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The LIBOR Transition

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The LIBOR Transition www.pwc.no The LIBOR transition Where are we now? Q1 2019 The LIBOR transition – Where are we now? A new paradigm, … …and our way to deal with it The transition away from currently used interbank offered To deal with this complexity, the present overview pro- rates, particularly LIBOR, to new or reformed benchmark vides the current status of the transition process along- rates poses one of the biggest challenges for financial side the five major currencies. We use a structured grid to firms in the upcoming years. Whereas some time ago, evaluate the administrative and methodological set-up of only few subject matter experts and newly appointed the new benchmarks, their envisaged fallback and term transition managers at financial firms dealt with the topic, approaches, the dynamics of their underlying borrowing it has in the meanwhile been brought to the attention of and lending markets, and the adoption of the rates by a broad range of industry practitioners. They all, how- cash and derivatives markets. ever, face the same challenge of coping with the growing For further thought leadership on this journey towards a complexity and faster pace of the developments around new financial paradigm, please have a look at pwc.com/ the transition. libor. …growing complexity… Staying ahead of the knowledge curve during the LIBOR transition increasingly resembles looking at a mosaic of information. Where LIBOR ensured a common, homoge- neous approach across multiple currencies, this simplic- ity will be lost under the new paradigm. The complexity is the result of multiple dimensions that accompany the transition. Different currencies, markets, approaches, fallback languages, etc. show how fragmented the land- scape is. 2 | The LIBOR transition – Where are we now? Rates overview CHF – SARON USD – SOFR GBP – SONIA EUR – €STR EUR – EURIBOR JPY – TONAR The LIBOR transition – Where are we now? | 3 The Swiss Average Rate Overnight (SARON) Administration and Methodology & eligible governance overview transactions The National Working Group on Swiss Franc Reference SARON is a secured rate Rates (“working group”) combines representatives of It is continually calculated in real time and published private-sector banks and the Swiss National Bank [1] every ten minutes. In addition, fixing is conducted The working group has recommended SARON as the three times a day: at 12am, 4pm and 6pm. The 6pm fi- alternative for the CHF LIBOR xing serves as the main daily reference for subsequent Originally, SARON dates back to 2009, when it repla- usage, e.g. for derivative payments or the valuation of ced the previously used repo overnight index financial assets [2] SIX Swiss Exchange calculates and publishes SARON SARON is based on concluded transactions and trade [2] quotes posted on the SIX Repo trading platform, provi- ded they lie within the parameters of a quote filter. The An application process for SARON to be endorsed un- filter prevents quotes that diverge too much from the der the EU BMR is planned. SIX expects the process current interest level from distorting the average rate to be completed around end-2019 [3] and thus limits the possibilities for manipulation. The rate is recalculated every time a trade is concluded or a new quote is issued, provided they meet certain specifications [2] Only standardised, CHF-denominated repurchase agreements with fixed-income securities eligible for SNB repo transactions (general collateral) are used to calculate the reference rates and indices 4 | The LIBOR transition – Where are we now? CHF – SARON USD – SOFR GBP – SONIA EUR – €STR EUR – EURIBOR JPY – TONAR Fallback Envisaged approach for solutions term rate construction ISDA is working on amending its 2006 Definitions to The working group came to the conclusion that a implement viable fallbacks for the discontinuation of robust derivatives-based term rate is unlikely to be different IBORs [4] feasible given the limited liquidity in Swiss derivatives Although the approach is ISDA-specific, it can be markets. A forward-looking term rate based on deri- considered as having a significant signalling effect for vatives referencing SARON is not expected to be as all IBOR-referencing products, not least since ISDA robust as the reference rate itself. If this changes in the reached out to a broad group of market participants in future, the use of a derivatives-based term rate as a its consultation fallback rate might be re-assessed. The working group therefore opted for a backward-looking calculation The approach covers CHF LIBOR and proposes method based on the average of daily SARON rates SARON to be its fallback rate as soon as CHF LIBOR over a given period. Wherever possible, a compound- is permanently discontinued (based on defined ed SARON should thus be used as term rate [5] triggers) Using a backward-looking compounded term rate can Since CHF LIBOR is an unsecured term rate, adjust- lead to cash flow uncertainty. However, there are ways ments for the term and the credit component have to to explore to mitigate this uncertainty, and further work form part of the fallback needs to be conducted as to how these could work in For the term adjustment, it was concluded after the practice and regarding potential legal challenges consultation that backward-looking, daily compoun- Given that derivatives markets in other currencies do ding of the o/n rate (i.e. SARON) is the most suitable have substantial liquidity and that those markets are approach actually considered as a favourable option for deriving This is combined with calculation of a historical ave- term rates, the transition over the next years might rage credit spread prior to discontinuation to account lead to a fragmentation of conceptual approaches for the credit risk component that forms part of CHF across currencies LIBOR but not of SARON In March 2019, SIX started to publish rolling, com- For CHF, this likely means that at the discontinuation pounded SARON rates with different time windows for of LIBOR, the average difference between LIBOR and illustrative purposes [6] term-adjusted SARON will be calculated for a time The working group is continuing to work out solu- period yet to be defined (probably several years) and tions as to how uncertainty about cash flows can applied as a fixed spread to the term-adjusted SARON be addressed best under a given backward-looking for the legacy contract approach Notably, this term approach for fallback language is The working group is further continuing to develop the conceptually close to the envisaged methodology of design of SARON-based derivatives such as options the working group for deriving term rates generally and cross currency basis swaps from SARON for cash products (see below) [5]; thus a chance can be seen for CHF to create a relatively har- The 3M followed by the 6M tenors are most widely monised approach between legacy fallback language used for CHF LIBOR according to a survey by ICE [24] and the actual market convention for term rates in the future The majority of respondents to ISDA’s consultation process prefer using the term and credit spread ad- justment across all currencies/benchmarks covered by the consultation Discussions on the fallback language for legacy retail loans referencing CHF LIBOR after 2021 continue on a Swiss-domestic level. A first draft basis for language respecting Swiss legislation is being discussed for retail loans Switzerland can typically be seen as a jurisdiction that particularly values the rights of individual parties to a contract. It seems unlikely that governmental or regulatory bodies could impose the acceptance of an industry solution upon parties against their consent Based on the consultation feedback, ISDA will analyse the results in further detail and continue to develop the final proposal for parameters in the fallback language with its independent advisors The LIBOR transition – Where are we now? | 5 Liquidity and Markets and rate dynamics products The transactions that underlie the calculation of Cash SARON and the adjacent volume permitted (binding Debt issuances linked to SARON are not known so far quotes) amount to approx. CHF 5bn daily [2] Historically, the volume of such transactions can vary Futures (see graph) [2] EUREX launched SARON futures in October 2018 for 3M based on the recommended specifications by the Historical rate volume underlying SARON working group, with a contract size of CHF 1m [7] 25 The current naming convention by EUREX may be changed in 2019 to align with futures contracts in other 20 currencies n 15 b The future volume for SARON has been steadily incre- F 10 H C asing since launch (see graph below); at the end of Q1 5 2019, open interest stood at approx. 1,100 contracts [8] 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 SARON 3M future volume at EUREX Rate volume SARON 1’500 Various term rates up to one year exist for the SAR 1’000 (e.g. SAR1M). The liquidity is, however, not high enough to support the derivation of term rates directly 500 (see graph below for 2018 [2]), hence the previously mentioned approach via compounding on o/n rates is - considered Nov Dec Jan Feb Mar New trades Open interest Liquidity of SAR[ON] and SAR[Term] 6 100% Swaps SARON swaps have started to be cleared by LCH and n 4 EUREX. The observable volume indicates that SARON b F 50% swaps have reached the levels of former TOIS swaps. H C 2 However, volumes are still relatively small compared to swaps referencing CHF LIBOR. It is expected that - 0% volumes will continue to pick up once cash products SARON 2W 1M 3M 9M are based on SARON Average daily volume (left scale) Looking at US transactions reported under swap re- Days without any volume (right scale) positories (DTCC/Bloomberg SDRs), ISDA counted 16 cumulative trades with a notional of CHF 2.5bn as per end-2018, up from 10 trades/CHF 1.3bn in the quarter before [30] At the end of 2017, SARON replaced the old TOIS with overnight rates, e.g.
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