A series co-authored by Lara Rhame, Chief U.S. Economist at FS Investments, and Tal Reback, Principal at KKR
LIBOR reform has been in the works for years, and key milestones this fall will push the process significantly further along. In this note we refresh the basics of LIBOR, discuss why market disruptions have not derailed the multiyear plan to leave LIBOR, and detail what‘s next for the overnight funding market.
- LIBOR reform is on track: LIBOR will be going away by year-end 2021.
- Market dislocation in Q1 2020 reinforced the urgency of LIBOR reform.
- Near-term market catalysts will push LIBOR reform further down the path.
- Look for ISDA’s protocol announcement, which will heavily impact the LIBOR-based derivatives market.
The London Interbank Offered Rate (LIBOR) is the benchmark interest rate for hundreds of trillions of dollars of global financial transactions. In other words, it’s like salt – it is not much of an exaggeration to say that it’s in everything – and it’s going away at the end of 2021. (See Leaving LIBOR for a broader overview). The long-awaited benchmark rate reform has been planned for years, but as 2020 draws to a close, the planning around the LIBOR transition has gone from theoretical to tactical. The stakes are high; a smooth transition is vital for broader financial stability. Several market triggers are occurring soon that will push us further down the path of this widespread transition.
LIBOR was created to reflect the rate at which major global banks can lend to one another. Hundreds of trillions of dollars of financial transactions – including business loans, derivatives and home mortgages – tie back to the daily survey results of 11–16 large international banks, who make the submissions that are ultimately used to calculate rates at different maturities. Herein lies the problem: This survey increasingly reflects “expert judgment” rather than what the rate was initially meant to track – real wholesale funding transactions. Indeed, the amount of interbank lending is only about $500 million per day, less than 0.5% of total U.S. commercial bank assets.
Amount of money tied to LIBOR, by category
Source: Alternative Reference Rates Committee, as of September 30, 2020.
The market dislocation of early 2020 made the need for a LIBOR replacement increasingly evident. The survey results below, shown for 3-month LIBOR, make clear why depending on a survey instead of a transaction-based rate is problematic. The survey results showed exceptionally wide dispersion, indicating that within the surveyed (or panel) banks, there was increased uncertainty about what interest rate correctly reflected interbank lending risk.
Dispersion of LIBOR 3-mo. panel submissions
Source: ICE Benchmark Administration, as of September 15, 2020.
This highlights the inherent shortcomings of relying on opinion or models, rather than representative transactions in the market, to determine interest rates. As a reference rate, the hundreds of billions of daily transactions that reference LIBOR are increasingly disconnected from the market the rate aims to represent. At its worst, like during the financial crisis of 2007–2009, LIBOR was subject to manipulation. Even when that is not a core problem, the need to transition to a rate that is transparent and transaction-based was reinforced by rate movements in early 2020.
SOFR will be the new LIBOR (in the U.S.)
Benchmark reform has been years in the making, and in the U.S. it is guided largely by the Alternative Reference Rates Committee (ARRC), a group made up of experts from the private sector, the Federal Reserve system and other banking and financial regulators. The expertise and perspective of this encompassing group is critical, because replacing LIBOR is exactly as complex as it sounds. In 2017, the ARRC identified that the secured overnight funding rate (SOFR) would be the recommended U.S. dollar LIBOR replacement rate. Other alternative reference rates have been identified for each currency that LIBOR is published in: GBP, EUR, CHF, JPY and USD.
SOFR differs from LIBOR in several ways. Critically, it is a market-determined rate that tracks transactions in the Treasury repurchase (repo) market. This was one of the key qualifications for LIBOR’s replacement. It is entirely transaction-based, rather than model-based, and as such, it more accurately reflects the cost of secured lending and borrowing in the overnight market.
Key differences of SOFR vs. LIBOR
|Determined by||Transaction-based calculation||Expert judgment/survey|
|Risk profile||Risk free||Credit risk|
|Term structure||Overnight rate||Term rate|
There are important differences between SOFR and LIBOR. SOFR is a risk-free secured rate because the underlying transactions are collateralized by Treasury securities. Because the underlying transactions are backed by an essentially risk-free asset, the rate does not include a credit component, whereas LIBOR reflects bank credit and liquidity risk. For this reason, the LIBOR rate is typically higher than SOFR.
This difference caused yields to diverge notably during the acute market volatility seen in early 2020. LIBOR surged in April as uncertainty surrounding bank credit rose, even as central banks slashed short-term rates.
LIBOR and SOFR rates
Source: Bloomberg Finance, L.P., FS Investments, as of September 19, 2020.
SOFR has passed the stress test
SOFR passed a critical test during the financial disruption of early 2020. Remember, overnight funding markets are the circulatory system of financial markets – and they have notoriously “frozen up” with poor liquidity in times of financial stress. This tips a financial market environment from scary to downright panic, as we saw in 1998 and 2008, because the overnight funding market is truly the lubricant that keeps our financial system working.
SOFR daily transaction volume
Source: New York Federal Reserve, as of September 15, 2020.
In 2019, as the ARRC and key market constituencies coalesced around SOFR as the most likely replacement rate, daily trading volume in the Treasury repo market steadily grew to over $1 trillion.
In early 2020, daily volume increased during the worst periods of financial market volatility, and it has remained steadily above $900 billion per day. This dwarfs transactions in the interbank lending market – the basis for LIBOR calculation – which generally total only about $500 million per day. In other words, liquidity in the repo market remained robust even in times of market stress.
Increasingly, the focus will turn toward the development of the SOFR futures market, which is still developing. While issuance of SOFR – denominated securities like floating rate notes has risen steadily, activity in SOFR derivatives and futures remains contingent upon a few key near-term catalysts. These market catalysts are rapidly approaching, including a change in how the vast majority of derivatives are priced, which could prove critical in enhancing liquidity in the SOFR market.
Near-term market catalysts
The bulk of LIBOR-benchmarked transactions are derivatives, and many have maturities of less than one year. In mid-October, the CME – the largest global derivatives exchange – and the London Clearing House will each switch from discounting cleared interest rate swap products that reference USD LIBOR to using SOFR. Some of the most common uses of LIBOR as a benchmark are to allow banks and companies to manage interest rate risk by swapping floating versus fixed interest rates, using forward-rate agreements, and overnight index swaps (to name a few). In the past, the Fed funds rate was used to discount expected future cash flows in order to mark these products to market. As of close of business on October 16, these firms will have to adjust how they manage discounting USD risk, which will now be tied to SOFR.
The expectation is that this move will help deepen the SOFR derivatives market, as market participants would subsequently need to manage risk denominated in SOFR. In short, this key milestone will help push LIBOR benchmark reform across the rubicon.
The second catalyst will take place imminently. On October 23 the International Swaps and Derivatives Association (ISDA), an umbrella organization that manages markets for private negotiated derivatives, will issue its final amendments to protocols for fallback language which will address how existing derivatives contracts will deal with the cessation of LIBOR. At that point, swap parties will be able to adhere to this protocol, which will incorporate SOFR into fallback language for the existing swap contract.
SOFR adoption has gained steam in 2020. Two upcoming market catalysts are expected to deepen the liquidity of the SOFR derivatives market.
Derivatives make up the bulk of financial contracts that reference LIBOR, and the new ISDA protocol will formalize transition fallback language for much of the huge OTC derivatives market. Therefore, despite its share of the market, this part of the transition is expected to be prescriptive and formulaic, which will likely make the switch for derivatives more programmatic compared to several other asset classes.
Tracking the transition
The herculean task of transitioning away from LIBOR is already further along than many realize. The ARRC has long maintained a “paced transition plan” detailing a timeline that is expected to facilitate a smooth transition on several fronts. What many market participants may not be aware of is that much of the planning to effectuate the transition has already occurred, even as LIBOR continues to be used ubiquitously. It may be helpful to think of the transition along three paths: market, contractual and operational.
The operational transition is a critical prong of the move away from LIBOR, as the payments and settlement changes related to these financial instruments need to occur on a massive scale. Banks, financial institutions, clearing houses and exchanges have operations that need to be prepared to support SOFR and other alternative reference rates (for example, for British pounds sterling, SONIA is already in use) by the end of 2020, a full year ahead of the planned phase-out of LIBOR. Think Y2K, only larger. The good news is that these institutions have worked with the ARRC to create these industry timelines and have been investing in this operational readiness.
A large focus of the transition is now on incorporating fallback language into existing contracts and phasing out LIBOR for the various LIBOR-linked products.
Updating contractual language is also at the core of the LIBOR transition. Outside of the derivatives market, where maturities are short-term and language is more centralized by large governing organizations, many other markets are more disparate and bespoke. Language that specifies what the new reference rate will be and the conditions for making the switch – widely known as fallback language – is being updated to permanently address LIBOR cessation and is increasingly being incorporated into existing contracts.
For new contracts, the ARRC now recommends specifying the new replacement rate and disclosing it at least six months prior to the date of transition to the new rate; this is also known as hardwiring. The upcoming ISDA protocol in the derivatives market will address a significant portion of financial instruments, but not all. Despite the sheer size of the derivatives market, a generally centralized marketplace and clearing house makes the change easier.
Outside of derivatives, the heavy lifting on the contractual side will come from other financial sectors and products, which also impact trillions of dollars of transactions but are far from centralized. Residential and commercial mortgages, student loan debt, floating rate notes and business loans also frequently reference LIBOR, but they may not have any fallback language or automatic trigger for when to make the switch away from LIBOR – and certainly no reference to what the new rate should be. Some of these contracts are decades old, and clearly there is increased risk that regular resetting of rates could be quite disruptive when, suddenly, a benchmark LIBOR rate is no longer available.
In accordance with the ARRC’s best practices, an industry timeline has been created encouraging various asset classes to adopt hardwired language, which can be applied to new contracts as well as amending existing contracts. The objective of hardwiring language is to help facilitate a smooth transition between reference rates with a prescribed approach. Given the amount of uncertainty that exists in today’s environment, hardwiring contractual agreements enables parties to plan for the future state, cash flow wise and operationally, while also providing efficiencies for when the market experiences a cessation trigger. The goal of hardwiring is to make an upfront determination that aligns with both assets and liabilities, enabling appropriate transition risk management.
|Product||Contractual amendments to include LIBOR fallback language||Target LIBOR
Floating rate notes
Syndicated loans: 9/30/2020
Bilateral loans: 10/31/2020
Student loans: 9/30/2020
3–4 months after ISDA amendments are published
Source: ARRC Recommended Best Practices for Completing the Transition from LIBOR, as of September 30, 2020.
Note: Anticipated fallback rates for floating rate notes, business loans and securitizations to be identified by 6 months prior to reset after LIBOR’s end.
With respect to existing contracts, especially in cash products where there could be more variation among language and fallbacks, taking the time to understand the contractual mechanics as they stand today is an important first step in deciding how to move forward. As mentioned earlier, most derivatives will have the option to adopt the new ISDA protocol, and the industry has taken that methodology as precedent on how to guide fallback amendments for cash products as well. The objective was to keep assets and liabilities closely aligned to minimize any potential basis risk. Given that contractual LIBOR language exists in a myriad of products, forms and clauses, we perceive the shift in the derivatives market to be a positive tailwind toward guiding and helping inform future state decisions for all LIBOR-referenced contracts.
The upcoming shift in derivatives markets will be a game-changer. It is now clear that the LIBOR transition is happening and tactically needs to be addressed.
As a byproduct of the market catalysts soon to come in the derivatives market, we see the third prong of the transition as deepening the existing cash SOFR market and creating a futures market. An underappreciated yet fascinating part of the transition away from LIBOR is the creation – from scratch – of an entirely new financial market. Historically, futures markets develop because there is widespread demand for cash products; think of many companies who use oil every day looking to manage its future price, which organically created a futures market for oil. Now this is occurring in reverse, as futures and other derivatives are being switched to a SOFR discounted rate, which will cause companies, banks and financial institutions to manage their cash holdings of SOFR.
The long journey ahead: Further reading
These upcoming events are just the next phase of what will be long road. Yet the upcoming shift in the derivatives markets will be a game-changer. Markets have been hearing about LIBOR being discontinued for years, but it is now clear that this transition is happening and needs to be addressed tactically. After all, as 2020 winds down, we enter the last year of LIBOR, and there is still much work to be done to ensure a smooth transition. This undertaking is enormous in scope and unique in nature. Investors and advisors need to be aware of the transition, track its progress, and understand how it impacts markets, risks and portfolios.
We will address this in a series of papers. The next installment will be a deeper dive into SOFR markets, followed by specific papers on the impact of LIBOR benchmark reform on various asset classes.