Because credit lubricates the machinery of just about every aspect of the financial industry, figuring out how to manage the looming retirement of the interest rate benchmark known as the London Interbank Offered Rate (LIBOR) has moved to the front burner for many firms as they head into 2020.
Although LIBOR will not completely disappear from the market until the end of 2021, the need for an end-to-end credit rethink – from examining all documentation that refers to LIBOR, incoming and outgoing loans, client arrangements, and a deep dive into a panoply of risk functions – means that the process must be well underway before the deadline nears.
Complicating matters for market participants, LIBOR is the interest rate benchmark used to price mortgages, credit card rates, and an estimated $300 trillion in fixed-income derivatives, and while LIBOR is sure to go away, no single replacement rate has been agreed. Instead, five so-called risk-free rates, which might more accurately be termed "nearly risk-free rates," have been developed.
Among the five, the main contenders are the Secured Overnight Financing Rate (SOFR), which the Federal Reserve introduced as a LIBOR alternative in the US and the Sterling Overnight Index Average (SONIA).
LIBOR is calculated from a daily survey of 20 leading banks in London, which left the process open to a rate-fixing scandal. SOFR, on the other hand, is based on Treasury overnight repurchase agreements, or repos, while SONIA is calculated by the Bank of England from interest paid on Sterling one-day deposits.
The Federal Reserve has been pressing financial firms aggressively to adopt SOFR as soon as possible. Federal Reserve Bank of New York President John Williams has expressed concern that firms were dragging their heels in transitioning to the new benchmark. “I don't always sense urgency among market participants on this issue,” Williams said. “Tellingly, contracts referencing US dollar LIBOR, without robust fallback language, continue to be written” he said in an August 2019 speech.
To ensure the transition moves ahead, the US government has started flexing its considerable muscle to promote adoption of SOFR. Mortgage guarantee agency Fannie Mae has issued $6 billion of SOFR-linked bonds and the Federal Housing Finance Agency, which regulates Federal Home Loan Banks, said the institutions shouldn't issue new financial instruments tied to LIBOR after the first quarter of 2020. The 13 banks have about $221 billion in outstanding LIBOR-connected notes.
SONIA is also getting attention, with the European Investment Bank issuing a £1 billion SONIA-linked bond, the first SONIA-linked floating rate note. The bond provides for quarterly interest payments at the compounded daily Sonia-rate plus 35 basis points per year. The World Bank also has issued two SONIA-linked £1.25 billion bonds.
In preparation for the transition to risk-free rates, the Financial Stability Board, the international financial monitor set up in the wake of the Great Recession, called on the International Swaps and Derivatives Association (ISDA), the derivative industry's trade body, to add what it termed a “pre-cessation trigger” into contracts for derivatives that still reference LIBOR. The reasoning is that if LIBOR ends for some reason prematurely, derivatives should be switched to the risk-free rates.
Drawbacks of replacement rates
One problem for many financial institutions is that the new risk-free rates are backward-looking interest rates, while LIBOR is a term rate for seven different maturities with a built-in term credit risk premium, which risk-free rates do not contemplate. As a result, finding the future cost of loans and derivatives is more problematic using the risk-free rates, which are composed of synthetic terms based on three-month averages of the overnight rates.
Because of this complexity — the final interest rate is often not known until after the term has expired — financial firms need to understand what this sea change actually means for their business. So far the industry approach to products based on the new benchmarks has been cautious.
For example, the Eurodollar futures market is a bet on future interest rates paid on dollar deposits outside the US. Many firms use these derivatives to hedge against interest rate swings, but without a term rate, that will be more difficult. The Chicago Mercantile Exchange has started issuing Eurodollar futures based on SOFR, but there has been limited uptake by investors so far.
SOFR's implementation hit a temporary snag in September 2019 when turmoil in the US money markets prompted the repo rate to spike, causing SOFR to reach 5.25 percent temporarily before the Fed intervened by injecting cash into the market. It was an alarming lesson, causing some market participants to avoid SOFR-linked debt, at least temporarily.
An urgent need to focus on risks
As part of the preparations for the transition away from LIBOR, regulators are asking financial firms to demonstrate their readiness to make the change. In a letter to the CEOs of major banks, the UK's Financial Conduct Authority (FCA) and Prudential Regulation Authority asked that that firms' senior managers and boards “understand the risks associated with this transition and are taking appropriate action now so that your firm can transition to alternative rates ahead of end-2021.”
Perhaps because the changeover has its roots in the LIBOR scandal, the UK's FCA is also trying to get firms to focus on conduct risk – behavior that might harm customers or have a negative effect on the financial system during the transition. For example, it is trying to ensure that clients don't get overcharged for the new rates. The acid test, as FCA Chief Executive Andrew Bailey puts it, is whether firms are seen to have done right by their customers.
“For many, LIBOR transition will impact their overall business strategy and front-office client engagement, rather than being a narrow legal and compliance risk,” the FCA said. “Potential impact and risk therefore needs to be considered and addressed in an appropriately coordinated way across a firm.”
If LIBOR transition isn’t incorporated into project planning for 2020 it should be. As we described, regulators are keen to see some demonstrable progress from firms with clear evidence of strategic planning. The closer we get to 2021, the date from which the FCA will no longer compel banks to maintain the LIBOR rate, the less integrity associated with LIBOR. Alternative rates will start to increase in prominence, liquidity, and infrastructure, and therefore should start to look more viable.
However, this move is a process, not an overnight deliverable, as so many areas of a firm’s business are involved in the transition. In order for a successful transition, this move needs careful global choreography to avoid pitfalls attendant to international regulatory arbitrage. The first step is to determine which benchmark to rely on. SONIA has been in existence for long enough to prove a credible alternative for sterling, but it will remain to be seen whether the US dollar replacement SOFR can win the confidence of the critical mass. Whatever it takes for issuers, lenders, borrowers, and other users of LIBOR to get comfortable with the benchmark alternatives, one thing is for sure – they must find an alternative.