While the market continues to wrestle with the list of LIBOR transition blockers, the real question should be how long do we have until LIBOR ends and at what cost?
On 1st April ICE acting as the LIBOR administrator proudly announced that they had successfully completed the transition of all LIBOR panel banks to making submissions using the Waterfall methodology. The recent increased volatility of the fixing is now a feature of the market, well at least until (or “if” for the naysayers out there) LIBOR ceases to exist.
The FSB has prompted ISDA to consult on their Pre-cessation Trigger which could bring an end to LIBOR promptly post 2021, in ISDA derivatives at the very least, as we wrote in IBOR transition car crash – how good is your insurance. The trigger means that fallback would occur when the FCA no longer deems the benchmark to be "representative" - this test occurs, as highlighted in the letter, whenever one or more panel banks drop out.
As a headline this seems like a sensible idea, but as things stand this only adds to the disconnect between LIBOR in ISDA derivatives and LIBOR in legacy cash products, with no documented or practical fallback. Some pragmatic, regulated, use of the LIBOR screen to deliver a projected SONIA rate plus the ISDA fallback spread for users solely in legacy instruments with no fallback provision still seems like the least worst option, leaving the holders of these instruments with derivative hedges running the basis between projected and realised SONIA.
Previous thinking would have suggested this could have been achieved by the LIBOR administrator updating their Reduced Submissions Policy to fallback to this when the number of panels banks hit a threshold. This approach, feasible or not, would not work with this proposed Pre-cessation ‘representativeness’ trigger - so whilst they mention markets participants desire for harmonised fallbacks in this letter – there is no clarity on how it might be achieved.
This could be resolved by aligning the LIBOR documentation in some other way such that the LIBOR screen rate becomes projected Term Sonia rate plus ISDAs spread when the FCA no longer deems the current rate to be representative – i.e. simultaneously with ISDAs derivatives, legacy products fall back. As ISDA highlight in the update they sent back to the FSB, the broader market needs clarity around the Term Rate as the confusion and arguably misguided hope that they’ll be able to trade derivatives against it is hampering the speed of transition and may impact the willingness for counterparties to sign up to their new definitions.
Two key problems to overcome in order to reach this pragmatic end state are 1) how to get the administrator to incorporate this into their documentation when they are incentivised to keep LIBOR going, when they might argue that they cannot be expected to publish a rate that isn’t representative of what they signed up to provide and 2) if the new ‘LIBOR’ rate is compliant, how does the regulator prevent any new business being written against it? If these don’t get resolved, then whilst the FCA may have an itchy 'trigger' finger and want to put LIBOR out of its misery, they may need to hold off using their pre-cessation powers for longer than they’d like.
This was our thinking behind SONIA - LIBOR: time to jump clear before this gets chaotic and led us to consider what would this mean for the LIBOR rate as it limps on - how would the rate be impacted by panel banks dropping out, and at what point might the FCA decide the rate was no longer representative? The latter we can only speculate on, but given that the lagged submissions data is made public on the ICE website we can make some estimates on how the rate would be impacted.
Currently with 16 panel banks for GBP LIBOR, the 4 highest and 4 lowest rates are excluded and the average of the remaining 8 is the LIBOR rate:
Once panel banks are no longer compelled to submit a rate at the end of 2021 you can quickly imagine the number of submissions dropping – and in all likelihood it’ll be the larger UK banks who stop first. Due to this change to the waterfall methodology one might imagine that these banks would account for the median rates in the middle of the pack as they’ll more consistently be submitting level 1 & level 2 numbers in the waterfall:
Using this logic, what would the impact be on the rate produced if we dropped out the middle 8 rates, and then trimmed the top and bottom 2 as above, and in addition what would happen if we drop 8 of the quotes at random?
As you can see below, we see significant differences to where LIBOR with all the submitting banks came in vs these reduced submitter scenarios.
Reduced submitter scenarios vs 6M LIBOR
Source: NatWest Markets
This is a classic case where the market needs to decide between some less than perfect options. Will the new fallbacks, especially in cash products, be regulated benchmarks? If not, it's unlikely that the administrator would publish the rates. If yes, then how would new business be prevented?
Maybe the issue lies within the name - a pre-cessation trigger that leads to action once LIBOR is "non-representative" has difficult ramifications. Instead should the current reduced submission policy threshold move from less than 5 to say less than 8, thus accelerating the end of LIBOR?
Phil Lloyd - NWM Sales
Dave Halstead - NWM Trading
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