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Bank of England ‘Turbo-Charging’ Libor Transition

The Bank of England is going to publish a new Sonia daily index and discourage the use of Libor-linked collateral to encourage the market to move away Libor to the new risk-free reference rate.

Andrew Hauser, executive director, markets at the Bank of England gave a keynote speech at the International Swaps and Derivatives Association/SIFMA Asset Management Group Benchmark Strategies Forum 2020 in London this morning.

Hauser said: “2020 is a critical year for Libor transition. Great progress was made in 2019, particularly in sterling wholesale markets but there is still a lot of ground to cover – particularly in the cash markets.”

After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates (RFR) based on transactions, so they are harder to manipulate and more representative of the market.

The UK has chosen the sterling overnight index average, Sonia, as its risk-free rate. The UK Financial Conduct Authority said two years ago that it will not compel panel banks to submit to Libor beyond 2021.

Sonia compounded index

In order to boost the transition from Libor the UK central bank intends to publish a daily Sonia compounded index.

“This would support the use of Sonia in as wide a range of financial products as possible by simplifying the calculation of compounded interest rates,” Hauser added.

The Bank of England is also considering publishing a set of compounded Sonia period averages and is consulting with the  market on the preferred conventions which will be used.

“We hope that, in time, this tool will complement others already available, helping to build further momentum for LIBOR transition in sterling cash markets – supporting both end-users and loan and infrastructure providers,” Hauser added. “But these firms should not wait for the index before undertaking their own broader preparations.”

Libor-linked collateral

In addition, the Bank of England will begin increasing haircuts on Libor-linked collateral it lends against from October this year. A haircut protects against possible falls in the value of the collateral  in the time between a counterparty default and collateral sale, including in times of potentially severe stress.

“Haircuts are scheduled to reach 100% (i.e. implying effective ineligibility) at the end of 2021,” he said. “These initiatives are aimed at turbo-charging sterling transition, helping the market deliver against its commitment to transition away from Libor and further de-risking sterling markets.”

Approximately one tenth of banks’ drawing capacity is collateralised by assets referencing sterling Libor such as securities paying a Libor-linked coupon.

“The risk is that, absent appropriate planning, these assets could become increasingly difficult for the Bank to value, risk manage and service as Libor cessation approaches,” said Hauser.

Tushar Morzaria, Barclays

He continued that the Bank’s Risk Free Rate Working Group, under the leadership of Barclays’ chief financial officer Tushar Morzaria, has set a road map for the transition with the latest version released last month.

“Amongst many important milestones on that map, the most important is to cease issuance of term sterling Libor-linked cash products by the third quarter of 2020,” Hauser added.

Progress has been in the sterling derivatives market with approximately half of new cleared sterling swaps referencing Sonia last year.

In addition the Bank and FCA have encouraged market makers to use Sonia as the standard reference rate for sterling interest rate swaps from 2 March 2020.

Although there has been progress in the swaps market, Sonia also needs to be increasingly used in futures and non-linear products.

“In preparation for the provision of a robust forward-looking sterling term rate, many banks are now streaming executable Sonia swap prices to regulated trading venues,” said Hauser. “Having the inter-dealer market able to trade Sonia in a single click is a key building block to helping firms hedge with the smallest friction possible.”

The Bank’s working group will be considering what more needs to be done to drive transition in these markets over the coming months.