X marks the spot for LIBOR end game

And here it is – the infamous announcement that LIBOR is to end with a cessation date of immediately after 31 Dec 2021 for all sterling, euro, Swiss franc and Japanese yen LIBOR settings and 1w & 2m US dollar settings, with remaining US dollar settings ending 30 June 2023.   

So what did the announcement say?

  • Dates: for specific currencies and tenors, LIBOR[1] will cease to exist from 31 Dec 2021. This covers all tenors for GBP, CHF, JPY and EUR LIBOR currencies and lesser used tenors (1w & 2m) for USD LIBOR. Main USD LIBOR tenors to cease 30 June 2023 (though no new USD LIBOR trading other than some permitted exceptions after 31 Dec 2021).
  • Spread: the announcement also stops the clock on the 5 year period used to calculate Credit Adjustment Spread (aka ‘X’) between LIBOR and RFR4 under the ISDA 5 year historic median methodology (5YHM) referenced in the ISDA Fallback Protocol. The spread to be applied come cessation to any remaining LIBOR trades that fallback using this method is now fixed.

Why do we care?

1.       We really know when now. Up until now although widely trailed as January 2022 (for £ at least, later for $), it was not official. Now it is.

2.       We know the credit adjustment spread (CAS) that will be applied when trades fall back. It was expected this announcement would come in Q1 2021, and forward curves have already priced in the 5YHM basis from Jan 2022 on this assumption, but now it is actually set. The spreads are published by Bloomberg here.

3.       This paves the way for news on synthetic LIBOR for tough legacy (for a restricted perimeter of products tbc), likely to be defined as term SONIA5 + CAS. Whether this will be how it lands is subject to market consultation over the coming months.

4.       Will this act as a catalyst to improve liquidity in RFRs and hasten active transition away from LIBOR for legacy backbooks? What do we expect this to do for liquidity in the LIBOR and RFR derivative markets? SONIA market already liquid, but SOFR6 has a long way to go.

And what is the number? 

You see in the graph below the effect the fixing of the CAS has had...the ‘snapped’ line is as a result of the announcement on 5 March 2021, the projected is where the 5YHM number would have gone based on forward curves if the announcement had not come, and we kept on shifting the 5 year window forward. 

If you observe any SONIA / LIBOR basis swap with a start date after 3 Jan 2022, you will see the level is very close to 12bps7 demonstrating the market has already priced in fixing the spread.

Source: NatWest data

What next?

Per the £RFR roadmap, the key upcoming milestones are:

·         Q1 2021: no new £ LIBOR loans and no new linear £ LIBOR derivatives (except for risk management of existing positions)

·         Q2 2021: no new £ LIBOR non-linear derivatives (same exception)

·         Q2-Q3 2021: cease cross-currency swaps referencing £ LIBOR

·         Q3 2021: complete active transition of legacy £ LIBOR exposure where viable

·         Q4 2021: no new USD LIBOR derivatives (ARRC8 milestone, similar hedging exception to GBP)

In February 2021 we saw the RFR Working Group (WG) make a further announcement concerning the Q1 linear derivative deadline providing some clarification, but emphasising that “the intention is for continued use of GBP LIBOR via risk management exceptions to be kept to a prudent minimum”.

Of course the ‘turning off the tap’ milestones are one thing; it’s clear now that the path is set, increasingly the focus will turn to active transition. The WG has set a target of Q3 to complete all active transition for LIBOR cash & derivatives “where viable”.

We’ve seen the RFR Credit Adjustment Spread paper in December and the Best Practice Guide for GBP Loans in February aimed at helping the loan market, and we may see more from the WG soon on the operational considerations of transition using fallbacks. But there are naturally some in the market that won’t wish to actively transition and would prefer to rely on fallbacks to do the hard work for them, notwithstanding those operational challenges. 

What about cleared swaps?

While the market waits on final plans from LCH9 for mass conversion of outstanding LIBOR trades shortly prior to the relevant LIBOR cessation date, the preliminary results suggest LCH will move away from cash compensation for the basis spread and will instead incorporate the basis into the new RFR leg. Further details to follow around precise conversion mechanics and timings. LCH has also confirmed that any transition of USD would happen at a later date.

Final thoughts

With this announcement fixing X, the widespread adoption of fallbacks, an emerging solution for non-linear referencing ICE Swap Rate, and some explicit ‘no new trading’ milestones, the path for derivatives is becoming fairly clear. With $ cessation confirmed as June 2023, also expect to see some pick up in RFR based x-ccy trades as SOFR liquidity develops.

The one remaining unknown is the speed at which active transition of legacy derivative portfolios will occur. Regulators are keen to see this happen, but many derivatives may hedge legacy loans or bonds that are still on LIBOR, and so hedges will only move at the pace of those transitions. And even beyond that, do counterparties want to actively move derivatives, or would they prefer to wait for fallbacks?

We will see whether now the uncertainty on X is gone, active transition accelerates. X may mark the spot, but it doesn’t mark the end.

Useful links


1 LIBOR: London Inter-Bank Offered Rate

2 IBA: ICE Benchmark Administration (ICE)

3 ISDA: International Swaps & Derivatives Association, Inc.

4 RFR: Risk Free Rates

5 SONIA: Sterling Overnight Index Average

6 SOFR: Secured Overnight Financing Rate

7 bps: Basis points

8 ARRC: Alternative Reference Rates Committee

9 LCH: LCH Ltd is a UK-registered clearing house

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