LIBOR’s 11th Hour: The Urgent Need to Phase Out the Reference Rate
The long wait is over and the wind down has begun. 2021 will be a critical year for transitioning away from LIBOR. It has been more than three years since then-Financial Conduct Authority Chief Executive Andrew Bailey signaled that publication of the widely-used reference rates would not be guaranteed beyond 2021.1 That deadline is now rapidly approaching.2
“Time is of the essence to prepare for the possibility that the production and availability of LIBOR might cease permanently,” according to the Alternative Reference Rates Committee, (ARRC) the group convened by the Federal Reserve (Fed) to facilitate the move away from USD LIBOR. “The transition from LIBOR is important because the potential disruption or cessation of LIBOR poses a financial stability risk as well as a risk to the individual firms with LIBOR exposures.”3
Already there are signs that LIBOR is vanishing. For instance, the volume of 3-month wholesale funding transactions by major global banks has become miniscule in the postfinancial crisis market: about $500 million on a typical day. Meanwhile, an estimated $200 trillion in financial contracts reference LIBOR.4 These include $190 trillion in interest-rate derivatives, $3.4 trillion in business loans, $1.8 trillion in floating rate notes, $1.8 trillion in securitizations and $1.3 trillion in consumer loans.5 Underscoring the urgency of moving away from LIBOR, during the week of March 16, 2020 there was no transaction data to support the setting of 3-month sterling LIBOR.
Regulators are urging financial market participants to treat the LIBOR transition with urgency. “Do not underestimate the operational, technical, legal, communications, and risk management work that will be required to move existing transactions off of LIBOR and prepare to use an alternative rate. It will take time and resources, and the price of failure or delay in any of those areas could be high,” warned Michael Held, general counsel of the legal group at the NY Federal Reserve Bank, in a September 2020 speech.6 The end of LIBOR, Held said, poses “operational risk, credit risk, regulatory risk, reputational risk, [and] a rather frightening litigation risk. ... So the possibility of a failed LIBOR transition is something that should keep all of us up at night.”7
Yet, there is substantial work left to be done. This is particularly true in the US, where the choice of Secured Overnight Financing Rate (SOFR) as an anointed benchmark has raised concerns. The recent news that certain LIBOR tenures will continue to be published until mid-2023 may have led some to believe that an extension has been granted. This is misleading, as the move merely constitutes a short-term solution for certain legacy products that are difficult to novate. US regulators have stressed the need to cease using LIBOR “as soon as practicable and in any event by December 31, 2021.”8
Dating LIBOR’s Demise
Exactly when LIBOR will cease being a reference rate remains an unanswered question. The precise date is critically important, not only because contracts will need to transition to a post-LIBOR benchmark, but also because a spread adjustment between LIBOR and the replacement benchmarks will be based on a 5-year lookback period from LIBOR’s last publication date.
Two events could establish the date. First, the Financial Conduct Authority could determine that LIBOR is no longer representative. Alternatively, LIBOR’s publisher, the Intercontinental Exchange (ICE) could state that it will stop publishing LIBOR on a particular date; in November, ICE announced that it would “consult on its intention to cease the publication of all GBP, EUR, CHF and JPY LIBOR settings.” It also indicated that it would issue a separate announcement about USD LIBOR after discussions with stakeholders have concluded.9 ICE has made clear that it would provide at least one year’s notice prior to cessation. As such, the end of LIBOR would occur in January 2021 at the earliest.
While the vast majority of LIBOR contracts will make the transition, there are a limited number of legacy contracts for which there is no workable alternative to LIBOR. For these, FCA is developing a stopgap synthetic alternative. As part of the UK’s Financial Services Bill, FCA is expected to be granted the power to compel benchmark administrators to publish this synthetic version of LIBOR, likely based on a risk-free rate plus a spread. On the same day ICE announced its consultations, FCA announced that it was launching consultation on its anticipated new powers surrounding synthetic LIBOR.
Transitioning from LIBOR at State Street Global Advisors
At State Street Global Advisors, we have been preparing for the transition for over two years. We have a LIBOR working group overseeing the transition, and various subgroups, each with its own timeline and responsibility for addressing such areas as information technology, market data, models, contracts, investments, public policy, communication and training. We are also keeping a close eye on key third parties. We are watching vendors, to ensure completeness of pricing data. We are verifying whether index providers are ready, and whether they will communicate effectively on portfolio construction, so that we will know if bonds are falling out of an index or will be included in a different index. We are working closely with Bloomberg, and intend to use a fallback analytical tool they are currently developing, which is expected to support 13 fallback elements and cover the global asset base.
Various issues remain pertaining to cash bonds, which comprise the vast majority of the LIBOR exposures we hold on behalf of our clients. These issues include assessing market liquidity and understanding the fallback language that would apply to each LIBOR-based product if LIBOR is no longer published. Overall, our exposures have dropped by more than half since the beginning of 2019. As of June 30, we had slightly less than $50 billion, compared to about $3 trillion in assets under management. If we did nothing between now and December 2021, we would hold about $8 billion in residual exposures, although of course we are actively working to ensure a smooth transition for any LIBOR-based assets that we hold after 2021. In the market, issuers have been calling and tendering bonds, and have significantly reduced issuance of floating-rate notes.
The bottom line: there is a process in place at State Street Global Advisors and we are addressing the challenge, despite many unanswered questions in the markets. We expect to be ready for the deadline, and are working to minimize any potential impacts.
The New Benchmarks
Authorities and market participants for each of the currencies covered by LIBOR have put forth alternative reference rates to replace LIBOR. In this section, we review future reference rates for pounds sterling, euros and US dollars. For further information on Japanese yen and Swiss francs, please consult your State Street Global Advisors representative.
The Sterling Overnight Interest Rate (SONIA) has been chosen to replace LIBOR as the primary interest rate benchmark in sterling markets. 10 Based on transaction data, SONIA reflects the average of the interest rates banks pay for borrowing sterling unsecured overnight from financial institutions and institutional investors. Compared to benchmarks in other currencies, SONIA benefits from a long history and from use for the discount curve for derivatives. Volumes of SONIA swaps outpaced LIBOR swaps in the first two months of 2020, although they later dropped due to COVID-related disruptions. Moreover, the Bank of England used SONIA as the reference rate for its COVID corporate financing facility.
In addition to establishing FCA authority over a synthetic LIBOR rate (as discussed above), language in the proposed Financial Services Bill is intended to help protect consumers and market integrity under the transition.
There are two widely used interest-rate benchmarks for euro-based investments, Euro Interbank Offered Rate (EURIBOR) and the Euro Overnight Index Average (EONIA). EURIBOR with its various tenures, underlies mortgages, floating rate notes and other instruments. It will not be discontinued, however financial instruments referencing EURIBOR will need to incorporate new or improved fallback language.
EONIA, which is mainly used for overnight interest rate swaps, will be replaced by Euro Short Term Rate (€STR). €STR reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area.” It is calculated using a weighted-average trimmed mean. €STR has been functioning well, with underlying volumes increasing since the European Central Bank (ECB) began publishing the rate in October 2019.
In the US, the Federal Reserve convened the ARRC to introduce a “more robust” reference rate and to facilitate the transition. This led to the Secured Overnight Financing Rate (SOFR) which launched and began publishing rates in April 2018. One-month and 3-month futures contracts began trading on the CME in May 2018. 2 Like SONIA and €STR, SOFR is based on actual transaction data, and is calculated using a weighted-average trimmed mean. Moreover, the volume of transactions in its underlying market — the US Treasury repurchase agreement (repo) market — is high, at about $1 trillion daily.13
ARRC has endorsed SOFR as its preferred alternative to LIBOR for certain derivatives and other financial contracts, and has set an ambitious timetable to encourage its use. Yet it has made clear that SOFR is not an exclusive solution.14 There are drawbacks and challenges associated with SOFR, and despite official-sector enthusiasm for SOFR, reception has been mixed.
Volatility has been an issue for SOFR. For instance, in mid-March, with markets roiled by COVID-19, SOFR dropped to 0.26% before doubling the next day, and then falling again. In September 2019, idiosyncratic strains in the repo market sent SOFR above 5%. This volatility has raised concerns that SOFR may not be an appropriate replacement for LIBOR,15 although the use of compounded averages for SOFR help to smooth the impact,16 and volatility should decrease as the volume and variety of products referencing the benchmark increase.
In cash bonds, government-sponsored entities have dominated SOFR-based issuance. The Federal Housing Finance Administration has prohibited the Federal Home Loan Banks from entering into LIBOR transactions or investments,21 and Fannie Mae and Freddie Mac will stop accepting LIBOR-based ARMs by the end of 2020.22 They have created new ARM products indexed to the 30-day SOFR average.23 Financial institutions and corporations, however, continue to prefer LIBOR. Given the low private-sector market volume, it may take a cessation of LIBOR to drive SOFR issuance.
Developing a term reference rate based on SOFR will also be key, although derivatives volume must increase before this can happen. In H2 2020, CME17 and LCH18 transitioned from using the Fed funds rate to SOFR to discount cleared swaps, which has resulted in increased volumes. ARRC has set a goal of creating the term reference rate in H1 of 2021.19
Importantly, there is private-sector interest in a US dollar alternative to SOFR that, like LIBOR, is sensitive to credit conditions. This is largely because floating-rate financial contracts based on SOFR can present risky imbalances, particularly for certain banks. During credit-market volatility, banks’ borrowing costs may rise. Products, such as floating rate business loans tied to LIBOR, serve as a hedge against such rising costs, because LIBOR is correlated with banks funding costs: as funding costs rise, so do the proceeds from floating-rate instruments tied to LIBOR.
In contrast, SOFR may move in the opposite direction from banks’ borrowing costs. Because SOFR represents the cost to fund treasury collateral, it does not have a credit component. Therefore, it does not reflect the cost of funding bank balance sheets. This can be an issue during market volatility, when fund flows put downward pressure on SOFR in anticipation of central bank policy easing. A drop in SOFR would decrease proceeds from floating-rate products tied to SOFR. During the 2009 financial crisis the spread between LIBOR (which reflects banks’ funding costs) and SOFR would have exceeded 50 basis points (bps) for about one year. During the H1 2020 downturn, the SOFR/LIBOR spread exceeded 50 bps for 41 days, peaking at 140 bps. This widening is a significant concern for smaller and medium-sized banks that rely on more credit sensitive funding, because they don’t hold Treasury portfolios needed to obtain funding via the repo market.
To address the need for a credit-sensitive reference rate, regulators have hosted a series of meetings with a Credit Sensitivity Group, composed mainly of regional banks, to identify potential solutions. Various possibilities have been explored, but no preferred option has been identified. In November, following a series of workshops convened by the Federal Reserve Bank of New York, senior bankers conceded that it is unlikely that a credit-sensitive rate would be ready prior to LIBOR’s demise, pushing banks to peg lending products to the risk-free rate.
One possibility gaining momentum among banks is the use of AMERIBOR, the alternative to LIBOR developed by the American Financial Exchange, reflecting the unsecured borrowing costs of more than 1,100 US lenders. In May, Fed Chairman Jerome Powell wrote “While [AMERIBOR] is a fully appropriate rate for the banks that fund themselves through the American Financial Exchange (AFX) or for other similar institutions for whom AMERIBOR may reflect their cost of funding, it may not be a natural fit for many market participants.”23
Given the magnitude of investments referencing LIBOR and the controversies that remain just one year before the deadline, the transition to new reference rates will be an important matter to follow in 2021. At a minimum, we expect a significant reduction in issuance referencing LIBOR. State Street Global Advisors has a process in place, and will continue to address any potential impacts to the bonds and other products that we hold.
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