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USD LIBOR’s days are numbered

Economic Comment

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To the dossier 'Benchmark reforms: Bigger than Brexit?'

Although they have long underpinned the USD market, beyond 2021 the publication of USD LIBOR fixings is no longer guaranteed. The risk of a sudden cessation of the LIBOR benchmarks after 2021 has led the US Alternative Reference Rates Committee (ARRC) to select SOFR as their preferred successor rate. To prevent potential disruption of contracts that reference USD LIBOR and mature after 2021, robust fall-back language should to be implemented.

LIBOR: Counting down the days

The structure of the USD market has changed since LIBOR was introduced decades ago. As a result, current USD LIBOR fixings are based on only a very limited number of transactions. The ARRC found that less than USD 1 billion in daily volume underpins the most commonly referenced 3 month USD LIBOR fixing. For the other tenors this is even less. This means that panel banks often have to rely on expert judgment, without much of a reference point to validate or justify their estimates. As such, the number of panel banks has shrunk dramatically: the USD LIBOR panel is currently made up of only 16 contributors.

The Financial Conduct Authority, which oversees all LIBOR rates, has agreed with these banks that they will continue to submit quotes until the end of 2021, but the FCA will not use its influence to guarantee the availability of LIBOR fixings thereafter. In fact, the FCA could also be the trigger of a future cessation event, if the regulator decides that LIBOR is no longer a representative benchmark. Although this does not necessarily mean that USD LIBOR will be discontinued after 2021, the risk that this may happen at some point is substantial. To prepare for this eventuality, the ARRC has set out a transition plan to move from USD LIBOR to SOFR, their preferred alternative.

SOFR: Fundamental differences

The Secured Overnight Financing Rate is calculated by the Federal Reserve Bank of New York, and it is based on actual transactions in a very active and liquid market: the US Treasury repo[1] market. SOFR does not rely on a panel like LIBOR. The ARRC judged that the SOFR is therefore a more accurate, more robust reference rate for the USD market.

In addition to the calculation methodology, there are two fundamental differences between the Secured Overnight Financing Rate and USD LIBOR. First, as the name suggests, SOFR is a measure of secured lending and is based on cash borrowing that is collateralised by US Treasury securities. By contrast, USD LIBOR has always been a measure of unsecured interbank lending. This means that SOFR does not represent the same credit risk as is embedded in USD LIBOR rates. Secondly, whereas USD LIBOR includes interest rate fixings for several tenors, SOFR is currently only available as an overnight rate. This discrepancy is arguably the biggest challenge in the transition to SOFR; particularly considering current exposures to term LIBOR.

Coming to terms with SOFR

The conversion between an overnight-only SOFR and a term rate can be done in two ways: in arrears, and in advance. The backward-looking term fixings are technically already available: this only requires daily SOFR fixings over the relevant term, and a method of averaging these. That does leave the discussion of a best practise for this averaging. For instance, should a simple average or daily compounded interest rate be used?

To support the adoption of SOFR, the New York Fed proposed on 4 November 2019 to help standardize this methodology by making available a daily set of compounded averages for 30, 90 and 180 day tenors, as well as a SOFR index that allows for easy computation of custom terms. The bank plans to start publishing these in the first half of 2020.

Figure 1: 90d SOFR average compared to 3m LIBOR
Figure 1: 90d SOFR average compared to 3m LIBORNote: 90d SOFR average is an estimate. 3m LIBOR has been lagged 90d to better match the in-arrears SOFR average in this chart.
Source: Bloomberg, Federal Reserve Bank of New York, Rabobank

These averages will effectively smooth daily volatility in SOFR, and the 90 and 180 day averages are even a bit less volatile than their LIBOR counterparts. The crucial difference with term LIBOR rates is that these compounded averages are only available at the end of the period, whereas LIBOR allows the interest rate to be fixed at the beginning of each interest period. So even though this method gives the most accurate representation of borrowing costs for the respective interest period, it does leave more uncertainty about the applicable interest rate until just a few days prior to a payment due date.

Figure 2: Forward-looking versus backward-looking
Figure 2: Forward-looking versus backward-lookingSource: Rabobank

The ARRC believes most market participants should be able to use an average of SOFR (i.e. in arrears) over the relevant term. However, the Committee does see some specific uses for a forward-looking term rate, and has set a goal of seeing a forward-looking term rate being produced.

Figure 3: SOFR futures trading is gradually picking up
Figure 3: SOFR futures trading is gradually picking upNote: Data are average daily volumes per month.
Source: Bloomberg, Rabobank

Since there is only a liquid overnight cash market, the currently suggested approach is to create a term rate based on SOFR futures and/or SOFR OIS[2] trades. That, in turn, does require a sufficiently liquid SOFR derivatives market – which is still being developed. The ARRC’s paced transition plan currently sees the launch of term rates only near the end of 2021, i.e. just as USD LIBOR may cease to exist. Moreover, although the SOFR futures market is gradually gaining traction, at present the ARRC cannot guarantee that a robust forward-looking rate can successfully be developed at all.

So, even though more familiar, forward-looking term rates are on the ARRC’s agenda, the long delay before these may become available creates substantial transition risks: forward-looking term rates may not be ready in time for the cessation of USD LIBOR.

Business impact

Any contracts referencing USD LIBOR that mature by the end of 2021 can be expected to do so normally. The FCA’s agreement with panel banks keeps LIBOR benchmarks available at least until then. However, any contract that matures after 2021 is at risk of a potential cessation of USD LIBOR. New contracts may already include fall-back language that avoids disruption due to a cessation event, but especially older, existing contracts may not have appropriate clauses to deal with such a contingency.

The Alternative Reference Rate Committee has released recommended fall-back language. In the case of pre-defined fall-back options, the ARRC proposes a set of fall-back rates, beginning with a forward-looking term SOFR, if available. If a forward looking solution isn’t developed by then, they recommend compounded SOFR in arrears. The advantage of such an approach is that it leaves the option of a forward-looking interest rate fixing, if it is available.

However, it is important to realise that various financial market associations may opt for different fall-back language that better matches their segments of the market. The International Swaps and Derivatives Association (ISDA) is developing fall-backs for USD LIBOR swaps based on the compounded settings in arrears SOFR. Such differences in the fall-back language could create hedging mismatches if USD LIBOR is discontinued in the future and contracts do not resort to the same back-up. It is therefore important to not only analyse the potential impact on single contracts, but on USD exposures as a whole as well.

Footnotes

[1] Repurchase agreement (‘repo’): a form of short-term borrowing. 
Party A sells an asset (usually of high credit quality) to Party B, and also agrees to buy it back after an agreed period at a predetermined price. This way Party A is effectively borrowing cash from Party B for the agreed period, with the difference between the sale and repurchase price being the implicit interest rate. The simultaneous exchange of the asset provides collateral for Party B if Party A fails to repay the loan.

[2] Overnight Indexed Swap (OIS): A swap where the floating leg is based on a daily compounded interest rate.

To the dossier 'Benchmark reforms: Bigger than Brexit?'

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Author(s)
Bas van Geffen
Rabobank KEO

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