LIBOR Transition: Expert Views – Kari Hallgrimsson

“Infrastructure will be the biggest hurdle for many clients; they have to be able to trade, book and risk-manage RFRs, but also untangle LIBOR from all their internal systems.”

Kari Hallgrimsson

Liquidity in SONIA-based derivatives is quite far ahead of other markets. What impact will the FCA’s cessation statement have on liquidity in SOFR-, SARON- and TONAR-based derivatives?

The statement should have a very positive impact on the liquidity for all Risk-Free Rates (RFRs). It provides much-needed clarity on the path of benchmark reform and, as a result, the market simply cannot delay transitioning away from the London Inter-bank Offered Rate (LIBOR).

By releasing the statement, the FCA effectively fixed the spread between LIBOR and the corresponding RFRs in the vast majority of the derivative markets, for any fixing after the predetermined cessation date. As a result, any market participant that had ‘LIBOR risk’ prior to the announcement, will have RFR risk now. This should materially increase the amount of trading in the underlying RFR, going forward, and hence the liquidity in the product itself.

Have you seen differences in approach to transitioning non-cleared derivative portfolios across customer segments? Do you think some customers will rely on the 2020 ISDA Fallbacks Protocol as the primary transition mechanism to RFRs for non-cleared derivative portfolios?

We can broadly group our clients into three categories with regards to transition speed. First, you have the early adopters that worked with us and proactively transitioned their linear derivative portfolios over the last couple of years. In the UK, this was mainly the liability-driven investment clients and bank treasuries. Secondly, you have clients that actively trade in derivative markets. Their positions change frequently and, as a result, they want their risk in the most liquid instrument. They tend to transition when the market for RFRs is as liquid as the corresponding LIBOR market.

In sterling, the liquidity tipping point where the Sterling Overnight Index Average (SONIA) became more liquid than LIBOR was, after the ‘SONIA first’ initiative where the market coalesced to change the default in markets to SONIA. I think a similar push to increase Secured Overnight Financing Rate (SOFR) trading would be beneficial; this could be done in stages where one part of the LIBOR market is targeted to switch to SOFR in each stage. The third group tend to be corporates who trade infrequently, and other clients who have underlying risk associated with products that have been slow to transition, such as non-linear or cross-currency markets.

I do think some participants may rely on the fallback, although there is a potential that any derivative which relies only on ISDA fallback could become less liquid.

The cross-currency and non-linear markets have been slow to develop in RFRs across the U.S., U.K., Japan and Switzerland, and some non-LIBOR jurisdictions have confirmed they will continue with a multi-index approach and maintain their domestic IBORs alongside existing or new RFRs. Meanwhile, domestic overnight index swap markets are not well developed across some of these jurisdictions. How do you think this will affect liquidity and the preferred quoting convention for the inter-bank cross-currency market?

The default convention for all major currencies is to trade against the U.S. dollar in the cross-currency market. That means that these cross-currency swaps are now effectively against SOFR for any transaction that has a maturity after June 2023. As a result, I expect that market conventions will change to be based on overnight indices on both sides. I would be supportive of an initiative where major market participants proactively change market conventions on specific dates, similar to what was successfully done in the sterling interest-swap market last year.

“The starting point for firms is to understand their exposure to LIBOR. They should map out their LIBOR risk by product, currency and maturity.”

Kari Hallgrimsson

Across cash and loan markets, there are a number of different potential payoffs for RFR-based caps and floors. Do you expect the inter-bank market to coalesce around a single payoff for hedging purposes?

Yes, I do. Taking the sterling market as an example, which is far ahead of other markets in terms of transitioning, the inter-bank market for caps and floors trades daily-compounded SONIA, paid quarterly. I would expect other currencies to evolve in a similar manner.

How do you think alternatives to daily RFRs, such as term fixings and credit sensitive indexes, will play a part in the post-LIBOR world?

The starting point is to understand their exposure to LIBOR. They should map out their LIBOR risk by product, currency and maturity. As a result, they will be able to understand the risk they face if they do not transition and rely on fallback methodologies. Secondly, they should make sure they have the infrastructure to transition. That includes ensuring they can book and risk-manage RFR products. Finally, they should develop a detailed plan on how they look to transition their portfolio through time, and be mindful to avoid the potential rush to transition right before the cessation dates.

What advice would you give to firms who are yet to start active portfolio transitions to RFRs?

Their usage will ultimately depend on end users and the issues they face in using an Overnight Index Swap-based index instead of LIBOR. For example, some trade capital and Islamic finance products require variable rates that are pre-determined and, as a result, would need terms. Other products might need the index to be linked to credit conditions, which RFRs generally don’t reflect.

What would you say is the biggest obstacle firms are facing as they prepare for the transition away from LIBOR?

Overall, I think infrastructure will be the biggest hurdle for many clients. Not only do clients have to be able to trade, book and risk-manage RFRs, but they will also have to untangle LIBOR from all their internal systems, which is easier said than done.

Additional Resource

LIBOR Transition Solutions

As the move away from LIBOR continues, Bloomberg offers a comprehensive suite of data, analytics, and portfolio solutions to help market participants assess the impact of the transition to risk-free rates, providing transparency and support for all products across our platform.

LIBOR Transition Solutions

As the move away from LIBOR continues, Bloomberg offers a comprehensive suite of data, analytics, and portfolio solutions to help market participants assess the impact of the transition to risk-free rates, providing transparency and support for all products across our platform.