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Funding Shifts, Not Credit Event, Led to LIBOR Spread Widening

Published April 05, 2018

LIBOR spread widening had investors scratching their heads, as short-term lending costs have risen to levels not seen since the financial crisis. Our view is that funding issues, not any worrying credit event, caused the spread widening, and therefore investors need not be alarmed.

Funding Issues Caused Widening

As with complex financial ecosystems, there’s no single factor that caused the recent LIBOR gap.  Instead, a confluence of events led to a perfect storm, including:

  1. The abundance of Treasury bill (T-bill) issuance – which is up $332 billion since February – following the resolution of the most recent debt limit dispute
  2. Offshore US cash repatriation, following the US tax reform
  3. A bit of March madness, with the Japanese bank year-end, the Federal Open Market Committee (FOMC) hike, and preparing for Q1-end all happening in close succession
  4. Ongoing Fed balance sheet normalization
  5. Shrinkage of  the investor base following  US Money Market  (MMF) reform, and
  6. To some degree, potential bank deregulation (recently passed by the Senate, but not yet vetted in the House)

These were funding shifts rather than credit event issues.  On the contrary, Q4 earnings evidenced strong, fundamental performance and growth for banks as well as the overall broad economy.  While short-term wholesale funding costs are higher and a permanent structural feature,  we believe it is a marginal headwind for earnings.

The Future of LIBOR

There is likely to be more focus on how LIBOR behaves, as we are quickly moving toward a stage when alternative reference rates are appearing. On April 3rd the Federal Reserve Bank of New York (FRBNY) launched a new daily rate, the Secured Overnight Financing Rate (SOFR), which regulators hope investors will gradually adopt as the preferred benchmark. Other countries in Europe have also been discussing LIBOR alternatives, following the rate-fixing scandals that marred LIBOR’s credibility. The collusion of US and European participant banks to manipulate LIBOR rates resulted in significant penalties for those banks and the search for an alternative rate.

For the US, a committee of regulators and bank participants determined that SOFR is a better alternative rate than LIBOR. SOFR captures daily transactions from various participants ranging from MMFs and asset managers to broker-dealers with transactional volume in the trillions. Put simply, it’s a broad measure of borrowing cost for overnight cash secured by US Treasuries.

The important difference between SOFR and LIBOR is the fact that SOFR is secured in nature as it is based on repo rates. It includes broad general collateral rates, tri-party general collateral rates and bilateral repo trades cleared via DVP (delivery versus payment). In addition, SOFR is an overnight rate whereas LIBOR captures rates ranging from overnight to one year. The FRBNY compiles the data and plans now to publish the SOFR rate daily at 8am. Additionally, CME Group has plans to introduce futures based on SOFR.  They will begin to trade in May and will help establish a forward curve. These rates will be critical to establishing term premiums.

The introduction of SOFR is a significant market structure event. Regulators expect  a gradual but comprehensive transition from LIBOR to SOFR as more investors warm to the new benchmark. But the transition process will be significant: roughly $240 trillion in notional debt and derivatives are currently linked to the LIBOR reference rate, across multiple asset classes and investment instruments as well as valuation and risk profiles. The UK’s Financial Conduct Authority (FCA) has said that member banks will no longer be required to publish LIBOR by the end of 2021. Clearly, this will impact the operating model for many market participants – affecting both financial institutions and clients.

The transition will be slow and measured, and it’s still early. While the market needs to gain confidence in the data consistency and behavior of SOFR in order to drive broader uptake,    the waning of LIBOR as a market benchmark is truly a historic change for markets and will require market participants to plan carefully around any transition. State Street Global Advisors’ Cash Team has been following these developments carefully since the LIBOR scandals erupted in 2012, and would be happy to answer any questions clients might have.

Definitions

LIBOR: The London Inter-bank Offered Rate is the average of interest rates estimated by each of the leading banks in London that it would be charged were it to borrow from other banks

Treasury Bill (T-bill): Treasury bills, or T-bills, are sold in terms ranging from a few days to 52 weeks. Bills are typically sold at a discount from the paramount (also called face value).

Secured Overnight Financing Rate (SOFR): SOFR is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight. A group of large banks, the Alternative Reference Rate Committee (ARRC), selected the rate as an alternative to the London interbank offered rate (Libor) in derivatives. It cited the depth and robustness of the market where around $800 billion is traded daily.

Repo rate: Repo rate is the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

Delivery Versus Payment (DVP): Delivery versus payment (DVP) is a securities industry settlement procedure in which the buyer's payment for securities is due at the time of delivery.

CME Group: CME Group is the world's leading and most diverse derivatives marketplace. The company provides a marketplace for buyers and sellers, bringing together individuals, companies and institutions that need to manage risk or that want to profit by accepting risk.

Disclosures

The views expressed in this material are the views of Pia McCusker through the period ended April 5, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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