Libor discontinuation is a certainty and adopting a wait and see strategy now is not advisable”

David Mcnally, Deutsche Bank Corporate Bank

Janet Du Chenne: IBORs or interbank offered rates, have long been used as financial benchmarks. Can you tell us when and how did the London interbank offered rate (Libor) come to be so widely-used by the markets?

Kam Mahil: Thanks, Janet. So this is actually a history lesson that I learned myself because I wondered what did the market use before Libor? And actually, the birth of Libor and the syndicated loan market are intertwined. And it was a function of London becoming a hub for offshore US dollar deposits in the 1960s. Banks were looking to deploy that capital. So Libor actually started in contractual form in the 1960s in syndicated loans, and was based on the reported funding costs, among a set of reference banks, and then reset to the start of every interest period, because banks were funding the advances through rolling deposits. And this contractual Libor was then passed on to a more formal footing in the 1980s, with the British Bankers Association taking on the publication and governance of the rate. And that was because in the 1970s, and 1980s, we saw the increased use of instruments like interest rate swaps, and there became a need for a recognised and consistent benchmark to be used across those transactions. Libor was becoming a proxy for bank borrowing costs across a range of tenors and currencies. This meant that Libor became a very popular rate to represent market conditions in a wide range of products.

Janet Du Chenne: Now, it was more than eight years ago that reports of Libor rigging emerged. But are there other reasons why Libor is no longer fit for purpose?

David McNally: Janet, I think that's a really good question, because it gets to the heart of some of the confusion in the market as to why exactly Libor is going away. Because I often get asked by borrowers, well, why can't we just reform Libor? And it's important to say that reforms have been made to Libor and its construction and methodology to mitigate against manipulation. And Libor is now based on a waterfall methodology to allow it to be based on transactions to the extent possible, and panel banks had to put in place very strict conduct procedures on submissions to the rates. And Andrew Bailey, now Governor of the Bank of England has said in recent speeches, that there is no reason to believe there is misconduct related to the Libor rates today.

The main reason it's going away is because there are a low level of transactions underlying Libor, because banks don't tend to fund themselves in the interbank market anymore. So increasingly, Libor is not reflecting the underlying market it seeks to measure because there aren't many transactions, which means a heavy reliance on expert judgement to set the rate, which impacts Libor’s robustness and sustainability long term.

Kam Mahil: Yes that’s certainly true that IBORs have been under the spotlight since the rigging scandal, which, as you alluded to, then led to the Wheatley review in 2012. But aside from the cases of attempted market manipulation, there are other drivers for this change, as you say, and principally owing to the post crisis decline in liquidity in the interbank unsecured funding markets. This has the potential of course, to undermine confidence in the reliability and robustness of the existing interbank benchmark interest rates. And so Andrew Bailey's comment, which you refer to is in partial recognition that that the unsecured interbank lending market just doesn't exist as it used to, and that irrevocably changed after the financial crisis. So Libor linked term funding as a source of funds for banking operations is insufficiently stable. Perhaps more importantly, though, many market participants as well as the official sector, don't think that Libor is the interest rate benchmark that most users want or need to have nowadays.

And that's evident if you look at the interest rate derivatives markets, where there's a predominant activity in participants trying to hedge their general level of exposure to Central Bank policy rates, or risk free rates, rather than their exposure to bank credit risk. Now Libor was a combination of both of those things. It embeds the expectation of what central bank policy rates will be in the future and the element of credit risk reflecting the bank term secured and unsecured. So, if you're a non- financial corporate, the question begs why would you want your interest rate payments to go up when the financial system is under stress, because that's what happens with Libor. And the credit spread element widens in times of stress.

And we only have to look to the behaviour of Libor at the onset of the Covid crisis to see further evidence of this. And despite the central bank actions taken, in early March, term credit premium jumped up at possibly one of the worst times ever, reinforcing why the move away from Libor is a logical and indeed a transformational change.

Janet Du Chenne: So could you tell us what alternatives to IBORs have been developed? And why is the transition to them such a lengthy process?

David McNally: Janet, this is a very complex market structure change, and involves industry practitioners, along with the support of the official sector, all carefully considering the consequences and the potential ramifications of such profound market structure change. And there are trillions of dollars of contracts that are based on Libor, which is why Libor has often been clipped as the world's most important number. Industry groups have convened to consider the alternative reference rates which have resulted in the development of the near risk free rates, where neither term nor bank credit properties referred to earlier are required.

And these risk free rates have been developed on a currency by currency basis, and are fundamentally different from IBORs. And this is because IBORs represent an average of the rates at which the panel banks believe that they could borrow money in the interbank market and reflect that credit and liquidity risk premia involved in that market. By contrast, the risk free rates do not have a term element. They are backward looking and reference historical transaction data and are calculated on that basis. They don't price the credit risk to the extent that IBORs do it based on overnight borrowing rate and do not include that premium for long dated lending. So risk free rates do not compensate lenders for making funds available long term.

Risk free rates are generally considered to have the following properties: they are based on reliable market data; they're robust, they're subject to appropriate controls and governance. And they reflect perhaps most importantly actual market funding rates on a realised basis.

As I said earlier, there's a risk free rate that has been developed in each of the five key IBOR based currencies in the UK. Sonia is the reformed Sterling overnight index average, in the United States, US dollar IBOR will be replaced by SOFR (the secured overnight financing rate) in Swiss francs its Sonar, which is another average rate overnight. And in Japan, it’s TONAR. In Europe, Ester has been positioned as the replacement risk free rate and is already pegged to Ionia by eight and a half basis points.

It’s probably worth mentioning that Euribor has been reformed so that it complies with the European benchmark regulation. And so currently, there's an expectation that it will continue to be used in its reformed state beyond the end of 2021.

There is an ongoing consultation right now on Euribor fallbacks. And that's expected to be published in early 2021. So for now, there's nothing actionable on Euribor. But something to keep a close eye on as we moved in into next year.

Janet Du Chenne: Can you bring us up to speed on recent developments and the activities designed to help market participants as they transition to alternative risk free rates, including the ISDA protocol publication, for example, and other best practices?

Kam Mahil: Of course, Janet, and there have been some really key developments, especially in the second half of 2020. So as David mentioned, there was a lot of work around thinking about how to actually use these overnight, risk free rates in products, like the loan markets where you need more of a term rate. And I think the most important development for the loan market was really the publication of conventions around using compounded risk free rates in arrears for loans in each of the US, the UK and the Swiss markets. That provided much needed clarity to the market on how to use these compounded rates in loans.

Another key development particularly for loans was around the strengthening of documentation requirements in respect of transition language. So for example, in the UK, parties need to include clear contractual arrangements in new Sterling Libor loans to convert to alternative rates ahead of the end of 2021. Now, there are a spectrum of approaches that have been suggested. So you could use either pre agreed conversion terms, which is effectively having an inbuilt switch mechanism with all the terms baked in, or you could use an agreed process for renegotiation, which actually means something more than the LMA 2019 version of the replacement of the replacement clause. The regulators have made clear that parties should be aiming for the switch mechanism. Now the LMA has produced exposure draft rates, switch facility agreements which reflect the sterling loan conventions. So you can see how the conventions look in a documentary context. And we've also published updates to the replacement of screen rate language to strengthen it by providing a set dates for renegotiation, and also agreement to some RFR terms up front to provide agreement to key commercial terms to try and minimise the number of future negotiation points.

You mentioned the ISDA fallbacks protocol and a related supplement. These were both published in October (2020). So the supplement will amend these standard definitions for interest rate derivatives to incorporate robust fallbacks from 25 January 2021. And that will mean that the fallbacks will apply to all new derivatives that are entered into from that date. The protocol allows parties to incorporate the fallbacks into their legacy, non-cleared derivatives provided that they and their counterparty adhere to the protocol. And that protocol is open for adherence, and it's due to take effect at the same date as the supplement on 25 January 2021.

David McNally: Deutsche Bank, we believe that is the strongly preferred method to ensure robust fallbacks are in place for those in scope derivative transactions and it’s a key tool to meet the challenge of IBOR discontinuation. So as such, we would strongly encourage clients to consider adherence to the protocol now that it's been published. There's also one very recent development, which is worthy of note here, and that is in early December (2020), ICE administration which compiles and oversees Libor announced a consultation.

And the consultation is effectively a proposed extension of most of the US dollar level tenors. That proposed extension would carry through until the 30 June 2023. And this is really significant for markets where the US dollar is embedded in legacy contracts.

The proposal broadly has two components: that would cease the publication of one week in two months dollar IBOR settings at the end of 2021. But to extent the publication of other remaining dollar Libor tenors, so the more widely used are overnight, 36 and 12 months, IBOR would cease in 2023. This proposal is in recognition of the time needed for the market to deal with legacy transactions. And depending on the outcome of this consultation, and if the proposal proceeds, it will impact transition timelines for dollar level deals.

I think it's important to remember that whilst the proposal would theoretically give parties additional time for remediation or amendment of legacy US dollar cash contracts, regulators and other market participants really emphasise that priority should still continue with their transition efforts whilst monitoring of the ongoing developments. So we don't think that this announcement should derogate from the task at hand, which is to consider active or near term transition of Libor linked exposure in contractual documentation. So that consultation has just been launched and is expected to close by the end of January 2021.

Janet Du Chenne: So if we look at these developments, how in your view, have they gone? And what are some of the key challenges that have been encountered?

Kam Mahil: So on the ISDA protocol side there’s been a relatively good uptake of the protocol, including by some big corporates like Tesco. I would say whether to adhere or not to the protocol is something that borrowers need to consider carefully, especially where they have derivatives hedging an underlying cash product. And that's because the protocol might catch the derivative, but not the loan that it hedges. And it's really important to check and ensure that both products move at the same time and to the same rate, otherwise, there may be some basis risk. I should say too that ISDA has published bilateral templates, which can be used to adopt the protocol bilaterally with amendments, or to exclude transactions from the scope of the protocol. So that's a way to try to ensure the triggers and the fallbacks in the underlying contract and the hedge match. And then with the supplement, because that applies automatically from the 25 January onwards, borrowers need to also consider this carefully for new transactions to ensure economic effectiveness of hedges that have been put in place, because there may be differences, as I said before, in the conventions between loan and derivative fallbacks to take into account.

Now in the loan market, because of the spectrum of approaches that I mentioned in regards to documentation, we have seen some different approaches being taken in the market. And some challenges include parties still getting up to speed with the published loan conventions, the new documentation requirements, updating of systems and how to approach multi-currency documents. But parties do need to get on with reviewing and understanding loan conventions, given that we don't have that long to go until we need to stop lending and borrowing based on Libor. And I think there also needs to be a focus on the switch mechanism, because that's the only way, apart from moving directly to risk free rates, that you're going to get certainty on transition.

David McNally: I think you've touched on an important consideration there. And that's namely the choice between active transition and reliance on contractual fallbacks. So each of these routes to transition away from IBORS has pros and cons. On the one hand, reliance on fallbacks has the benefit of consistent timing, when and if the market relies on fallbacks, and consistent pricing when the market relies on fallbacks.

However, we know that existing fallback qualities vary widely across different product ranges. And some of those fallbacks are just not workable, which means that you might have to amend them in any case. And if you have to amend them, it may just be worth considering amendment and active transition if you're going to look at contracts at the same time.

On the downside of the reliance on fallbacks, the final fallback rate is unknown at present.

The last thing to consider is that the risk of operational stress when lots of contracts change simultaneously to risk free rates by the application of a fallback language may just heighten that operational risk.

On the other hand, the other choice is active transition, which is proactively supported by the risk free rate working groups, and of course, the official sector. Now, this comes with the benefits of improving liquidity in risk free rate markets. The pricing is known at the agreed point of transition. You reduce that operational stress I talked about a second ago, by implementing fallbacks at the end. And you reprice deals as you go along, so there's less of the concentration of change around the cessation date. Also, you reduce your primary exposure prior to the expected discontinuation dates, and that provides lots of time for renegotiation of certain contracts and time to consider.

So, either option has its benefits, and of course, ultimately, it's entirely up to market participants to decide which route is the best for them.

Janet Du Chenne: We’ve seen a few recent transactions on the ground that have taken place. So I wondered if you could provide a couple of other examples and comment on the collaboration with financial institutions such as Deutsche Bank, in driving awareness on these deals.

Kam Mahil: First, it's worth saying that the loan market is a private market, but we have helpfully seen some parties publicising their deals. In particular, we've seen some good use of the switch mechanism that I mentioned. So for example, by British American Tobacco, Shell, Associated British Ports and Sea Star just to name a few. And we've also seen some bilateral deals moving directly to risk free rates, including Riverside and National Express. So a good range of corporates are taking action. And there has been more activity, as David said, since the conventions were published.

And at the LMA, we are tracking these loans. And that tracker is publicly available on our website. I would really urge listeners to take a look at the tracker just to see what other corporates have done, but also which banks are doing these deals. And the tracker does also include links to some video interviews that we've done with corporates on their deals, so listeners can hear from the corporates directly.

David McNally: Thanks, Kam. I think it’s also worth mentioning that in many of the deals that you reference, that are in the public domain, early on in the development cycle we saw a trend of clients that were embedding this switch mechanism. But more recently, we've begun to observe more active transition in the marketplace. And one important transaction that I would highlight that both Deutsche Bank and a number of other relationship lenders were involved in was the completion of a refinancing for GlaxoSmithKline. This is important because it was the first global large scale credit facility to be linked to risk free rates from the commencement date and certainly the first one that we know of its size.

More importantly, it was also a multicurrency facility, so priced over SOFR and Sonia and adopted many of the conventions that were recommended in the loan conventions, publications that we talked about a little earlier.

Kam Mahil: Thanks, David. I think it's also worth mentioning that that since then, we've had the Tesco deal as well, which also then references the loan conventions which had been published. And just picking up on your point about collaboration, because the loan market is a private one, as I said, collaboration with financial institutions, but also with corporates and advisors is hugely important. And David and his colleagues have been very helpful in terms of publicising deals where they can, but also being willing to speak at events and share experiences. I think parties generally don't like to be a first mover, especially on a change as big as this. So the more that we can collaborate and learn from what others are doing, the better. That's great.

Janet Du Chenne: So as we prepare for such a significant change, why is 2021 so crucial in this transition journey?

David McNally: I think the regulatory message is very clear: that firms need to be prepared to lend or borrow based on risk free rates by the end of 2021. But as you say, there are some key deadlines that are approaching during the course of the year. So for example, in Sterling, there is a deadline that there should be no new Sterling Libor lending after 1 April 2021. And in the US, the relevant currency group has stated that there should be no new US dollar Libor ending by the 30 June. And there are also milestones that are being set around needing to assess legacy books and coming up with plans to tackle that legacy book. So 2021 is the year where parties need to be ready, which is why it's so crucial.

Janet Du Chenne: And finally, what advice or actions would you suggest corporates adopt as they prepare for their journey?

David McNally: Well, Janet, the message for anyone impacted by the discontinuation of Libor is: be prepared. This is really now a near term issue on which we all need to focus. And as we've discussed today, the path for transition away from using Libors is pretty complex. You really need to understand the differences between Libor and the alternative reference rates, you need to understand those both from a financial and an operational perspective as part of your transition discussions. Libor discontinuation is a certainty. And adopting a wait and see strategy now is not advisable in my opinion.

Next, on a practical basis, read the consultations, read the recommendations of the working group, and the other industry groups. Additionally, Deutsche Bank is publishing a white paper on Libor discontinuation in January, which we hope will be a useful additional reference point for readers.

And then also on another practical basis, produce an inventory of the systems you use that might be affected when Libor is no longer published. Consider the changes you need to make to those systems to enable alternative rates in your infrastructure. You also need to actively reduce your reliance on Libor, consider using alternative or risk free rates in new transactions now.

And for your legacy transactions, identify the products and contracts the reference Libor, quantify the amount of your Libor-linked exposure, especially that exposure which matures beyond the end of 2021. When you've done all of that, create a roadmap for transition and consider the merits of active transition as a potential pathway. And lastly, and perhaps most importantly, please get in touch with your Deutsche Bank representative on this topic. We'll help to increase your understanding of these issues and we'll work with you to agree your transition plan.