ROUNDTABLE: What does life after Libor look like?
Senior legal, syndicate and treasury directors at the EBRD, ICMA, NatWest and RBC talk frankly on the industry’s transition to risk-free rates
The demise of Libor has left lawyers, bankers and everyone in between scratching their heads. From discrepancies in approach between products to a perceived dearth of regulatory guidance, there's no shortage of issues.
Practice Insight sat down with senior legal, syndicate and treasury sources at some of Europe’s biggest banks and trade associations to discuss what’s happened so far, what still needs to be done, and where the risks lie.
This is a transcript from a panel at IFLR’s European Capital Markets Forum on April 4.
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Iain Budge, director, UK & Ireland, FI solutions and origination, NatWest Markets (IB)
Katie Kelly, senior director, market practice and regulatory policy, ICMA (KK)
Isabelle Laurent, deputy treasurer & head of funding, European Bank for Reconstruction and Development (IL)
Sean Taor, managing director, head of European DCM & syndicate, Royal Bank of Canada Capital Markets (ST)
Moderated by Elizabeth Meager, managing editor, IFLR & Practice Insight (EM)
EM: It’s been almost two years now since the FCA’s Andrew Bailey said that Libor is not a reliable enough benchmark and that markets must transition away from it. As with any big regulatory reform, some are petrified, and some are incredibly laid-back. How concerned are you?
Katie Kelly, ICMA: I’m very concerned. There are massive implications surrounding the discontinuation of Libor, as to which there is a huge amount of work going on behind the scenes. In terms of how worried we are going forward, I think that adoption of the new risk-free rate, which in the UK is Sonia [sterling overnight index average], is going well. There have been quite a number of transactions based on Sonia so far.
But we are concerned with the legacy problem, however, because it’s difficult to say exactly how many transactions are outstanding beyond 2021. There will be a significant number that continue to reference Libor, so we need to make sure that there’s something they can fall back to, other than the default position in the terms and conditions.
Sean Taor, RBC Capital Markets: I am concerned, but less concerned than I was a year ago. Before July 2017 Libor reform was really not on the radar. I think very few market participants thought Libor would be going anywhere – no one was prepared for potential transition back then – but since July 2017 the world has changed pretty quickly. The transition from Libor in the UK has been hugely impressive in terms of volume of new issuance, overall market engagement, and the number of issuers, underwriters and investors who have changed and adapted their systems to incorporate SONIA. I think the UK adoption of the risk free rate, so far, has been a great success stories, especially compared to the US.
The transition to SOFR [secured overnight financing rate] in the US – which is arguably more important in the US than Sonia in the UK - when you look at volume of legacy fixed income products linked to dollar Libor vs sterling Libor– has shown that awareness in the UK dwarfs that in the US.
But despite the success of Sonia-linked new issuance I’m not content yet, as I agree that legacy bonds are a huge challenge. The last time RBC ran the data we found the equivalent of roughly $850 billion of legacy bonds tied to Libor. Even if that number is now only 75% correct, it’s a huge problem. But in terms of education and behind-the-scenes work, I would give the industry’s efforts in the UK so far an eight or nine out of 10.
Iain Budge, NatWest Markets: The main worry at the moment is simply that there’s a lot of work to be done. It’s true that different jurisdictions are at different stages.
For instance, in the sterling market, there is now a way forward for bonds, but there still remains a legacy problem. We still haven’t seen any Sonia-based loans, so there’s both a legacy and a go-forward issue there.
The swaps market is moving in the right direction. We’ve got much more clarity on sterling Libor-based derivatives. In the euro market, it looks like reformed Euribor will be the way forward without too much work to be done. In the dollar market meanwhile we have a brand new rate, SOFR, which is illiquid at the moment and only has a few derivative trades based on it per day.
Education is an issue between different types of institutions – there’s a huge difference between a sophisticated bank with hundreds of people working on the project compared to a small corporate that’s only now finding out about this.
EM: What was the process like working on the Sonia-based debt deals that have come to market so far?
ST: The first Sonia-linked transaction was an RBC sole-lead deal for EIB launched in 2010. We learned at the time that there were many investors that didn’t need to buy an FRN that wasn’t linked to Libor because no one back then thought Libor might be disappearing.
More importantly many investors just didn’t have the systems in place to be able to book a trade linked to Sonia. However whilst that deal was challenging it did lead the way for all the Sonia deals that came to the market in 2018 and since, as the DNA on all those subsequent deals was more or less the same as the deal launched back in 2010. The only real difference between the two is the coupon calculation: on the 2010 deal both Sonia and coupon were compounded whereas on all subsequent deals Sonia is compounded daily and the coupon is then added. The 2018 EIB deal, the first linked to reformed Sonia, took a year to put together, including a test bond that was used to ensure investors could actually book the trade if they wanted to.
There were 12 transactions in total over 2018 – just under £7 billion worth of issuance – which was about 5% of all syndicated sterling issuance last year. The first deal of 2018 had around 50 investors in total, whereas at RBC by the end 2018 we had sold Sonia-linked bonds to just over 155 separate investors.
Over 2019 so far there had already been 28 Sonia-linked transactions and over £14 billion worth of issuance, involving 18 different underwriting banks, which is closer to 30% of total sterling syndicated issuance. That shows how quickly the primary market in the UK has embraced Libor transition.
"In theory two rates can co-exist, but that could bifurcate liquidity in Sonia bonds"
- Katie Kelly, ICMA
EM: What was the inflection point for that change?
ST: The regulator. Obviously some market participants acted on the FCA’s announcement in July 2017 faster than others, though to be fair the banks had Mifid II to contend with, which was a huge, costly and time-consuming exercise.
Subsequent speeches saw the FCA reiterate that banks have to transition. The regulator also sent ‘Dear CEO’ letter to 30 banks, which highlighted that the rhetoric was getting much stronger. I think the initial skepticism around transition has disappeared very quickly.
EM: It’s true that the progress in bond markets is remarkable, but for other products it’s been more difficult. For loans and the corporates who rely on them, for instance, the lack of a term rate is still a big issue. Is there progress towards a term Sonia rate?
IB: First of all, the problem with a Sonia-based coupon as opposed to a Libor-based rate is that for the former, you only know your coupon at the end of the period so it is more difficult to make payments and manage cashflows. So for the 2018 EIB issuance and all subsequent deals, we’ve taken a daily Sonia rate five business days in advance. That means you know your coupon five business days, i.e. at least week, before the end of the period.
In bond markets it was a case of getting a deal out there and getting enough investors interested. Investors then made a choice whether they wanted to continue to invest in Libor bonds, where their future cashflows may be uncertain upon a demise of Libor.
Meanwhile in the loan market, the largest corporates are comfortable with overnight Sonia, but mid-sized corporates – for cashflow and IT reasons – would like a forward-looking term rate. For instance, three-month Sonia.
That would involve looking to the swaps and futures market, which is the predictor of where rates will go. And that’s fine – there has been good work done in this space – but the problem is that as soon as you move away from overnight Sonia, there are questions around robustness.
Plus, it’s not clear how to use term Sonia in derivatives markets. To hedge a term Sonia exposure you need to enter into an interest rate derivative. But a derivative based on a rate that is also a derivative creates issues, which the market still has to solve.
EM: As there are so many overlapping factors here – loans are so closely linked to derivatives, for instance – it’s so important that different markets work together here. It’s great that trade associations are working closely together. Is that reflected internally within banks? Are you working with different product desks on this?
ST: We’re absolutely working with all the product groups to understand the risks to both our clients and to us.
Regulators have been very clear that Libor is not a robust rate. Sterling three-month Libor, which most legacy products are set against, trades roughly £187 million a day. Meanwhile Sonia trades roughly £48 billion a day.
I do have concerns around the robustness of a term Sonia rate. I appreciate that some investors would prefer a term rate as is easier knowing your payments in advance however in reality if, for example, an investor bought a five-year sterling floater linked to three-month Libor then on day 1 the investor would only know the first three-month coupon payment. The other 19 coupon payments, 95% bond’s coupon payments, would not be known at that time.
For loans it is far more problematic because there are many companies that need certainty of cash payments well in advance. However I am unsure that term Sonia is the solution. So while I understand that some market participants would like to see a term Sonia rate I would like to hope that we can avoid relying on it.
EM: As discussed, some products have made more progress than others. Can you see a time in the future where different products are on different rates? What are the consequences of that?
IB: Looking first at derivatives, as that’s where the most progress has been made, we now have a methodology for fallbacks. It’s an overnight compounded Sonia rate set in arrears plus a credit spread. The credit spread is yet to be determined; it depends on the historic period and average you use, but we at least have a clear sense of what will happen to derivatives if we sign up to the Isda protocol.
What we don’t know is what happens to legacy bond deals where the majority revert to the last Libor rate should the reference bank mechanism not work. That could see floating rate bonds convert to fixed rate, which wasn’t what issuers intended when they sold them, nor investors when they bought them.
This could mean loans, bonds and derivatives fall back in three broadly different ways, subject to bespoke terms within each individual agreement.
ST: Globally, the market is moving towards an overnight risk-free rate for most products. The problem is that the risk-free rates are not the same.
In the US, SOFR is more or less the same calculation as Sonia, but it’s a secured rate, whereas Sonia is unsecured. Ester, the euro replacement, will be unsecured. In a way that doesn’t matter as long as the process of issuance and new issue conventions – particularly for issuers who sell across currencies – becomes standardised. And I think investors would like to see that as well.
EM: Can you see a time where different rates emerge beyond even Sonia and SOFR, and differ between products? Would that be a problem?
KK: Different formats of the rates – term Sonia, for instance – will absolutely emerge. The importance of a term rate for the loan market has already been highlighted, and the Sonia FRN market is currently working with overnight rates, so differences could definitely become a reality. From our perspective, in theory two rates can co-exist, but that could bifurcate liquidity in Sonia bonds.
ST: From a hedging perspective, derivatives are all based on the same underlying Sonia rate, so bifurcation of liquidity wouldn’t be ideal – but it wouldn’t be a huge issue. The problem would be writing derivatives linked to the term rate, because that will come with extra transaction costs that would likely be then passed on to the end-users.
"In terms of education and behind-the-scenes work, I would give the UK industry's efforts an eight or nine out of 10"
- Sean Taor, RBC Capital Markets
IL: At EBRD, like other SSAs, we’re dealing with real economy clients. The real economy have made it clear that they want term rates. So if we find ourselves, as we currently do, issuing in compounded overnight rates to respond to the change, we like most other similar issuers have swapped the proceeds to term floating rates, because that’s what we’re still using for loans, and would expect to do going forward. One of the difficulties is that even when we issue fixed rate deals, we tend to swap to term floating rates in the currencies in which we denominate loans. So it will be very difficult if banks can’t easily clear these swaps. We’re not active in clearing but would need to see the basis swap at least, to make it easier for banks to offer us that product so we can service our clients in the real economy.
ST: I understand that in the real economy, people absolutely want to know what they’re going to be paid and what they need to pay as early as possible. The counterargument to replying on term rates, though, is that they aren’t necessarily going to be robust, and for most products, today you don’t know what you’re paying that far in advance based on Libor either.
IL: You may know roughly, but I don’t think that’s really what people want. Certainly most of the peer institutions I know use six-month Libor, because their clients feel they need to know the precise payment 180 days in advance.
When you start looking at retail, it is even more important, which is I think why the European Central Bank is coming up with the notion it will definitely have a term rate, a reformed Euribor, because there are retail products, small institutions, and many others that link to term rates, for whom it would simply not be workable to use a compounded overnight rate.
It’s true that it’s not that volatile, and that’s certainly the case in the current environment when we don’t anticipate significant rate rises. But they’re looking for exact certainty, and that is more difficult.
EM: What does the work on fallbacks look like at the moment?
KK: ICMA has been looking at the fallbacks in current Libor-referencing bond documentation, which extends beyond the end of 2021, to establish that the default position would be. So far the vast majority anticipate falling back to the last given rate, which would then be fixed for the rest of the life of the bond – so, essentially, reverting back to a fixed rate. This was never meant as a solution to permanent discontinuation; it was only meant to be an interim solution and so doesn’t reflect the commercial intention.
We’ve spent a lot of time in our working groups considering the various alternative options, the first of which is the default: reverting to a fixed rate. An alternative option could be a consent solicitation or buyback liability management exercise, though there are a number of issues with that. Then we have to consider any other alternatives, such as the continuation of Libor in one guise or another.
Both of the latter options pose considerable challenges. A consent solicitation can be carried out at any time because it’s enshrined in the bond terms and conditions, but different issuers may want to take different approaches – for instance, overnight Sonia or term Sonia.
Then an adjustment spread would be needed to economically mimic the bank credit element which is inherent in Libor but not in Sonia lacks.
For consent solicitation, there are also differences between US and English law-governed bonds. In the US, 100% bondholder consent is needed – which is really, really difficult to achieve. That may result in dollar Libor bonds remaining outstanding while their sterling equivalents are amended. That’s certainly not desirable for issuers or investors.
ST: For an international issuer, treating different currencies differently is problematic. I see consent solicitation as a bespoke solution for some issuers, but not an industry solution at all. Either way, it will be incredibly difficult to satisfy all investors, and fragmentation is highly likely.
In my opinion the most viable industry-wide solution – which I think we would all welcome – is to find a way, adhering to existing documentation, to still ensure that bonds remain floating-rate going forward. That might be as Sonia plus a spread- which is agreed bilaterally between the swap and bond markets- with that continuing to be quoted.
IB: We can generally split Libor bonds into two categories: those sold pre-July 2017, and those sold since then. The former pose a true legacy issue where there is no contemplative fallback beyond the last available Libor rate. But since then we have seen a lot of bespoke fallbacks in contracts.
The problem for issuers at the moment is being prescriptive on the mechanical fallback methodology because there’s no real consensus. In an ideal world, it would look similar to that in the derivative and loan markets, with similar credit spread adjustments that interact well together.
"The problem for issuers at the moment is being prescriptive on the mechanical fallback methodology because there's no real consensus"
- Ian Budge, NatWest Markets
IL: I would say there are three types of bonds: the two mentioned, plus those linked to Libor that aren’t pure FRNs, for instance, those such as constant maturity transactions that are often bought by life insurance and pension firms. There are also various other types of transactions linked to Libor where the relationship is less well understood. I was recently sent a ghastly article: ‘Hedge funds prepare post-Libor litigation attack lines’. Apparently some are buying up transactions –especially those that need 100% bondholder consent – to use them as litigation tools. This is exactly the kind of thing that puts the fear of God into issuers.
So I think we need to be very careful about next steps. If we can encourage people not to use Libor going forward for new transactions, that would be awfully helpful. If we can find a solution that’s Libor-equivalent but also forward-looking with a clear credit margin, then we can find a way forward. Then it’s just about de-risking the litigation aspects.
KK: There’s also a point to be made about consistency here. The more options for converting transactions there are, the higher the risk of litigation, because there are more differentials to litigate on. So it’s arguable that doing nothing and letting the bond become fixed poses the smallest risk of litigation. It may not be the solution everyone is looking and hoping for, but it may be a reality if no cross-jurisdictional approach emerges.
ST: It’s true that some investors will look at this as an opportunity. Just a year ago the worry was that if FRNs ended up as fixed rate then investors would be left with bonds with below-market yields as a result. However since then overnight rates have risen more than three month Libor, while underlying gilt yields have fallen. That means there may well be little impetus on the buyside’s behalf to go through a buyback or consent solicitation process as they would be economically better of not doing so.
For me the only solution that suits both sides is having a quoted rate that’s robust and doesn’t trigger any move to fixed rate.