Concerns Related to the Impending Replacement of LIBOR
Concerns Related to the Impending Replacement of LIBOR
Ernie de Lachica, CPA, CGMA
On June 22, 2017, the Alternative Reference Rates Committee (“ARRC”) selected the Secured Overnight Financing Rate (“SOFR”) as their final choice to replace USD LIBOR past calendar year 2021. At present, LIBOR is the most widely used benchmark on the globe as it is used in a wide variety of financial products such as mortgages, corporate loans, government bonds, credit cards, as well as for a variety of Eurodollar and interest rate derivatives. As LIBOR presently underlies assets that are estimated to total more than 350 trillion dollars in notional amount, the undoing of these products is expected to be extremely complex and fraught with challenges.
What is LIBOR and what is SOFR?
LIBOR is the most widely used benchmark interest rate today and is meant to reflect the rates by which the world’s largest banks charge each other for short-term loans, effectively defined as an Interbank Offering Rate (“IBOR”). LIBOR, which is the acronym for the London Interbank Offering Rate, is published across five currencies and seven maturities by the Intercontinental Exchange Benchmark Administration and is based on daily submissions by contributor banks.
SOFR is a comprehensive measure of the cost of borrowing cash, which is based on transactions in the overnight Treasury repurchase market and is widely considered as representative of the general funding conditions in the repo market. Rates such as SOFR and the Overnight Index Swap Rate (or “OIS”) are termed Alternative Reference Rates (“ARR”). SOFR is published by the Federal Reserve Bank of New York and is supported by the broadest measure of transactions in comparison to any other Treasury repo rate available today.
What are some of the valuation hurdles that are expected in this transition?
The most apparent obstacle that has surfaced in transitioning from LIBOR to SOFR is that LIBOR is a term-based rate whereby SOFR is an overnight rate. As the structures are fundamentally different, trying to convert from an overnight rate to a term structure is going to require that a projection method be developed. The consequences of making this conversion to already existing contracts is going to create unforeseen value transfers as an equivalent rate may not be that equivalent.
Second, modeling complexity is most likely going to increase as various techniques are going to be needed to perform calculations that were considered mainstream in the past. Techniques that will include a multi rate environment and curve building and development are all going to become more relevant. For example, curves and bases for dollar denominated instruments will need to be modeled in LIBOR, OIS and the new ARR. If multiple currencies are added, the modeling approach will expand exponentially. This will lead to increased complexity and modeling risk.
The final obstacle worth mentioning is that no comparable history currently exists for many of these new ARRs, which will make back-testing almost impossible. As a result, data that is presently relied on to calculate volatility and convexity is going to need to be created. In addition, until new products are traded with increased frequency, implied data also will not exist. Hence products such as options, swaptions, etc. will be difficult to value.
What should users be doing to prepare for this transition?
All indications lead us to believe that a transition from LIBOR to SOFR is going to take place. The questions that are more uncertain are when it will take place and how it will unfold. At present, there are various pieces that are beginning to take shape.
First, various groups, such as the International Swaps and Dealers Association (“ISDA”), have been taking a more active role in the transition by focusing on fallback language and protocols for derivative products. From a recent consultation, the ISDA has been crafting language to be implemented for new and existing LIBOR based instruments, thereby lessening the impact of a disruption should a triggering event, such as LIBOR cessation occur.
The other supporting event that has occurred is the advent of 1- and 3-month SOFR futures trading on the CME and the recent initialization of trading of SOFR swaps. Albeit, liquidity is limited on some of these instruments at present, comments regarding how the instruments were received has been positive and volume has been steadily increasing. The hope is that increased trading in these products will provide enough liquidity to achieve critical mass and to address pricing over the entire yield curve in less than two years, making the transition from LIBOR to SOFR more plausible.
All these positive steps do nothing to diminish the need for preparedness and planning, which should already be taking place. Recent surveys indicate that many companies are taking a wait and see attitude or are expecting the markets to sort it out prior to getting involved. This posture has many concerned in that it will only intensify the tipping point when it does arrive.
Companies should already be underway, or at least in the initial stages, with focusing on this topic. This would include performing a risk assessment and taking inventory of all of the current IBOR-based instruments in your portfolio, performing an assessment or impact analysis on the identified instruments to understand the potential exposures, formulating a transition plan that is to be implemented (including the implementation of fallback language and possible scenarios) and establishing policies and procedures to address the process on a go forward basis.
What is the expectation regarding whether LIBOR will remain after 2021?
Obviously, the magnitude of converting from an index that is so widely used to one that is still in its infancy is daunting, which is why this question is presently being vigorously debated. There are numerous individuals that believe the timetable to make this transition is unrealistic and that LIBOR will continue onward but will be phased out slowly. This approach would have us believe that the transition period is going to be lengthy, whereby as LIBOR based instruments terminate or mature, they would be replaced with new ARR products going forward. If this were to occur, LIBOR could continue for many years as many LIBOR-based instruments have longer term structures; some extending out 10 or 20 years. Although deadline extensions are possible, it is hard to believe that they will encompass longer tenors so many existing instruments will need to be renegotiated, converted or terminated.
The approach that was initially envisioned for this transition was more voluntary in nature and was meant to take place in stages. Once an ARR was identified, new products would be created for this ARR, which would allow banks and other firms to start marketing these products to potential clients. As the products became more widely accepted, the liquidity would increase thereby setting up a circular effect. More liquidity would mean more products, which would mean more liquidity. This approach would also provide the needed impetus for the infrastructure to handle this new market.
Our expectation for reality lies somewhere between the two approaches outlined above. We can understand that LIBOR may need to be extended as new markets come online. This is definitely possible, but once markets reach a certain stage, it is conceivable that banks will limit or stop offering LIBOR-based products as they may be too fraught with risk. The end result will be that markets will hit a tipping point where LIBOR products may exist one day and be gone the next.
What are the differences between LIBOR and SOFR?
There are numerous differences between the two rates, but the foremost difference is the tenor of the instruments themselves. IBORs are instruments that are based on multiple rate tenors (such as 1, 3 or 6-month durations) that form the basis of the term structure, where ARRs usually are much shorter in duration and do not have this type of structure. The consequence of this difference is that IBORs carry additional risk as a result, whereby ARRs are much more cash oriented and are truly more risk free.
As such, IBORs tend to include some degree of inherent credit risk, which is captured as part of the rate structure. Since ARRs are very short-term in nature and truly more risk free, they tend to be devoid of this additional risk. There is clear evidence of this during the financial crisis whereby the LIBOR to OIS spread spiked to 350 basis points upon lending concerns that were raised by banks.
What is the basis for switching away from LIBOR to another benchmark index?
Since the financial crisis, the continued existence of LIBOR has become more tenuous. Various reasons have been cited but the concerns are primarily focused on the lack of transactional data underlying LIBOR, the reduced credibility of the LIBOR setting process because of recent scandals, and the reticence of member banks to continue making LIBOR submissions. All these factors have compounded the need for a replacement.
Why is SOFR a good replacement for LIBOR?
SOFR is a widely used measure of short-term borrowing collateralized by treasury securities. As it underlies a repo market with more than $700 billion in daily transactions, there is transactional data that widely supports the published rate, which is very liquid.
LIBOR, on the other hand, is very thinly traded and is subject to a panel of banks that provide their submissions on a daily basis. The actual trading activity for LIBOR has diminished considerably over the last few years with actual interbank loans at the wholesale banking level numbering 15 actual transactions in the most recent year.
As banks have grown more cautious about providing submissions, the number of banks participating has also begun to dwindle. Recently, the Financial Conduct Authority (or “FCA”) had to exercise their authority to compel banks on the LIBOR panel to continue providing submissions. The FCA also let panel banks know that they would not require them to continue making submissions past 2021. This means that member banks are going to continue for the meantime but are expected not to continue supporting LIBOR submissions soon.
Although this transition is not expected to occur for some time, the sheer magnitude of this transition, the extent of the interaction with a vast array of instrument types, and the complexity of the hurdles that are just now surfacing are all going to require time to be properly addressed. The focus is to begin getting prepared as it will be here sooner than we think.