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Early Libor Shift for Derivatives Is Weighed by Clearing Houses

William Shaw and Alexandra Harris
·3 min read

(Bloomberg) -- Global clearing houses are considering whether to shift trillions of dollars of interest-rate derivatives away from the London interbank offered rate weeks before the benchmark expires.

LCH Ltd. is consulting clients about an exit strategy for swaps before the possible retirement of multiple Libor benchmarks at year-end, according to Phil Whitehurst, head of service development, rates at SwapClear, which is part of the firm. CME Group Inc. opened a similar consultation on Thursday.

The proposals could address limited progress to replacement rates in the derivatives industry. LCH alone has approximately $150 trillion outstanding of swaps, basis swaps and forward rate agreements still referencing Libor. As clients make their own transition plans those numbers may fall, yet there’s no guarantee it will happen without a push.

“It’s an event we would be using to sweep up the population of outstanding Libor trades,” LCH’s Whitehurst said in an interview.

LCH could carry out a switchover in late November or early December for some Libors, Whitehurst said. Key dollar Libor tenors could run on until mid-2023, yet competing constraints on swap market liquidity might mean LCH has to act sooner, according to a person familiar with the matter, who declined to be named given the sensitivity.

The move could protect companies from turbulence during tight liquidity in the final days of Libor, if firms rush for the exit.

It echoes the so-called big bang in October, when clearing houses switched swaps to the secured overnight financing rate, the main U.S. Libor replacement, for the purpose of determining their value. The reset saw SOFR replace the effective federal funds rate and was part of a push to make it a standard U.S. reference rate.

Clearing houses are now planning a full transition from a rate that’s been undermined by manipulation scandals and a shortage of trading data to inform its setting.

“We know Libor cessation is a challenge for everyone,” Whitehurst said. “We’ve had some big events already such as the discounting switches. They do involve work for all involved but we think they represent the best possible outcomes.”

The clearing houses propose overseeing a compensation system, where they distribute cash from clients who benefit from changes to those who lose out.

Both firms will also be using the International Swaps and Derivatives Association’s Libor protocol, which contains standardized contractual language to help clients automatically transition. The protocol will help firms avoid complex renegotiations with counterparties but will only enable a shift to new rates at the moment Libor dies. A clearing house switch meanwhile would let firms get out early.

LCH’s proposal “will provide greater simplicity for market participants than only relying on ISDA’s fallbacks,” Whitehurst said.

Analysts say clearing houses are well placed to help after the big bang -- a major logistical undertaking -- proceeded smoothly. LCH switched $120 trillion of contracts and CME switched $7.2 trillion in cleared swap products during the market reset. Warnings of unruly price action proved off the mark.

“There’s still some uncertainty around the last few weeks before Libor dies,” said Marcus Burnett, director of SOFR Academy, an education technology firm whose clients include banks and asset managers. “Standardizing the mechanisms for the transition where possible generally makes sense.”

(Adds context on ISDA protocol from 11th paragraph.)

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