these Sonia cashflows already include the bond-style five-day lag, The company also had issued US dollar privately placed fixed rate debt, which Kennedy says the company can use these positions to hedge any new Sonia- is hedged with £285 million of cross-currency swaps. These derivatives saw ABP linked floating rate note issuance. pay sterling Libor and receive a fixed rate in US dollars. The six swaps, struck with ABP had to update its systems to be able to handle Sonia ahead of the one dealer, also had mandatory breaks in 2018. restructure, says Kennedy, but so did a number of banks. One obvious way to convert the long-dated interest rate swaps from Libor to “Some of them have done Sonia in the past and were quite comfortable Sonia is to unwind and restrike. For ABP this wasn’t an option as the mark-to- with it. Others, it was like the first time they were doing a Sonia trade. So there market was heavily against the firm due to falls in interest rates after the 2008 was a lot of working with banks, making sure if that was a new thing for them, financial crisis. Unwinding would require the company to pay the current mark- that they were getting their systems ready and getting themselves ready to do to-market, which was just over £1 billion. Sonia,” he says.

risk.net 17

LID_Feature_0919_ABP.indd 17 29/08/2019 16:59 Associated British Ports

The calculation will be done on a five-day-lag basis, where the “I’m not bothered about term rates. I’m quite comfortable interest period starts five days before the relevant interest period and ends five days before the interest payment date, giving the issuer time using Sonia compounded. For me, I look at what’s out to calculate the coupon. The first coupon derived from the new rate will there in terms of what sort of instrument would I want be paid on September 26, based on an interest period covering June 21 to use. I want the thing that’s the most liquid, the most to September 21. stable and most transparent in terms of pricing” Choosing fallbacks Shaun Kennedy, Associated British Ports Kennedy aims to steadily transition all of ABP’s sterling and US dollar Libor exposure onto the new risk-free rates by the FCA’s end-2021 deadline. “I don’t “We were pushing them a lot, saying ‘you’re either able to do Sonia or you’re like the idea of getting to the end of 2021 with all of my instruments still in not going to be involved,” he adds. Libor, hoping that something’s going to happen and that someone is going to do In all, discussions started with the banks in February 2018, with the it all for me. In terms of minimising our risks, it’s better that we try and transition restructuring finalised in November of that year. Kennedy says he was very happy products as and when we can, when other people are ready,” he says. with how the execution went. But he admits there may be some overhang. This means some swaps may One downside was timing. The deal was completed three days after the have to rely on fallback language being developed by the industry, which would International Swaps and Derivatives Association released near-final methodology be inserted into the existing bilateral contracts and force them off Libor if the for the fallbacks – a mechanism for contracts to move off Libor and onto Sonia rate was to cease, for example. should the former cease, for example. These will be inserted into legacy contracts. Being bilateral, similar language can also be inserted into the loans The basis had already been on a downward trend for the previous nine months, and private placements when it’s available, contingent on counterparties’ having moved from 29.15 basis points on March 28 down to 22.5bp on November permission. Inserting fallbacks into listed bonds also requires consent 26. Publication of the fallbacks consultation on November 27 was followed by a solicitation. If you are going to run that process, Kennedy says, “you might as 14% fall in the 30-year three-month Libor-Sonia basis over just three days. well just change it to Sonia”. At restructuring, ABP’s Libor cashflows turned into Sonia plus the basis at the Even with private placements, finding the right fallback language to insert is relevant maturity. As a net Sonia receiver, this meant the company received less difficult. The Alternative Reference Rates Committee – the US working group for than it might have earlier in the year – a situation Kennedy says was “less good”. RFRs – has finalised the fallback methodology to use for floating rate notes, but ABP will look to convert more swaps to Sonia in the coming years, Kennedy the sterling group has yet to come up with a similar template. says, as further mandatory breaks in swap contracts bring dealers back to the New floating rate note issuances include fallback language as standard, but negotiating table. some buy-side investors have refused to invest if the wording is considered weak. Kennedy says it’s hard to build language that’s completely robust, but “it’s Obtaining consent better to say something than nothing”. The next step was to tackle ABP’s floating rate sterling debt. This comprises four He views fallbacks as the “emergency” option rather than something to private placements totalling £460 million, linked to six-month Libor, and two be relied on. One problem is a mismatch between asset classes. For example, publicly listed issuances totalling £135 million, linked to three-month Libor. triggers to move off Libor might be different for bonds compared to swaps. There is less ABP can do with these instruments, as any change requires the Also, bonds look set to fall back onto a forward-looking rate in line with the US permission of noteholders. Privately placed debtholders are known and Kennedy consultation, while swaps will fall onto a backward-looking rate. says it’s a case of waiting until investors are ready to move. “We’ve told them we’re interested in transitioning and that when they’re Waiting game ready just to let us know. We ask the question if we see them or every few Looking forward, Kennedy says ABP plans to use compounded Sonia for any months or so,” he says. new swaps. He wants to do the same for loans and despite early brick walls, says “For a lot of them though, it was something they weren’t really even thinking momentum is slowly building. He puts this down to the influence of the letters about. And I think that’s what’s starting to change. So those conversations sent by the FCA and the UK’s Prudential Regulation Authority to major bank continue and they’re all in various different stages.” CEOs in September 2018 asking for details of their Libor transition plans. The listed bonds are more complicated. Instruments are broadly held and it’s “I’m not sure many people are actually ready to do it yet. But I think that does not clear who the holders are after a deal is issued. To change the interest rate seem to be coming this year, from the conversations we’ve had, so that’s really to Sonia, there are two options – buy the notes back and reissue at Sonia, or good,” he says. run a consent solicitation process to get permission to change the terms. At least Eventually he wants to issue new Sonia bonds as well. While there have been 75% of holders would need to agree. a number of financial institution issuers of Sonia-linked debt so far, corporates ABP opted for the latter. On June 11, it obtained consent from the noteholders to are yet to debut. amend a £65 million floating rate note due in December 2022 so that subsequent “That’s the thing we found quite frustrating, that away from the derivatives coupons are linked to compounded Sonia instead of sterling Libor. The threshold market those products for corporates in the Sonia space just aren’t available. So was 75%, with a quorum of 75% of holders of the principal amount of the notes. although there are Sonia bonds being done, they’re in this sort of five-years-or- The coupon will be amended to reference Sonia plus 2.5%, plus a Sonia-Libor less bucket, and tend to be issued by financial institutions.” basis derived from an interpolated formula. This formula takes the three- Again, he says, it’s just a case of waiting for the UK asset managers who tend year Sonia-Libor basis, and as the note has slightly more than three years of to buy these bonds to get comfortable enough with long-dated Sonia-linked remaining maturity, adds a spread derived from interpolating between the three- notes before they can go out to the market. ■ and four-year basis points. Previously published on Risk.net

18 Libor in depth Special report 2019

LID_Feature_0919_ABP.indd 18 29/08/2019 16:59 European Central Bank

ECB’s Holthausen on Euribor, fallbacks and Eonia’s end

QE wind-down could boost Euribor, but panel bank expansion is unlikely. By Lukas Becker

n a hotel conference room in Brussels in April, Jean-Paul Servais, the head of to the same Emmi consultation, for three-month Euribor, 69% of inputs were Ithe Belgian securities regulator, had something to get off his chest. On a panel based on expert judgement; for six-month Euribor, it was 82%. Unlike the old that was supposed to be about non-EU benchmarks, he instead gave a lengthy system, though, expert judgement under the reformed approach does need to be statement about his delight with the progress of Euribor’s reform and how he linked in some way to a relevant transaction. was likely to give it the green light for use under the region’s benchmark rules in Holthausen admits the proportion of expert judgement is “quite high” but the coming months. says the reforms result in an improved system. It underlined the progress the eurozone and its working group on euro risk- “I think it’s fine, because you still have the 20% or 40% transactions. And free rates (RFRs) has made in the past year, though its direction of travel differs these transactions also give a level for the rate, so you could also observe if from other major currencies. something was really off,” she says. “I was happy to hear this stated publicly, because I know that for many banks, “Ideally, we should have more transactions, but given the circumstances it it’s really important to have the support from the public sector being explicitly was the best that they [Emmi] could come up with. So, I’m hopeful that this made,” says Cornelia Holthausen, deputy director-general in the Directorate- reform will work out and delivers a good rate.” General Market Operations division of the European Central Bank (ECB). “The working group has really made a kickstart and I’m quite pleased with Mortgage dilemma what they are doing, and with the level of engagement within the group.” She stresses that it is not the ECB’s job to decide whether Euribor should live The region has moved from the back of the pack to a leader in benchmark or die – ultimately, that’s for others, such as Belgium’s Financial Services and reform, one market participant recently remarked. That’s quite the turnaround from Markets Authority (FSMA). But the thing to remember, she says, is that Euribor a year ago, when any discussion about the progress of benchmark reform in the is the reference rate for a host of retail mortgages, making it an extremely eurozone would be accompanied by an eye roll, a shrug and a bemused laugh. tricky benchmark to dislodge without a messy and drawn-out process. Progress had lagged other major currency groups because of the eurozone’s “When taking a decision on whether a certain benchmark should discontinue differing stance on how the issue should be tackled. While the UK Financial and be replaced by another rate, one should consider the cost and benefits of Conduct Authority (FCA) has taken a hard line, deciding to withdraw its power to each approach. So, the regulators who think about this might consider that it compel banks to submit quotes from the end of 2021, which many believe will would be very risky to discontinue Euribor because of the mortgage contracts, eventually lead to the death of the benchmarks, the Europeans wanted to reform and it’s not clear how they could transition to something else,” she says. and retain Euribor and Eonia. Holthausen says some market participants have suggested using Euribor reform is now being phased in and despite earlier fears, it looks highly legislation to legally move retail mortgages off Euribor, but she says this is likely at this point to succeed. But scepticism over attempts to retain the rate not on the cards: “As far as I understand, the legislators are not looking at remains. Some point to the fact that three-month Euribor’s post-reform average this,” she says. daily volume is around €2.24 billion ($2.53 billion) for the one-week, three- So, with mortgage contracts running decades into the future, how long month and 12-month tenors, according to its administrator, the European Money could Euribor conceivably last? Legislation that extended the EU Benchmark Market Institute (Emmi), in its second consultation on the topic. Regulation deadline to the end of 2021 also extended the period that regulators A recent release by Ice Benchmark Administration said that so-called same-day could force banks to contribute to critical benchmarks, from two to five years. funding transactions – understood to be the transactions that make up average This means Euribor will be around for at least another five years. daily US dollar Libor – stood at around $3.69 billion in total. So while the FCA is Beyond that, she says, it will depend on a range of factors, such as how turning the screws on Libor rates, including US dollar, for having too few underlying long banks want to keep contributing to the panel. Unlike the Libor panels, transactions, Euribor rates are continuing despite recording similar figures. banks haven’t committed to remaining until at least the end of 2021. Monte Holthausen says she expects the number of underlying transactions to dei Paschi departed the Euribor panel in January and the National Bank of improve once the ECB’s quantitative easing policy eventually ends, which would Greece left at the end of May, bringing the number of participants down to 18. force cash-seeking banks into the interbank lending market once again. The minutes of the February 2019 meeting of the euro RFR working group “Right now, we have a very special situation with all the excess liquidity show that it and the European Commission hope more banks will join the panel that’s out in the market thanks to the ECB’s asset purchase programme. So, I over time, though it’s not necessarily critical for Euribor’s survival. Some say would think that once that liquidity goes down it will trigger a revival of different banks lack motivation to join, given the legal and operational risks involved, and market segments,” she says. Holthausen can understand the reasons. Another concern is that reformed Euribor contains a waterfall approach that “I would see it difficult to convince individual banks to join the panel. Maybe includes so-called expert judgement if transactions are not available. According if there was some concerted effort of some type, that would then make several

risk.net 19

LID_Feature_0919_ECB.indd 19 29/08/2019 16:57 European Central Bank

considering forward-looking approaches. “It’s not inconceivable that you have a mix of both “It would be very risky to discontinue forward- and backward-looking rates… depending on the Euribor because of the mortgage contracts, type of asset that you’re looking at,” she says. and it’s not clear how they could transition to something else” Trigger-happy? For a fallback to work, it needs a trigger to activate it, Cornelia Holthausen, European Central Bank and one of the more controversial topics currently under discussion is whether this should be reliant on a regulator’s join in some way. That may be conceivable. But overall… it’s view of the robustness of an Ibor rate. The FCA is pushing probably very difficult and unlikely that this could work.” for all contracts, including derivatives, to include pre- She says that activity in other markets is also a factor cessation triggers, which would allow fallbacks to be affecting Euribor’s survival. If other markets move away from activated if an Ibor is still alive but only being propped up Ibor-type rates and onto overnight benchmarks, the euro by a handful of dealers, for instance. market might naturally follow over time. The FCA wants one of the pre-cessation triggers to be based on the In the meantime, she says, European regulators will not be pushing market regulator’s view of whether a rate is still representative of the underlying participants to transition their existing legacy trades off Euribor. “If we keep market. If a bank leaves an Ibor panel, the EU Benchmark Regulation requires Euribor, they can stick with it forever,” she says. the overseeing regulator to assess whether the rate is still representative of the underlying market. If the regulator says that is not the case, the FCA wants this Focus on fallbacks declaration to be the trigger to activate fallback contracts across all products. The working group’s focus will be on embedding so-called fallback language Bond, loan and securitisation products in the US have adopted this trigger in into Euribor-linked contracts, so that if the benchmark did cease, they would their new fallback language. Isda is consulting the non-cleared swap market on have a way to move onto the euro short-term rate (€STR). “What’s important whether to include such triggers in fallback language, which will be inserted into now is that fallbacks are embedded into the contracts. As far as Euribor goes, willing counteparties’ legacy swap contracts en masse via a protocol once it is that’s the most important thing to worry about,” she says. finalised. But some market participants suggest the non-cleared swap market is The European approach to fallbacks took a controversial turn in February, less keen than others to adopt these particular fallback triggers. when a consultation found that more than half of 73 respondents thought a A trigger based on representativeness could make sense, according to forward-looking term rate was “essential” or “desirable” as a fallback for all Holthausen, but the decision ultimately sits with the FSMA. It is crucial, though, Euribor-linked products. that such triggers do not make it into contracts until eurozone rates have been If applied, this would mean that should Euribor cease, the fallback language fully reformed, she warns. would see a contract move onto a term version of €STR, constructed from “The current Eonia is not considered representative, for instance. So, if we overnight indexed swap quotes, plus a spread making up the difference between had such a trigger in place, then we may have had a reaction that we would not the two rates. have liked.” While forward rates are being adopted as the fallback for cash products in the US, the International Swaps and Derivatives Association consultations on €STR transition derivatives fallbacks so far have all focused on backward-looking rates, with The focus for the next few months is firmly on the transition from Eonia to €STR. compounded-in-arrears methodologies winning favour in the sterling, yen, Swiss Once it became known that Eonia was beyond saving, thoughts at the RFR working franc and Australian dollar markets. group turned to how the market can transition off the rate in a sensible way. The November 2018 release of the near-final fallbacks for those currencies On October 2, Emmi will change the methodology of Eonia to become €STR also said preliminary feedback on euro contracts pointed toward a market plus a spread. The spread will be an average of the basis between Eonia and the preference for backward-looking fallbacks. pre-€STR rates published intermittently by the ECB over the previous 12 months. In addition, the Financial Stability Board (FSB) has warned against using The basis has remained steady at around 8–9 basis points. forward-looking rates as fallbacks for derivatives contracts, noting that this This is viewed as an elegant solution that allows the market to move onto an approach will not address the core weakness of existing Ibors – the lack of deep €STR-linked rate without having to immediately repaper existing contracts. But and liquid underlying markets. The regulatory body said narrow use of forward it does mean a change to the timing of the rate’s publication. Currently Eonia is term rate fallbacks could be acceptable in some segments of the cash markets, published at the end of the trading day, but €STR will not be available until the but reiterated its opposition to use in derivatives. following day. This means market participants will have to update their systems to Holthausen acknowledges that the forward-looking route would deviate from be able to handle the change to market convention – for instance, banks will have the direction of travel in derivatives markets so far. to start doing their portfolio calculation runs during the day instead of overnight. “In a way, it would go against what other jurisdictions are doing and what The UK market saw a similar change when the Sonia rate was reformed in the FSB is recommending, I agree. But on the other hand, each jurisdiction is very April last year, so it should be manageable – but only if the market is fully aware. different. So, in the end you have to find the solution that best fits your market, Holthausen worries that not everyone will get the message. and it may be that various jurisdictions end up with different solutions,” she says. “Here, I fear that at this point in time many market players are not yet The decision is far from final, and Holthausen says the working group is aware of what they have to change and what applies for them,” she says. A also analysing backward-looking fallbacks for various asset classes including subcommittee of the euro working group is conducting outreach to help get the derivatives. She acknowledges that the consultation was “probably a bit word out, she adds. ■ confusing”, and may have given the impression that the group was only Previously published on Risk.net

20 Libor in depth Special report 2019

LID_Feature_0919_ECB.indd 20 29/08/2019 16:57 Untitled-2 1 04/06/2019 16:44