As the 2021 deadline for the cessation of LIBOR approaches, two key milestones for the LIBOR transition in the derivatives space are set to occur in the second half of 2020. These are the SOFR discounting switch and publication of the ISDA Protocol and Supplement amending the 2006 ISDA Definitions. Market participants anticipate that these changes will continue to increase risk-free rate (RFR) trading volumes and address liquidity concerns.

SOFR discounting switch

In October 2020, major central counterparties will change price alignment interest and the discounting index for all cleared USD interest rate swaps from fed funds to SOFR. This migration was identified by working groups as being key to driving liquidity in SOFR-linked products, and market participants hope that this will lead to a ‘big bang’ in the trading of SOFR-linked swaps.

ISDA Protocol and Supplement amending the 2006 ISDA Definitions

ISDA intend to publish a supplement to the 2006 ISDA Definitions, after which all new transactions incorporating the 2006 ISDA Definitions will include fallbacks that will apply upon the permanent cessation of certain IBORs, and upon an announcement of LIBOR ceasing to be representative. ISDA will also publish a protocol to facilitate amendments to incorporate these updated 2006 ISDA Definitions into legacy derivative contracts. Though no definitive date has been provided for these publications, they are anticipated within the coming months.

Liquidity Concerns

Despite the positive trend of trading volumes in RFR-linked interest rate derivatives (IRD) shown in Q1 2020, there is still concern among market participants that significant progress needs to be made to meet the end-2021 deadline. Whilst SOFR-linked IRD traded notional rose 68.9% in Q1 2020 compared to Q4 2019, the traded notional only amounted to $280.4 billion, compared to $35.89 trillion in USD LIBOR-linked IRD. While the SONIA swaps market is much more liquid, the slow uptake of SOFR-linked swaps is a concern, and market participants are hopeful that trading volumes will accelerate in the second half of 2020.  This concern was echoed by ISDA’s Chief Executive, Scott O’Malia at the ISDA/SIFMA AMG Benchmark Strategies Forum in February 2020, who noted the short-dated nature of many RFR-linked swaps in the market. For example, 96.5% of the SONIA-linked IRD traded in Q1 2020 had a tenor of up to one year. He went on to say that it is hoped that the implementation of the above changes will start addressing these concerns.

That being, whilst these are significant milestones for the LIBOR transition in the derivatives market, whether they will succeed in providing the desired liquidity for RFR-linked derivatives remains to be seen. An increase in liquidity will ultimately depend on completion by market participants of their internal and operational policies.

Please contact any of the authors of this briefing or your regular McGuireWoods contact if you have questions about, or would like assistance with, the LIBOR transition.