Why investors must face up to Libor’s demise
When the death sentence for Libor was first announced, investors’ initial reaction was: “If it ain’t broke, don’t fix it.”
But clearly the scandal-ridden benchmark is broken.
By any measure, shifting the US market off Libor and over to Sofr — the secured overnight financing rate — is a tough task, broader in scope and complexity than the conversion to a single currency in Europe in 1998, preparation for Y2K or the adoption of post-crisis regulatory reforms such as the Dodd-Frank Act, or Basel regulations on bank capital, to name a few. Maybe it is regulatory fatigue, a resistance to change, or sheer apathy, but investors have been slow to embrace the new benchmark.
They must. After all, the switch affects the $200tn interest-rate derivatives market and $10tn of cash products — floating rate notes, mortgage-backed securities and other securitised products, syndicated loans, student loans and structured notes.
Regulators on both sides of the Atlantic have been explicit that it is not a question of if, but when Libor ceases to exist, especially because the infrastructure behind it is decaying. Given dwindling daily volumes of interbank transactions, panel banks compiling Libor often derive their submissions based on judgment, rather than on actual deals. In the most popular tenors, one month and three months, ICE’s quarterly volume reports show most volumes are based on market data points, rather than transactions.
So why the resistance to change? Two key features underpin Libor’s appeal to investors. First, Sofr is not a precise replacement. Libor, for all of its faults, is an unsecured term rate that is set in advance. Investors know what the rate is for the next three months, providing certainty on cash flows at the beginning of the compounding period. In contrast, Sofr is a secured overnight rate traded in arrears, meaning cash flow payments for a compounding period are derived from averaging daily Sofr rates over that tenor. They are therefore determined at the end of the period.
Second, as Libor is viewed as reflecting interbank borrowing costs, a credit component is embedded in it. In contrast, Sofr is derived from overnight US Treasury repo transactions and is more akin to a pure risk-free rate. In past credit crises, three-month Libor tended to diverge from other risk-free rates, with that spread acting as a hedge for investors seeking to protect themselves against deteriorating credit conditions.
A lack of understanding of the dynamics of the overnight US Treasury repo market is making the transition even more complex. The choice of a secured rate in the US, but an unsecured rate in the UK and other jurisdictions, has implications for other traded instruments, such as the cross-currency basis, which is the premium paid for swapping into a currency in demand. Solutions for addressing these issues have not been finalised.
Recent market volatility around month- and quarter-end has fuelled scepticism over the broader adoption of the new benchmark. Further, the costly regulatory reforms of the past decade have left little appetite to expend time and resources on the transition.
Ultimately, the main hold-up for broader adoption, at least in the derivatives markets, is the slow take-up of Sofr swaps and futures. With substantial liquidity in the existing derivatives contracts linked to Libor, there is little incentive to try something new. Many financial institutions are waiting for the publication of a Sofr term rate covering set periods of time, as outlined in a transition plan from the Federal Reserve’s Alternative Reference Rates Committee.
Again, though, that is problematic. A term rate can work only with adequate volumes and liquidity in derivatives markets — a classic chicken and egg problem. For its part, the ARRC has not guaranteed that it will publish such a rate. Its message is clear: do not wait for the creation of a sustainable term rate to begin work on switching to the new benchmark.
The clock, after all, is ticking. After 2021, the UK’s Financial Conduct Authority will no longer require panel banks to support Libor.
While efforts are under way to introduce new Libor-like alternative benchmarks, such as the ICE Bank Yield Index and CBOE’s Ameribor, the ultimate success of competing benchmarks will depend on their compliance with principles set down by the International Organization of Securities Commissions. History shows that there is little appetite for multiple benchmarks and investors will probably gravitate towards the one measure that is broadly adopted.
The 2021 deadline seems aggressive, given the scope and magnitude of the global transition effort and the fact that transitioning some of the more complex legacy products is likely to be extremely challenging.
But, like it or not, change is coming. Investors had better be prepared.
Subadra Rajappa is head of US rates strategy at Société Générale in New York
Letter in response to this article:
Revive an interbank market that functions / From Patrick Berryman, London N10, UK
Gloss