In March, the U.K.’s top financial regulator, Andrew Bailey, addressed an issue that has plagued investors, consumer and corporate lenders and borrowers since plans were announced last July to move away from the benchmark for over US$200 trillion in loans and derivatives by 2021.
At a finance-industry confab in London, Bailey asked – rhetorically – what is to be done about the $36 trillion in legacy bonds, securities, derivatives, swaps and other Libor-based financial instruments that will mature when contributor banks are no longer required to submit quotes for the index?
Bailey, the head of the Financial Conduct Authority, acknowledged it may not be “practical or economic” to change reference rates on outstanding long-term, floating-rate instruments, and said the FCA supported the creation of a Libor “proxy” to stand in for the benchmark approaching its three-year exit window.
But can a “synthetic” rate be created that emulates Libor, derived from secured and potentially less-volatile benchmarks that the U.S. and U.K. are developing?
“I’m not sure,” Bailey said, answering his own question.
With just over three years to go, a shrug of the shoulders is about as good a response as any as to how financial markets will adjust.
The FCA is unwavering in its plan to stop requiring contributor banks to submit quotes.
In April, the U.S. Federal Reserve started publishing a new overnight repo funding rate designed to replace Libor for the swaps and derivatives market, but it is not suitable for longer-term assets. There are plans to develop a term rate replacement that is derived from the Secured Overnight Financing Rate (SOFR), but it will not be ready until the end of 2021.
The Intercontinental Exchange (ICE) Benchmark Administration, since 2014 the administrator of 35 Libor rates of various tenors and currencies, has vague plans to continue to publish some of the indexes, relying on voluntary submissions by banks.
“There is a lot of planning, a lot of modeling, a lot of thinking,” said Adam Schneider, a partner with the research firm Oliver Wyman who has consulted with financial institutions on plans to replace Libor as a benchmark for their long-term assets. “Not a lot of deciding at this point.”
Each alternative has its shortcomings.
A term rated derived from the SOFR passes a crucial test that the FCA has applied to a benchmark’s credibility: reality. SOFR is based on the nearly $800 billion in daily clearing activity in the overnight Treasury repurchase agreement market. By comparison, Libor is a benchmark derived from opinions, and increasingly less reliant on actual interbank, overnight lending transactions that have all but disappeared in the post-crisis era.
But any benchmark based on transactions that are essentially risk-free would not compensate lenders for the counterparty risk they are taking on when they lend to each other, to companies or to consumers. That’s a particular concern during times of market volatility, when Libor (or a suitable replacement) would be expected to experience bigger moves than an index based on U.S. Treasurys.
Oliver Wyman ran a comparison of spreads on the new U.K. overnight rate – the Sterling Overnight Index Average (or SONIA) – to the pound-based Libor, and found a wide-ranging difference in stressed periods of more than 400 basis points.
A possible fix is in the works. The International Swaps and Derivatives Association is developing a methodology that would essentially add a credit-risk spread premium to a SOFR-derived rate to make it work more effectively as a fallback standard for legacy Libor products. There appears to be broad support for these efforts. Advisory firm Chatham Financial managing director Todd Cuppia said the consensus is that the new SOFR-derived index “is going to be the one that wins the day” as the expected fallback language that most investors and issuers will agree to.
Even after such an index is developed, however, it must gain wide acceptance from both buyers and sellers before the market for securities linked to it becomes liquid. It remains to be seen how long that will take, even once it is published.
BlackRock, which has $6.3 trillion of assets under management, has described this as a “chicken or egg problem.” In an April client newsletter, it said that “investors will not adopt” alternative reference rates “if liquidity is insufficient, but sufficient liquidity will not develop if investors do not adopt ARRs.”
Adds Schneider, “You can’t determine a number without trading volume, which is a core problem.”
There’s a parallel movement to keep Libor alive after 2021, in some form.
In February, ICE President Timothy Bowler said there is an overwhelming preference in the loan market to keep Libor ongoing using voluntary bids from contributor banks for new as well as legacy debts (albeit for not necessarily all 35 indexes currently published by ICE). The ICE has been encouraging lenders, investors and borrowers to lobby contributor banks to continue reporting quotes on a voluntary basis.
And in April, the index administrator announced a “gradual” transition to a new bid system that asks for interest rates on actual wholesale financial transactions (if available) rather than solely in-house opinions.
Many have reservations about any ongoing use of Libor, however. Joseph Forte, a partner at Sullivan & Worcester, says that contributor banks would prefer to bow out of Libor submissions, which “is a bid on something that doesn’t occur.”
Participant banks may also find themselves in a legal stew with investors and issuers if the new or synthetic version of Libor doesn’t comport with existing rates. “My fear of keeping Libor alive is the borrower has something to point to” for a class action, said Forte.
David Knutson, head of credit research in the Americas for the U.K. asset manager Schroders, agreed that “expert judgment, I think is risky” with Libor but said he is concerned that there is embedded risk in a SOFR-derived rate, risk that is not garnering enough attention.
The potential for a SOFR term rate to perform more steadily in a stress period may tame volatility, but Knutson wondered whether that is a good thing. “There’s been some discussion how some of that volatility can be damped,” he said. “I, on the other hand, think damping is dangerous.”
“Risk isn’t something that moves in a predictable-step function – it is emotional, it is flexible, it is a surprise,” said Knutson, a co-leader on the advisory board of The Credit Roundtable, an advocacy forum for institutional investors. “As a research analyst, I need to see these ‘risk pops’. If you go from one day, ‘everything’s fine,’ to the next day ‘everything is collapsing,’ I think that’s a worse outcome.”
Paul Norris, a managing director and head of structured products at the global asset manager Conning, argues that extending Libor is likely the best outcome for the fixed-income market, including CLOs. “I think the reality is, most people are comfortable with the fact that halfway through 2018 that nothing has been done,” said Norris. “The closer we get, the less it becomes a reality that it’s phased out by 2021.”
Until the path to the new rate is more established, the sum of corporate loans, residential and commercial mortgages, student loans, bonds and securities indexed to Libor that mature after 2021 will only continue to mount. As of April, the total was $1.9 trillion, according to the Federal Reserve.
Three and a half years might seem like plenty of time, but problems arising from the upcoming absence or change in the benchmark are already manifest.
Oliver Wyman warned in a February report that the transition from Libor will bring considerable costs and risks for financial firms. With new payment reference rates, firms must undergo a risk management overhaul to calculate any long-term changes in asset value, which will require new market-risk profiles and interest-rate hedging strategies.
More immediate is the risk from gaps in how deal documents will govern the transition to a Libor replacement or extension.
“Prior fallback provisions [to replace Libor] just assumed a temporary interruption,” said Oliver Wyman’s Schneider. “Not that it was potentially going away.”
Indeed, fallback language in securitization, loan and derivatives contracts “are all over the map,” said Gary Horbacz, a principal for PGIM Fixed Income’s structured products team. “Unfortunately, there was no standard,” even within asset classes, such as CLOs and commercial mortgage-backed securities, he said.
Some contracts call only for the most recent Libor rate – which would affix a final published Libor rate (presumably Dec. 31, 2021) as a perpetual fixed rate for the duration of a note. Others might convert to the Fed’s prime lending rate, or abide by the federal funds rate on U.S. Treasury securities. Some allow for lenders to claim a new Libor rate based on self-polling of London or New York banks. Still others, according to an April report from PGIM, lack of any fallback language.
According to Oliver Wyman, the risk in having either specified or undetermined fallback options is that, as a new rate option is deployed, “the economic impact is likely to be significant, with one side a winner and the other a loser.”
Chatham’s Cuppia points out that even should the ISDA derive the compensating spread to SOFR, it could still “create a lot of operation difficulty with respect to payment invoicing” for borrowers, lacking the “transparency of what your debt service costs will be over a certain period,” he said. “That’s not a problem with Libor; it’s a forward-looking index.”
Investors are sensitive to these changes since, by and large, they can represent a loss of long-term expected yield over what Libor rates would have provided. “Even in cases where there is fallback language,” said Cuppia, “there’s oftentimes no consideration for the change in the [Libor] spread” through maturity.
How best to reach an agreement is a question that, like most issues surrounding Libor’s evolution or its endgame, is still awaiting an answer.