LIBOR transition: How should firms manage their legacy portfolio?

This article is based on a Risk.net podcast with Steffan Tsilimos, Global Head of Interest Rate Derivatives Product at Bloomberg.

The long road of the LIBOR transition has seen a remarkable amount of co-ordination among regulators, governments, investors and banks, with high levels of transparency and inclusion, as diverse consultations have helped fine-tune the mechanics of the new RFRs as well as fallback mechanisms in legacy LIBOR contracts.

The educational drive has been so widespread that there is now little excuse for market participants with LIBOR-based products in their portfolio to not have a transition strategy in place. Nevertheless, with less than a year to go before LIBOR’s scheduled demise, significant complications in the practicalities of transition-related activities remain, leading to a variety of approaches, often depending on the jurisdiction and the product.

LIBOR legacy transactions represent a known problem area that continues to challenge market participants. In derivatives markets, regulators and working groups recommend that users exit or reduce their LIBOR exposures well in advance of a cessation date. Users can reduce exposure through compression, or even by terminating existing LIBOR contracts and replacing them with RFRs. In the bond market, however, the situation is less straightforward. Unlike OTC derivatives, which typically involve two parties, bonds may have dozens or hundreds of different stakeholders. In the UK, where the amendment threshold is roughly 75%, there have been some successful incidences of consent

solicitation in which bondholders have agreed to change the coupon from Sterling LIBOR to SONIA. However, in jurisdictions such as the US, where 100% agreement is typically required for modifications, such an approach is less likely to be effective. For this reason, in the US there are proposals for a legislative approach that would enable contracts with weak or non-existent fallback language to transition automatically to the ARRC defined fallback in the case of a cessation event.

Understanding the logic behind the various fallbacks in LIBOR legacy products is a crucial part of transition efforts.

Over the past two years, Bloomberg has been working closely with clients to identify and classify different kinds of fallbacks for thousands of LIBOR legacy securities across a wide variety of fixed income products, such as FRNs and mortgages. While understanding fallbacks in fixed income products requires looking at each specific security, OTC derivatives contracts may follow the ISDA fallback rates, which are calculated by Bloomberg Index Services Limited (BISL) . For older legacy derivatives transactions, customers will need to opt in to the ISDA fallback protocol, which went live in January 2021. As the end-2021 date looms ever closer, Bloomberg expects to see an increasing number of market participants seeking clarity around fallback-related issues.

The outlook for 2021: LIBOR An interview with Steffan Tsilimos, Global Head of Interest Rate Derivatives Product at Bloomberg

How to calculate exposures and upgrade systems

On a more general level, it is important for firms to understand their LIBOR exposures. The first step is to look through existing portfolios and identify legacy deals, be they derivatives or fixed income products, and then work out the suitability of the various transition options for each legacy product. Some market participants might still be discounting with LIBOR rather than OIS, a testament to the ingrained nature of the discredited benchmark rate. Formulating a plan to move away from LIBOR and onto RFRs to discount derivatives might therefore be another crucial step.

From a cost-benefit perspective, many firms are weighing the pros and cons of a proactive approach versus potentially doing nothing. Such firms may analyze the potential cost of exiting exposures in LIBOR derivatives by looking at the bid-ask spread or the potential value transfer from mark-to-market on the LIBOR derivative versus a new RFR-based replacement. They may then juxtapose these costs with potential scenario analyses and outcomes if the LIBOR derivative remains on the portfolio post cessation and triggers the ISDA fallback calculations. Understanding the different approaches, potential costs and benefits is a vital part of any transition strategy.

Firms should also have systems and portfolios that can support RFRs, which do not function in the same way as their LIBOR counterparts.

To ensure RFRs and daily compounded or average payments take place on time, systems need to be able to facilitate mechanisms such as lockouts, lookbacks, and payment delays, and any averaging or compounding conventions, as they are critical characteristics of RFR-based payments.

SOFR versus €STR

Market participants should take note of the differences between the various RFR replacements. For example, while SOFR is intended to replace LIBOR in all transactions, EURIBOR, the EU’s main credit index, is expected to exist beyond 2021, meaning the majority of interest rate contracts may continue to reference EURIBOR as opposed to the newly created €STR, the replacement for EONIA. In terms of whether the RFRs are actively traded, Bloomberg has seen many customer transactions referencing both SOFR and €STR over the last two years.

Clearing houses have also played a significant role in encouraging the adoption of RFRs, as the major changes in Price Alignment Interest that took place in 2020 enabled more hedges to reference RFRs. For example, in the US, the migration from Fed Funds discounting to SOFR has helped boost activity in the longer end of the SOFR yield curve for basis swaps.

2021: the road ahead

Perhaps the most significant game-changer for 2021 will be the publication of timelines that clarify the exact moments LIBOR will end for the respective currencies. Such clarifications will help stakeholders prepare more formally for system updates and LIBOR to RFR migrations. Pre-cessation announcements, for example, are widely expected to happen in Q1 2021.

This year will also see a greater liquidity shift from LIBOR to RFRs. While a significant number of transactions have already taken place in various kinds of overnight index swaps (OIS) and basis swaps, 2021 should deliver more movement into volatility products such as swaptions and caps.

Bloomberg is helping clients understand the impact of the LIBOR transition on their portfolios, offering a comprehensive suite of data, analytics, and portfolio solutions to help market participants assess the transition to RFRs, providing support for the adoption for all products across its industry leading platform.

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