Fair to say the official sector is firmly in the “act now” camp. Numerous statements have been made recently (see the Roadmap and the Dear CEO letter for example) encouraging the market to actively transition from LIBOR² to RFR³ now. Risks of leaving it until later or depending on fallbacks are listed in these recent papers – loss of liquidity in LIBOR, operational risk and hedge misalignment etc.

However there has also been a huge push to get everyone to sign-up to the ISDA⁴ Fallback Protocol. And it has been very successful – 13,862 legal entities signed-up at the last count covering the vast majority of open notional in LIBOR-linked linear derivatives in the market. What is the point of all this adhering if actually everyone needs to actively transition? We are seeing counterparties that consider waiting for fallbacks to kick-in to be a perfectly valid transition strategy.

So what’s the answer – jump now or hang on? 

Spoiler alert – there is no single answer, it will depend upon your particular circumstances, hedging dependencies, risk appetite, operational readiness and no doubt a host of other factors. Though one thing we can say is that doing nothing is not a good option...if you have no fallbacks in place and have not actively transitioned, then you will face challenges come cessation. 

Below we try to set-out some of the main paths available, and our take on the pros & cons of various options.

What are my options?

First thing to say is not all fallbacks are created equal. Or more accurately, there are plenty of transactions where fallbacks are hard or impossible to implement, and realistically active transition is the only option. Many cash products, across both bonds and loans, fall into this category – they do not have robust fallbacks built-in today, and rather than attempt to negotiate them now it is easier just to negotiate the transition to RFR.

It’s a different story for derivatives, where there is a very clear and robust fallback solution available that has been widely adopted in the market. That’s not quite the whole story though, as where those derivatives hedge cash products there may be a need to retain alignment, and that might be best effected by active transition of both loan & swap together.

And Although I say that the ISDA protocol has been ‘widely adopted’, really I mean it has been widely adopted across financial institutions where most of the open swap notional resides, however it is not nearly so widely adopted amongst corporates. The exposure there may not be so material from a market perspective, however the number of legal entities affected could still be high.

Then there are some non-linear derivatives where either the ISDA Fallback Protocol does not apply (e.g. Swaptions and CMS⁵ that reference the LIBOR ICE Swap Rate when cash settled) or it does apply but changes the economics or behaviour of the trade (e.g. some Caps & Floors). Active transition rather than reliance on fallbacks might be a better option there.

Finally, there is something of a hybrid emerging as an increasingly popular option in the loan market. Often referred to as “deferred switch”, the borrower and lender(s) negotiate the amendment of the terms of the loan to RFR + a credit adjustment spread now, but it does not come into effect until the first reset date after cessation. So, it is a quasi-fallback solution even though referred to as a ‘switch’ and could equally well be considered as ‘active transition’. Distinction is just the timing – is the deferred switch date before or after cessation.

In the below diagram we set out in simple terms the main paths that can be followed, across active transition & fallbacks, and across the main asset classes. At the bottom we show common outcomes for the conventions used when moving to RFR (based on Sterling market, appreciating USD and other markets may vary). Disclaimer – we are not trying to set out all the options and outcomes here, just give a flavour for the alternatives.

A few notes to go with the diagram:

• Bond consent: all GBP bonds that have actively transitioned so far have been via positive or negative consent; fallbacks (for post cessation transition) can be added by way of +/-tive consent solicitation processes or in conjunction with Independent Advisor determination where applicable in the bond documents. Virtually all pre-2017 issuance has no suitable fallback.
• Forward Curves: calculate the credit adjustment spread between LIBOR and RFR using forward curves at point of transition, thus minimising difference in projected payments at that point; generally the method adopted for valuations when actively transitioning ahead of cessation (though not necessarily, and 5YHM is being used as well).
• 5YHM: 5 year historic median, the methodology adopted by ISDA in the Fallback Protocol, and published by Bloomberg per currency/tenor, to calculate Credit Adjustment Spread (CAS); since 5 March now a known fixed spread, which will be applied to derivatives falling back to RFRs on cessation. 
• 5d lag: day convention common for SONIA⁶ loans where rate is observed from 5 business days prior to allow interest calculation to be known 5 business days prior to end of interest period; lag methodology uses the days in the interest period for the compounding calculation (aka lookback lag).
• 2d shift: alternate day convention, using only 2 business days prior for rate observation; shift uses the days in the rate observation period for weighting instead (aka Backward Shift); this is the convention adopted by ISDA and Bloomberg in the adjusted rates that are being published as the fallback rate for use with the protocol following cessation and has also been used in some recent SONIA FRN issuance.
• Matching swaps & loans: when actively transitioning a loan and swap together, it is possible to set what conventions are preferred on the swap; so if the loan is 5d lag, then swap can match that, hence why in the diagram for derivatives it shows as 0d/5d lag – really it is adhoc preference; 0d is the default for OIS⁷ and the default for the bulk of non-linked swaps portfolios. 
• CCP Migration: LCH plan a big-bang migration of all open cleared GBP LIBOR swaps on 18 December 2021 to SONIA + 5YHM CAS; this will effectively be a forced market-wide active transition of all swaps facing LCH ahead of cessation; worth noting that LCH are encouraging participants to transition ahead of this date, and indeed are planning to chargefallback fees for outstanding £LIBOR contracts from Sep 2021 and conversion fees for those who wait until 18 Dec; expect to see an intensifying of compression activity over the coming months.
• Tough Legacy: per BoE paper last year, the extent of products permitted to fall into the ‘Tough Legacy’ bucket is expected to be very restricted, for example older issuance where consent from noteholders would prove impossible to obtain; here the FCA⁸ will define a Synthetic LIBOR screen rate, likely built from Term SONIA + 5YHM, that these legacy contracts may reference.

Pros & Cons

The £RFR WG statement sets out pros & cons against each approach across 6 risk categories which we have summarised in the table below (see paper for full details).

The overall conclusion of the paper is that on balance it is better to actively transition than wait for fallbacks, though that judgement is a little more evenly balanced for derivatives than it is for cash products.

So far in the market we have not seen the wholesale move of legacy portfolios to RFRs, though with the new Q1 milestone requirements around no new GBP LIBOR derivatives trades, except for risk management, the balance of new bookings is shifting further towards SONIA.

The table above provides a brief bullet summary of the points made in the £RFR WG statement Active transition of legacy GBP LIBOR contracts together with our own commentary on the right (not part of the WG statement). Please see original statement for full details of WG views.  

What are the operational challenges of fallbacks?

One of the key concerns in the industry is how counterparties will cope with implementation of fallbacks come cessation for any legacy GBP LIBOR trades that are left at the end of the year.

This is why the RFR group has published their second paper, highlighting the various risks around this process and the steps firms should be taking to mitigate against them.

In the paper they list considerations and recommended next steps across six themes:

• Trade booking infrastructure
• Risk management infrastructure
• Accounting infrastructure
• Regulatory reporting
• Market infrastructure providers
• Timing of conversion/cessation

In general the message is to understand your trade population and the fallback types linked to them, ensure you have considered the impacts to all impacted systems and processes (including risk management, accounting and reporting), secure sufficient resources and maintain appropriate oversight and governance.

All good advice that not many would argue with, and one would hope at least the bigger market participants already have well in hand. Perhaps smaller players or those further removed from transition efforts do need to take stock and review plans. If there is a possibility you will have any trades left to fallback come the end of the year, then you need to plan to be ready.

It is worth remembering that although we talk about a ‘big bang’ at the end of the year, the fallback rates actually become effective on the first reset date following cessation. So not everything has to change on Tuesday 4 January (first working day in 2022) – the amendments/booking changes to start referencing the fallback will play out over a period of months depending on tenors and last fixing dates for legacy trades.

Of course, the building blocks must be in place from the start, and risk management challenges apply immediately (indeed projected risk out beyond Jan 2022 already should reflect the expected changes implicit in £LIBOR trades falling back to SONIA + CAS).

One thing to note – on EMIR reporting (or “UK EMIR reporting” post Brexit) the paper confirms that fallbacks do trigger EMIR reporting “at the time the alternative rate takes effect”. Lower down fallbacks are defined as “effective from the first reset data after cessation”. So, no bulk EMIR reporting on the first day of January, but gradually over time as the swaps hit their next reset dates.

So, lots to consider here, but nothing that of itself suggests that fallbacks are unmanageable and can’t be used as a viable transition mechanism.

Conclusion?

There is something of a disconnect between the tone of the official sector pushing for active transition and many in the market (certainly in the derivatives space) comfortable with letting the fallbacks just play out. 

We suspect that some large bilateral portfolios between financial counterparties will use the fallback route, and the focus of resources will be on assisting smaller entities who have not adhered to the protocol if they have derivatives, or have more bespoke needs to align swaps and cash products, to navigate the right path for them. 

NatWest stands ready to support all our counterparties in whatever transition path they choose, and welcomes calls to discuss the options available. But we will also be ready to implement fallbacks for those that hang on.

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