Libor transition – What is the endgame?

By William Mitting, founder and managing director at Acuiti 

No-one expected the transition away from Libor to be easy. At the outset, some doubted whether the transition was even possible. However, with less than a year left before the expected cessation of Libor as a regulated benchmark, the transition certainly remains achievable on schedule.

Much progress has already been made. Over-the-counter (OTC) volumes in Sonia are strong, the transition to risk-free rate (RFR) price alignment interest and discounting is near complete at central counterparties, and fallback agreements at the International Swaps and Derivatives Association have now been announced. All of these developments represent significant steps forward.

Acuiti and CurveGlobal Markets released a report last year into the levels of preparedness and current barriers to a successful transition. The report found strong evidence of progress across the market, with respondents most likely to be well advanced in their preparations for the transition in listed and cleared OTC instruments.

The loan markets are also exhibiting encouraging signs. The Acuiti survey found that 75% of asset management respondents will reduce investment in Libor-referenced instruments over the next six months, which indicates a growing acceptance of RFRs in the crucial cash market.

However, many risks remain. Ultimately, the transition risks creating a vicious circle of inactivity. In the simplest terms, if one or more parts of the market fail to make the transition, the demand in the derivatives market will remain subdued, and other markets will be unable to move across unless there is an extensive liquidity pool in which it can be hedged.

Respondents to the Acuiti survey cited a lack of liquidity in OTC and listed derivatives as the central barriers to a successful transition at the end of 2021.

Breaking this circle and its replication in myriad areas of the transition will be key – the question is how. Most look to the Bank of England and the UK Financial Conduct Authority (FCA) for leadership. This month, the FCA all but guaranteed a pre-cessation announcement by the of this year. Many expect this announcement to act as the catalyst to break the impasse.

Uncertainties remain, such as whether term rates are a critical component of the transition to address legacy issues.

The reality of a complete migration away from Libor is that there will have to be a compromise on terms rates – either in complex risk trade-offs between multiple rates (term and accrual) or in significant changes to some parts of the market to adopt the forward-looking rates.

UK regulators have now legally secured the mandate to make changes to Libor post-2021, which eliminates the risk of a ‘zombie Libor’. In the US, the view seems firmer on the need for term secured overnight financing rate (SOFR) – and welcome signs of market alignment between the US and the UK are already apparent. 

Inevitably there will also be compromise elsewhere. Ultimately, the market will decide on many of the outstanding issues. Not only will that be an efficient means of solving the challenges, but it will also create significant opportunities.

New benchmark providers will develop indexes that will co-exist with the RFRs to achieve outcomes, including term structures or credit adjustments. Liquidity in futures trading could shift venues in a once-in-a-generation opportunity to seize market share in the lucrative interest rates market.

Over the next 14 months, the pieces of the puzzle will come together, but the full picture of a post-Libor world will not emerge for years to come. Regulators are successfully pushing the move away from Libor, but the market itself is creating the post-Libor world. The Acuiti study found a broad consensus on solutions and direction and encouraging signs that the market is forging the road ahead.

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