LIBOR transition: Eliminating regulatory barriers
08 October 2019
‘The time for last orders is now’, said Sir Dave Ramsden, Deputy Governor for Markets & Banking at the Bank of England (BoE), in a speech on LIBOR earlier this summer. Time and time again, the BoE and FCA have reiterated that LIBOR will stop after the end of 2021 and that market participants should get ready for this. To reduce reliance on LIBOR, regulators and central banks from across the globe have set up working groups to develop new risk free rates (RFRs) and promote their use wherever possible .
However, the level of preparedness in adopting the RFRs varies greatly across firms, as revealed by the responses to the FCA's recent UK Dear CEO letter, asking firms about their LIBOR preparations. One of the barriers to progress is uncertainty arising from regulatory requirements. What are the issues firms are facing? Are they all understood?
When you ask firms why they have yet to pull the plug on LIBOR, responses vary. Some firms point to the lack of a liquid market for RFRs, some cite uncertainty about the behaviour of these rates, others are concerned about the vast task of repapering, etc. Another factor is increasingly cited in these conversations: interaction with regulatory requirements. LIBOR no longer represents a liquid market and regulatory requirements mandate the use of more robust benchmarks. Yet some elements of the post financial crisis regulatory architecture may prevent firms from moving away from LIBOR.
Say you traded a swap referencing LIBOR before margin requirements entered into force. If you amend that trade to reference SONIA, do you now have to exchange margin for it? Or if this trade is standardised enough, do you need to clear it? Turning to prudential requirements, the Fundamental Review of the Trading Book will undoubtedly be a daunting task for most banks, requiring them to take a second look at their entire market risk framework. How do you factor in the lack of historical data on these new RFRs? If you are an insurer, your liabilities might be impacted given LIBOR is built into Solvency II. If the issue is not addressed, insurers may have to recalibrate their investments, including hedges.
These are just some of the barriers that market participants and regulators have started looking into as part of the LIBOR transition. Dubbed ‘regulatory dependencies’, they will be the focus of some of the RFR working groups across the world. In the UK, a taskforce mandated by the Working Group on Sterling RFRs is compiling all these issues and will soon write to the BoE and the FCA to try to resolve them.
Progress to resolve these problems varies. In March 2019, BCBS/IOSCO tackled the issue with a statement for derivative users, noting that trades executed to move away from LIBOR should not in principle be subject to the uncleared margin requirements. To take legal effect, margin rules need to be amended in each jurisdiction. In the EU, an amendment to EMIR has yet to be announced.
And while these barriers are expected to be tackled with straightforward amendments, others may be more difficult to understand, and resolve. Regulators and market participants are increasingly getting to grips with the interaction between LIBOR transition and conduct regulation. For instance, if you amend a contract to reference a RFR whose liquidity is low, could best execution obligations be a problem? Do market participants discussing a transition from one rate to another risk accusations of collusion? Mapping all rules which could prevent the adoption of RFRs will be a challenging exercise but is very much needed.
In the transition to a post-LIBOR world, regulators will need firms’ help to identify those issues and find suitable remedies, which don’t undermine the robustness of existing regulation.
With a little over two years before LIBOR is expected to cease, every step will count to ease the transition. Firms and regulators should work together to eliminate as many barriers as possible, quickly and efficiently so that firms can move on to repaper their contracts.