Edwin Schooling Latter, director, markets and wholesale policy at the FCA, warned at the ISDA Benchmark Strategies Forum that US dollar Libor should not be used for new contracts after this year.
Scott O’Malia, chief executive of ISDA, said at the forum that the announcement from the UK ’s Financial Conduct Authority on 5 March effectively heralded the death of Libor. He said: “We know for sure which Libor settings will end on which date, and which tenors will become non-representative.”
After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates based on transactions, so they are harder to manipulate and more representative of the market. The FCA has already said it will not compel panel banks to submit Libor beyond 2021.
In March the FCA confirmed that all Libor settings will either cease to be provided by any administrator or no longer be representative immediately after 31 December 2021 for all sterling, euro, Swiss franc and Japanese yen settings, and the one-week and two-month US dollar settings. The remaining US dollar settings will end immediately after 30 June 2023. The UK has chosen Sonia as its risk-free rate while US regulators have chosen SOFR to replace US dollar Libor.
O’Malia added:.“In fact, US regulators have made clear they expect US-regulated firms to stop using US dollar Libor for new trades after the end of 2021, subject to a few exceptions.”
He continued that the new ISDA fallbacks came into effect on January 25 this year. As a result a large portion of the derivatives market now has a safety net based on a consistent, robust and transparent methodology, if an IBOR ceases to exist or becomes non-representative.
“This significantly reduces the systemic risk of a cessation event occurring while firms continue to have exposure to these rates,” he added.
The fallbacks will automatically take effect for remaining derivatives contracts referencing euro, sterling, Swiss franc and yen Libor on the first London banking day on or after January 1 2022. For outstanding derivatives that continue to reference US dollar LIBOR, the fallbacks will automatically apply on the first London banking day on or after July 1 2023.
“We know there’s only eight months before 24 Libor settings disappear for good and another six become non-representative. Time is short, and firms should use it wisely,” said O’Malia.
Edwin Schooling Latter, director, markets and wholesale policy at the FCA, said at the forum that some market participants have doubted that the deadlines for Libor were real.
“There is no longer any doubt that publication of the euro and Swiss franc settings will cease at the end of this year,” he added. “We’ve set out our plans to consult on requiring publication of synthetic rates for certain sterling and yen Libor settings for a further period, but these will only be for use in some legacy or live or contracts and they will not be for use in new contracts.”
Schooling Latter continued that makes participants should already be using alternatives to sterling Libor in new business across all the major asset classes. He stressed that US Libor should not be used in new contracts after this year and used only in legacy contracts or to manage legacy Libor risk.
The FCA is consulting on producing synthetic Libor rates for some circumstances.
“Assuming a synthetic Libor is implemented in due course, we will need to determine who is permitted to use it,” Schooling Latter added.
The UK regulator also plans to consult this quarter on the proposed policy framework for permitting legacy use of a permanently non-representative benchmark.
Schooling Latter explained that the ISDA protocol provides the derivatives market with simple mechanism to remove its reliance on Libor. He added: “One of the reasons we signalled our end-game plan well in advance is so that market participants are clear on the need to sign the ISDA protocol.”
The UK parliament is expected to pass legislation to give the FCA new powers over benchmark rates this summer in good time for the end of this year.
Michael Barron, director, UK insurance and pensions at Deutsche Bank, said on a panel at the forum that most of the necessary convergence in the sterling market had already occurred before the FCA announcement.
“Clients are seeing that active transition between now and December cessation date for sterling Libor is becoming an operational decision and there’s really no economic or commercial aspect to it anymore,” he added. “This is really catalysing further transition and given the market the confidence that the the milestones will be met.”
Jack Hattem, ISDA board and managing director, global fixed income at BlackRock, agreed on the panel there had been a smooth market reaction to the FCA’s announcement.
“There were no major market moves on the March 5 announcement date,” he added. “We are already trading alternatives to Libor in our legacy book because we know how those instruments will be valued upon the cessation dates.”
CME reported that trading volume in the exchange’s SOFR futures rose to 112,000 or $232bn in representative notional, per day in the first quarter of this year. This was almost double, a 98% increase, year-on-year. Open interest hit multiple highs throughout the quarter, reaching 765,000 contracts on March 2 and large holders of open interest in SOFR futures grew to a record 196.
Agha Mirza, global head of interest rate and OTC products at CME Group, said on the panel there is a network of more than 550 diverse global participants using SOFR contracts.
He said: “In the next 18 months there will be further adoption of SOFR in cash markets, as well as OTC non- linear products.”
Hattem said the liquidity build up in SOFR has been much slower than he expected, but it is beginning to grow steadily.
“We now have some certainty that this is happening so that behavioural shift is going to be the pivot that’s going to take place over the next several months,” he added.