Hello. My name's Jim Byrd. I'm the Head of rates trading at RBC Capital Markets. Today, we're going to discuss the topic of LIBOR transition, and I'm very lucky to be joined by Harri Vikstedt, Senior Policy Director in the Financial Markets Department at the Bank of Canada. In his current role, Harri is focused on financial market-related issues, including global and domestic benchmark reform, he's a member of the Financial Stability Board's Official Sector Steering Group, and co-chair of the Canadian Alternative Reference Rate working group or CARR, as it's known. CARR is responsible for helping to transition the Canadian financial system from the Canadian Dollar Offered Rate, CDOR, to the Canadian Overnight Repo Rate Average, CORRA. Harri, I want to thank you for joining me today.
Before we get started, I just wanted to clarify that the comments and views are my own and do not necessarily represent those of the Bank of Canada or the Official Sector Steering Group, which I'm a member of.
Noted. With over $400 trillion of financial products linked to IBOR globally, the transition to risk-free rates is a broad and impactful change for the financial markets. While every jurisdiction is at a different pace in the transition to RFR's, for today's discussion, we would like to focus more specifically on how the transition may impact the Canadian market. There's a lot to discuss. So, why don't we get started? So Harri, why is there a move away from LIBOR?
This applies to other interbank offered rates as well, so not just LIBOR. But in a nutshell, there's basically four drivers. The first is that there was some manipulation of some of these rates during the global financial crisis in 2008/2009. Secondly, the reality is that derivatives in general do not need IBORs or LIBORS as the floating rate benchmark. Thirdly, there's been a reduction in the short-term interbank funding due to regulations that have been introduced since the crisis, and fourth, which is very important is, that there is a desire by many of the banks on these panels to leave them. So, I'd like to expand on these points by providing a quick history, if you don't mind.
So, it started in 2012 with the Wheatley Report. Basically Wheatley recommended that LIBOR should go down from 10 currencies to five, and some of the tenants to be discontinued, the reasons being that there was no underlying market, and they weren't being used. In 2013 IOSCO, which is the umbrella organization for the global securities regulators introduced their principles for financial benchmarks. These set out what a robust benchmark should be, and basically, it should be based on transactions from a liquid underlying market. Also, in 2013, the FSB created the Official Sector Steering Group, to review financial benchmarks, and the focus there being on LIBOR, Euribor and TIBOR.
The FSB also formed the Market Practitioners' Group, which was composed of roughly 40-plus large global players, including RBC as the subject matter experts on benchmarks and derivatives. In 2014, the MPG and the OSSG released the report with three key recommendations. Firstly that these IBORs were to be made more transaction-based, i.e they were to be reformed. Secondly, that jurisdictions should create risk-free rates, and that these should really be the basis for derivative. This was coming from the market practitioners, not from the official sector. And thirdly that the fallbacks that many products relied on should be made much more robust.
But overall, the view was that most jurisdictions would remain multi-rate, i.e. that you would have an IBOR and a risk-free rate. One of the other things that happened as a result of the global financial crisis was that there were new banking regulations that were introduced. This basically meant that the interbank lending market begun to dry up, so there weren't very many transactions. And as a result, many of these panel member banks were interested in leaving these panels. Remember that they're doing this as a public good, they don't get paid for it, and some of them had also paid large fines.
So in 2017, Andrew Bailey, who was the CEO of the FCA, the FCA is the regulator that regulates the IBA, the administrator of LIBOR as well as LIBOR itself, gave his famous speech about the end of LIBOR. Basically he said that the FCA would not use its power to compel banks, panel member banks, to remain on the LIBOR panels past the end of 2021. And it's clear from the recent announcements at the end of last year from the IBA and the FCA that these panel member banks do not want to be on these panels. As a result, four of the LIBOR currencies will cease at the end of this year, and five out of the seven US dollar LIBOR tenures will continue to be published for another 18 months. So that's towards to the end of June of 2023.
Okay, thanks for the background. So what can firms do to prepare for transition? How can they get plugged in?
There are many important components, but I'll highlight the few that I think are the most important. Firstly, you need to understand your exposure, both on the asset and liability side. And it's not just the securities' exposure, it could potentially be related to leases, oil contracts, sales contracts, et cetera. So the key there is what is your exposure? You also need to understand what happens to those contracts once LIBOR is stopped, i.e. what are the fallbacks? And you specifically want to focus on those fallbacks that are not robust. In other words, is there a right fallback?
There could be many implications from implementing those fallbacks. It could be accounting, relate to hedge effectiveness, systems. I think a lot of people don't focus a lot on systems, but the systems component is a very critical component of this transition. So can your systems handle fallbacks, or can your systems handle new products? One of the things that people need to remember is that there's a fundamental shift happening in the plumbing of the financial system. IBORs, this includes LIBOR, are a forward-looking rate. We are moving towards risk-free rates, which are overnight rates and are calculated in arrears. So it's important to understand that.
You should obviously allocate, i.e. have the resources to look at all these issues. For many of the large global players, the large money center banks. I mean, this can run into hundreds of millions of dollars. So this is not an insignificant effort. One of the things that you should obviously be doing is making sure that you don't increase your exposure to LIBOR, and if you do, just make sure that any contracts that you do going forward have robust fallbacks. And then the last point is that you really need to start transacting in new products or in these new benchmarks. So in the case of the US, it's SOFR.
With respect to kind of how can you be plugged in? There are many good sources of information. And I would start with ISDA's website. It has extensive information, not only on the drifted fallbacks, but in general on the transition efforts globally. The Official Sector Steering Group also has materials. So for example, we released a roadmap in October of 2020 i.e. last year, we also do an annual update, which was released in November. If you're focused on LIBOR specifically, then obviously the IBA, as the administrator and the FCA as the regulator, are important sources to follow.
Each of the currency groups, LIBOR currency groups, has the national working group in the case of the US it's the ARC, and there's extensive material on the transitioning there. For the non-LIBOR currencies, they also have national working groups. As you mentioned, I'm the co-chair of CARR, so it's important to follow what's happening in those jurisdictions. And then obviously you should be talking to your dealers like RBC. The one advantage that the dealers or the banks have is that they themselves are going through a transition effort. And to a large extent, it's a huge effort because these benchmarks are really the cornerstone of the bank plumbing.
And then lastly, you should really be talking to your system providers to make sure that you will have the systems ready when these benchmarks end.
Okay, some good pointers, good tips there. And also a pretty good segue into... You mentioned CARR, tell me a little bit about CARR, why was it created, what's its mandate?
The bank has been involved in the global benchmark efforts since day one with the formation of the Official Sector Steering Group. But since Andrew Bailey's speech, it was clear that with US dollar LIBOR disappearing, the world would be moving to a risk-free rate basis, even in those jurisdictions that were multi-rate, like Canada. This was due to products like cross-currency basis swaps, multi-currency loans, et cetera. So we created CARR in the spring of 2018, and the focus there was really to make sure that Canada had a robust risk-free rate.
CORRA, which is the Canadian Overnight Repo Rate Average, has been around since the late 1990s, and the group thought that it was the right risk-free rate, but that the calculation methodology should be enhanced to include a larger set of underlying transactions. Which we did, and the Bank of Canada took over the administration of CORRA this past June.
The work of CARR also includes making sure that the Canadian market is ready to transition to using CORRA across a range of Canadian financial products over time. One of the things that we did with CARR's mandate last year in the fall, was to expand the mandate to include a review of CDOR.
While there have been multiple reviews of CDOR in the past several years, most have focused on the submission process. And we really wanted to do a review of the architectural underpinnings of the rate. Part of the reason for that is that bank funding has fundamentally changed because of the Basel regulations introduced since 2008/2009. And CDOR is based on the BA market, and it's not clear that it is the most effective funding that the banks can have. And therefore, we wanted to look at the efficacy of CDOR, as a benchmark. With the change in the mandate, we also reconstituted CARR, to include a broader set of stakeholders.
Let's change gears a little bit here, and talk about the ISDA protocol. I think most of the people who'd be listening to this have probably at least heard of the ISDA protocol. And it was published at the end of October, it goes into effect at the end of this month, the end of January. What is it, what's the significance of its publication?
So ISDA's work on the fallbacks in the protocol are significant developments in my opinion. And we've been working, when I say we, the OSSG has been working with ISDA since 2016 on both the new fallbacks and the protocol, and I've been very much involved in that work. The issue, as I mentioned earlier, is that the fallbacks were weak, and needed replacing. So ISDA worked on making these fullbacks more robust for a range of IBORs, including CDOR. So, any derivatives that are written on ISDA the documentation as of January 25th, will incorporate these new fallbacks. But that leaves a huge amount of legacy exposure that will not have these new fallbacks. And that's where the protocol comes in.
It basically allows any two counter parties that signed the protocol to incorporate the new fallbacks, the new robust fallbacks, into the legacy portfolio. This is extremely important, because what it means is that for the existing huge legacy exposure, basically by getting most market participants to sign the protocol, you minimize disruption. You have certainty, you have contract certainty for when LIBOR stops. So this is very, very important. So it really allows participants to have clarity on the outcome. So that's why it's important that market participants sign the protocol if possible. Obviously you need to fully understand your exposure and risks before doing so. It's good news that over 5,200 counterparties globally have signed since it went into effect, including the six biggest Canadian banks.
You sort of mentioned this tangentially earlier, at the end of November, the IBA, the ICE Benchmark Administration, the administrator of LIBOR announced that they're going to consult on its intention to cease one-week and two-month dollar LIBOR at the end of 2021, but that they will not cease publication of the remaining US dollar LIBOR benchmarks till the end of June 30th, 2023. What are your thoughts on this announcement, and how is it changing transition going forward?
In my opinion, I think it's good news since it allows the next 18 months to deal with the tough US dollar LIBOR legacy issues. And what I mean by tough legacy issues is, I'm talking about specifically cash products. I mean, the derivatives are taken care of by the ISDA fallbacks in the protocol process. But there's a lot of cash products, floating rate notes, securitizations, loans, et cetera, that need to be renegotiated or re-papered, and that takes a lot of time.
So what this allows the market to do, is it allows the next 18 months to basically take care of that. It also allows people to focus this year on making sure that they have new products that reference alternative reference rates, not LIBOR, allows you to focus on getting the systems up to date, so you can really start transacting in these new rates.
The other aspect obviously is by extending the date by 18 months, it reduces the amount of legacy transactions, because as every day, there are contracts that mature. However, given this change, I think it's important that market participants don't also take their foot off the gas. There's still a lot of work that needs to be done, but it really allows the market to focus on creating those new products and starting to transact away from LIBOR. It is expected that no new US dollar LIBOR exposure will be entered into past the end of 2021. So that date in fact has not changed. It's really focusing on the legacy book.
I understand. I think the whole market spent a lot of time talking about the LIBOR currencies. Canada's kind of been a little bit lost in the shuffle. So how are these ISDA IBOR fallbacks impacting organizations with exposure to CDOR?
Well, I would say that the good news is that ISDA included CDOR in their fallback work. And what I mean by it's good news is that should CDOR ever cease to be published, we have robust fallbacks in place. So currently, it's not necessarily that we need... We need them, but they will be there. However, as you're aware, Refinitiv has announced that the six and 12 months CDOR settings will be stopped as of May of this year. So in fact the ISDA fallbacks will be used for those tenors, although the derivative exposure is minimal. So this is really a test-run for LIBOR. But I would say that Canadian market participants should be aware of firstly, that they do have new ISDA fallbacks, and over time, making sure that the systems are capable of handling those fallbacks should the key one, two, and three-month CDOR tenors disappear.
Okay. So does that mean that the shorter dated CDOR tenors will continue to be published beyond the end of 21, or even the end of 23, or middle of 23, you'll say?
Well, there's no timeline at the moment for CDOR publications to cease, and here I'm talking about the ones, twos and three month CDORs. As I mentioned, the six and twelve month tenors will disappear. But as I mentioned earlier, CARR's mandate has been expanded to include a review of CDOR, and make recommendations based on that review, to make sure that Canada has a robust benchmark regime. So we still have to do the review, and we hope to have that completed with recommendations by the end of Q2 of this year.
And then depending on the recommendations, we'll have a white paper out by the end of the summer of this year. So it's not clear that those tenors will continue to be published, but it's also not clear that they will not. So let's do the work and do the full review, and then see what happens. But just, just looking at other jurisdictions, I mean, other jurisdictions are looking at the same thing. The market has evolved, some of these benchmarks are well passed their best-by date, they've been around for 20, 30-plus years, and they need to be reviewed because the underlying market has changed.
Got you. I mean, it feels like the dollar market's going one way, maybe cash markets, bond markets could potentially go another way. Do you see a scenario where derivative start using CORRA, but maybe non-derivative products in Canada could stay on CDOR?
That's the big question globally, on whether there is a need for credit-based benchmark in addition to a risk-free rate benchmark. So it's not just a question for Canada, it's being discussed in other jurisdictions. And in some jurisdictions, the answer seems to be no. So for example, in the UK, they seem to be moving only to having a risk-free rate, SONIA, and don't see any need for a credit-based benchmark. The same is true for Switzerland, where they're relying on their recipe rate, which is SARON.
However, there's been a lot of discussion south of the border in the US, with respect to a credit-based benchmark. Obviously there's been developments. We've got a few administrators globally looking at a US benchmark. The IBA is looking at bank yield index, Bloomberg is developing one. We have an overnight credit-based benchmark being developed in the form of AMERIBOR. So I think you're going to see some jurisdictions live with just one benchmark, which is the risk-fee rate, others will potentially multiple benchmarks. But I would say that in general, the discussion for the need for a credit-based benchmark really relates to kind of banking products, specifically loans, including revolving credit facilities.
This is most probably true for CDOR or Canada as well. It's not clear that you necessarily need a credit-based benchmark for floating rate notes. We've seen in the UK, they're using SONIA and they're using SONIA in arrears. I think the one big question again, that CARR will be looking at is, if you don't have a credit-based benchmark, do you need a term rate for the risk-free rate, as well as the overnight rate?
Right. And sort of extension of that topic, but I think one that has to be asked. Do you see that CORRA's replacing CDOR as the benchmark for interest rates in Canada?
Yes, I do. I do believe that CORRA will eventually replace CDOR as the predominant benchmark in Canada. So currently, there's roughly 85 to 90% of the exposure that relates to CDOR, the balance to CORRA. And here I'm excluding any exposure to the various bank primes. I expect this to fully flip, so that CORRA will account for 85 to 90% of the exposure. Most of this obviously is derivatives, i.e interest rates swaps, and then the CDOR or some other credit-based benchmark making up the balance, but primarily in loan products.
Obviously the speed at which this happens is somewhat dependent on how quickly the US flips from USD LIBOR dissolves. Because that's going to be driving the transition globally, not only in Canada. But even in euros, where they're continuing to have EUROIBORs as the credit-based benchmark, they will also start using their Euro short-term rate much more actively as USD LIBOR disappears.
Well, thank you, Harri. I appreciate you joining me for today's discussion on LIBOR transition. There is a tremendous amount of interest in the topic, and we'd love to have you back for another conversation at some point in time.
Thanks for including me in this, happy to come back at any point in time. I think this is the biggest thing that's happened in my career in the financial markets. We are changing the plumbing, not owning Canada, but globally in the financial system. This is important. So happy to come and speak at any point in time. And I would just like to encourage market participants to go and follow what's happening in Canada on the CARR's website, which can be found at the Bank of Canada's website.
Great. We'll push that ourselves. And if anybody has any follow up questions, I'd encourage you to reach out to your RBC capital market sales person. I just want to say thank you to everybody for listening, hope you found this session useful.
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