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TD Securities
Libor: An Inconvenient Truth

In recent months the future of Libor has been the subject of intense debate. While the topic has been intermittently discussed since the financial crisis, when it became clear that Libor fixings were not in line with bank funding conditions, the debate has sharply intensified in recent months. July remarks by Andrew Bailey of the Financial Conduct Authority (FCA) — the regulator of Libor — jolted the market and spurred many participants into taking the transition away from Libor more seriously.

Libor is a public good…until 2021
The FCA has regulated Libor since 2013 and has made significant improvements to the rate through its administrator, ICE Benchmark Administration (IBA). IBA and the twenty panel banks that submit contributions have introduced changes in the quality of governance around submissions, aiming to anchor submissions to transactions. However the underlying market that Libor seeks to measure — the market for unsecured wholesale term lending to banks — is no longer active. According to ICE, fewer than 30% of USD 3m Libor submissions are based on transactions.
Meanwhile, many banks reportedly wished to withdraw from being a Libor submitter. Such a move would severely weaken the representativeness and robustness of the rate, potentially creating a domino effect that leads more banks to leave the panel. UK and European legislation only gives regulators limited power to compel banks to continue submitting to Libor. In the case of the European Benchmark Regulation, the “compelling power” is only one to two years. However, FCA’s Bailey and Fed’s Powell have suggested that banks have volunteered to stay on as submitters until 2021, giving the industry time to transition to a new benchmark.

What happens after 2021?
Part of the reason that the 2021 deadline was set is that the FCA believes work on a transition is unlikely to begin in earnest if market participants assume that Libor will last indefinitely. The fate of Libor after the end of 2021 is up to the IBA and the panel banks. They could continue to produce the rate, but because the FCA cannot oblige panel banks to stay, the robustness of Libor could deteriorate.
Global regulators have meanwhile blessed a number of alternative benchmark rates. All of the rates chosen globally to replace Libor have the benefit of being anchored in much more active markets than term Libor, involving little expert judgement. Additionally, in order to resolve the issue of which members to put on a rate-setting panel, these alternative rates use data from all relevant market participants.

SOFR So Good
The NY Fed is expected to release the SOFR rate in Q2 2018 along with two other rates based upon trade-level data from various segments of the repo market. Fed Chair Nominee Powell blessed SOFR in a recent conference, noting that, “The alternative reference rate needs to be able to stand the weight of having trillions of dollars written on it, and the ARRC has definitely met this standard in choosing SOFR.” The transactions underlying SOFR total nearly $700bn/day — much larger than the volumes in overnight unsecured markets and even larger than Treasury bill trading volumes. Powell’s endorsement of SOFR is the first time that a US regulator has been so explicit about the move away from the current Libor benchmark. Note that an estimated $160tn of contracts are linked to Libor and 90% of the that is linked to USD Libor. In August the Fed Board invited public comment about the plan for producing these rates.

These rates will improve transparency into the repo market by increasing the amount and quality of information available about the market for overnight Treasury repo. The rates will be volatile by construction, but given how many transactions these rates incorporate, it will be difficult for any one market participant to influence the rate. The tri-party rate will effectively be the offer side of the market and will be less volatile.

How is SOFR calculated?
The NY Fed proposes using a volume-weighted median as the central tendency measure for SOFR, which would be consistent with the methodology used for the Effective Federal Funds Rate (EFFR) and Overnight Bank Funding Rate (OBFR). In the event of an even number of transactions in the data set, the median would be considered to be the higher of the two numbers (i.e., it would be rounded up). There is a case to be made for a volume-weighted average (geometric or arithmetic mean) rather than a median since SOFR might have a bimodal distribution. One peak would represent relatively low tri-party rates and a second peak would reflect GCF and DVP GC transactions. The median of a bimodal distribution could be more volatile from day-to-day than a traditional volume-weighted arithmetic average if the valley between the two peaks is flat and low. Depending on the shape of the distribution, small changes in the relative volumes of the two peaks can result in significant shifts in the median rate.

All repo transactions that are initiated by a collateral borrower that requires a specific issue tend to trade below the GC repo rate. However, some form of filtering needs to be applied to the SOFR rate to remove transactions that are “special”. Simply removing transactions based on recent issues keeps other issues that may be trading special in the calculation. It would also exclude those on-the-run issues that may not be trading special. It is difficult to know the exact level of filtering required.

How does SOFR compare with other rates?
There are a few key features that distinguish SOFR from other rates:
Overnight: SOFR and EFFR are overnight rates, while Libor has term rates.

Secured: SOFR is a secured rate and therefore incorporates the cost of balance sheet while EFFR and Libor are unsecured.

Risk free: SOFR and EFFR are measures of the risk free rate, while Libor has some credit component since it measures bank funding costs.

Arrears: SOFR and EFFR are rates where payment occurs in arrears versus Libor, where you can settle in advance.

The similarity between SOFR and EFFR makes it useful to compare the new rate to EFFR. The Fed has released SOFR data going back to August 2014 and since then, the 3-month geometric means of SOFR and EFFR have generally tracked closely. Over this period SOFR has averaged about 4bp below EFFR, which is sensible since SOFR is a secured rate and may incorporate some special transactions. The rate is more volatile during month- and quarter-ends, where balance sheet pressures tend to move SOFR above EFFR.

A brave new world with SOFR

Below we discuss the ARRC transition plan. However, we believe that ultimately it is the liquidity in SOFR-linked contracts that will drive the pace of transition. Since SOFR is an overnight rate, many market participants may need to build out the infrastructure of compounding a daily rate. SOFR-based swaps are also likely to be uncleared initially, while Libor-linked swaps are cleared. Regulators may need to incentivize investors to switch to SOFR for new swaps entered into before 2021.

Another key issue as the market transitions to SOFR is the inclusion of the new rate in the FASB hedge accounting standards. Current standards include the SIFMA Municipal Swap Rate, the US Treasury Rate, the Libor Swap Rate, and the Fed Funds Effective Swap Rate. Inclusion of the SOFR will help build liquidity in contracts referencing SOFR and ease the transition for many derivative counterparties.
The paced transition plan:

  •      H2 2018: Infrastructure for futures and/or OIS trading in the new rate is put in place.
  • By end 2018: Trading begins in futures and/or bilateral uncleared OIS that reference SOFR.
  • Q1 2019: Trading begins in cleared OIS that reference SOFR in the current (EFFR) PAI and discounting environment.
  • Q1 2020: CCPs begin allowing market participants a choice between clearing new or modified swap contracts (swaps paying floating legs benchmarked to EFFR, Libor, and SOFR) into the current PAI/discounting environment or one that uses SOFR for PAI and discounting.
  • Q2 2021: CCPs no longer accept new swap contracts for clearing with EFFR as PAI and discounting except for the purpose of closing out or reducing outstanding risk in legacy contracts that use EFFR as PAI and the discount rate. Existing contracts using EFFR as PAI and the discount rate continue to exist in the same pool, but would roll off over time as they mature or are closed out.
  • By end 2021: Creation of a term reference rate based on SOFR-derivatives markets once liquidity has developed sufficiently to produce a robust rate.

The legacy problem
The FSB’s Market Participants Group (MPG) estimates the notional volume of outstanding financial products referencing USD Libor at more than $160tn. USD-denominated interest rate swaps represent approximately 90% of this outstanding gross notional volume. In terms of other USD-denominated products, the MPG estimates that USD Libor is used as the reference rate in 97% of syndicated loans, 84% of floating/variable rate notes and 71% of collateralized loan obligations. A transition for all of these contracts and products will be a complicated task to say the least. The key question for the transition is whether the industry needs to:

  •  Amend contracts to reference an alternative rate, or
  •  Amend the definition of Libor through the fallback protocol to replace the current methodology with alternative reference rates. This could be done by developing a spread, which could be added to the base of the risk free rates.

By March 2018 the International Swaps and Derivatives Association (ISDA) plans to draft a report that includes a survey for the users of Libor (derivatives, securities, loans, MBS), identifying issues with the transition in existing and new contracts, and recommendations.

ISDA Triggers: What determines that Libor doesn’t exist?
The first question is what determines that an investor has to find a replacement for Libor in an existing contract. If all panel banks stop submitting Libor, it would be an obvious trigger. But it becomes more difficult if a few banks drop from the panel. What determines that the panel may have “degraded” is a very subjective issue. Currently, the ISDA trigger is a public statement by the supervisor (in this case the FCA) about an insolvency of the relevant administrator (in this case ICE) or that Libor has been permanently or indefinitely discontinued or that it may no longer be used. Another ISDA trigger is a public statement by the administrator that it will cease publishing Libor.

ISDA fallback: What should replace Libor in a contract?
Current ISDA fallback protocol is meant for a temporary disruption for Libor. Many contracts allow the counterparty to call up 3 banks in London and obtain an average quote. However, in a situation when banks have stopped submitted Libor, this does not seem like a feasible alternative. Thus more work needs to be done on a permanent solution for a time when Libor may not exist. ISDA has already confirmed it is willing to develop a protocol that would allow market participants to update existing documents to insert a fallback rate should Libor cease to be published after 2021, or possibly sooner in the case of Euribor.
Under the ARRC transition plan, counterparties to Libor-linked swaps would amend their documentation to reference an alternative rate well before Libor might cease. Moving from Libor to SOFR would create a valuation change given that SOFR is lower than the Libor rate. The aim is to find the amount of compensation that each side will be willing to pay and receive to make the switch. That amount could be thought of as a spread which could be added to SOFR, which would replace Libor in an existing spread.

How do you compute and administer the spread?
There are two approaches are currently being discussed to compute the spread: a historical approach and an auction approach. A historical approach would freeze the Libor-SOFR basis on the day the benchmark is ceased while the latter would involve determining the Libor-SOFR basis each day via an auction process.

The cash problem
So far we have discussed the issues for the transition away from Libor for derivatives. However, there are many cash products that are linked to Libor, with a many of these products possessing terms past 2021. The ARRC has expanded its work to incorporate the cash transition plan, resulting in discussions about creating a term reference rate. That term reference rate would have to be built by first developing futures and OIS markets that reference SOFR. It will likely not be as robust as SOFR itself, and so derivatives transactions will almost certainly need to be based on the overnight rate. However, a term reference rate could conceivably be used in some loan or other contracts that currently reference Libor.
Below we discuss some of the current fallback issues across different products. We would expect new products that mature beyond 2021 to have a more robust fallback as a world without Libor looks much more likely now.

Current fallback language in Libor-linked cash products
 Mortgages and other consumer products: Typically the contract language in mortgages gives the noteholder the ultimate authority to name a successor rate if Libor was permanently discontinued. Other consumer loans may be more varied, but generally seem to have similar flexibility.

  • Floating rate notes: There are an estimated $1.5tn in outstanding Floating Rate Notes referencing USD Libor. However, 84% of these FRNs will mature by the end of 2021, and 92% by the end of 2023. Typical contract language would direct the calculation agent to first poll a sample of banks (similar to the ISDA fallback language) and then convert to fixed-rate at the last published value of Libor if quotes are not received. It would typically require unanimous consent of the noteholders to adjust these terms.
  • Securitizations: Approximately $1.8tn in outstanding securitizations reference USD Libor. Agency MBS allow Fannie Mae and Freddie Mac to name a successor rate if Libor was permanently discontinued, but typical contract language in other securitizations would require a poll of banks and then convert to fixed-rate at the last published value of Libor if quotes are not received. CLOs are typically called after an initial 1-2yr period, at which point fallback language could be amended.
  • Corporate Loans: Flow of Funds data estimate the level of nonfinancial corporate loans at $2.7tn (does not include committed but undrawn lines). A large share — $2.1tn — are syndicated loans (according to SNC data). Roughly 85% percent are floating rate, and a large share of those appear to reference Libor. The typical contract language appears to name the Prime Rate or the Effective Fed Funds Rate plus a spread as the fallback if Libor was discontinued. Note that bilateral loans can be renegotiated by the borrower and lender to amend this, while syndicated loans currently tend to require unanimous lender consent to amend these terms. However, syndicated loans are amended fairly frequently, so it is very likely that most or all of the outstanding stock of loans would be amended before the end of 2021. We expect that lenders will make sure that new and existing loan documents make sense in a world without Libor. Where possible, lenders and borrowers may look to adjust their credit agreement voting provisions so that any change to the rate benchmark will not require a 100% vote. In syndicated loan documentation, borrowers may want the selection of a replacement rate to require the approval of a majority of lenders, rather than requiring unanimous approval.
    Priya Misra, Gennadiy Goldberg

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