Fitch Ratings: USD Libor Transition Still Difficult Despite Protocol Milestone

LAGOS (Capital Markets in Africa) – The January 2021 launch of fallbacks for derivatives contracts that reference Libor will still make it challenging for the industry to adopt new term rates referencing the Secured Overnight Financing Rate (SOFR) before Libor ceases to be quoted at end-2021, Fitch Ratings says. Development of a SOFR term reference rate relies on sufficient liquidity in the SOFR-based USD derivatives market, which remains thin compared to traded notionals for USD Libor and SONIA, the successor for GBP LIBOR.

The International Swaps and Derivatives Association (ISDA) announced on Oct. 9 that the fallbacks supplement to its 2006 Definitions and the related protocol will take effect beginning Jan. 25, 2021. The announcement follows confirmation from the U.S. Department of Justice that it would not challenge ISDA’s proposals and is consistent with ISDA’s statement in September that it expected the effective date to be delayed until mid-to-late January. Market participants had advised ISDA that an effective start date at year-end 2020 would create operational challenges and coincide with financial institutions’ traditional year-end code freeze.

The coronavirus pandemic has already delayed other transition milestones, and SOFR-based derivatives adoption remains low relative to the USD Libor derivatives market, and other transitioned currencies by traded notional values. For the week ended Oct. 2, weekly SOFR-traded OTC notional totaled $20.4 billion compared to $472.6 billion for total weekly SONIA-traded notionals (per ISDA, excluding SOFR exchange-traded derivatives volumes). ISDA’s announcement means that further protocol delays should be avoided, reducing the risk that the U.S. dollar derivatives market does not transition to SOFR ahead of Libor cessation at year-end 2021, which could lead to significant operational and market disruption.

Importantly, the switch to SOFR from the Federal funds rate for U.S. interest rate swap discounting, which should naturally support SOFR adoption in the derivatives market and improve liquidity in the primary market, is progressing. Clearinghouse operators LCH and CME Clearing are both scheduled to begin this transition after the closing of business on Oct. 16.

However, the various delays in creating a robust SOFR-based derivatives market have raised the risk that the corresponding creation of a SOFR term rate will not happen far enough ahead of the potential cessation of U.S. dollar Libor at year-end 2021. This would materially increase various risks facing U.S. financial institutions, including operational, reputational, economic, and legal risks.

Fitch already viewed the advent of term SOFR as unlikely before mid-2021, and meeting this timeframe remains challenging despite the ISDA fallback announcement. This is because the dollar market has lagged the sterling market in transition preparations, with timelines envisaged by the U.S. Alternative Reference Rates Committee (ARRC) projecting the adoption of many best practices in late 2021. This leaves little room for further unexpected delays, including a SOFR term rate, which ARRC plans to start calculating next year.

The latest developments reinforce Fitch’s view that transition risks partly arise from some market participants taking a wait-and-see approach, rather than embracing workable if imperfect, solutions to the challenges presented by Libor cessation well in advance of year-end 2021 to avoid a disorderly transition.

Fitch will continue to engage with market participants, industry groups, and regulators to assess transition preparations and risks. Continued progress will reduce the risk of rating impacts, particularly if it is underpinned by legislative or regulatory measures to help address potential litigation risks and operational issues.