LIBOR transition heats up

| September 28, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Regulators in the UK on September 19 turned up the heat on financial markets to transition away from LIBOR to other reference rates for an estimated $8.3 trillion in outstanding loans and securities and $190 trillion in notional derivatives. It’s a pivotal signal that regulators plan to push the transition hard. A broad part of the market looks likely to transition well but pockets could run into complications that reduce liquidity and soften pricing. Parts of the market beyond the reach of regulators might not transition at all.

A letter to chief executive officers

The Bank of England and the UK’s Financial Conduct Authority sent a joint letter to banks and insurers (here) asking by December 14 to see a board-approved plan to mitigate LIBOR transition risk. The letter, addressed to chief executive officers, asked each company to quantify its LIBOR exposure across a wide range of scenarios and identify senior managers in charge of managing and mitigating any risk.

The letter emphasized that financial stability and market integrity depended on transition away from LIBOR and towards alternatives and that firms should treat an end to LIBOR “as something that will happen and which they must be prepared for.” The FCA will no longer require banks to submit LIBOR settings after 2021.

The head of the FCA, Andrew Baily, has noted in the past that LIBOR quality could get to the point where it no longer meets regulatory requirements, implying that the FCA could stop regulated institutions from using it. The recent letter seems to make the issue part of each board’s fiduciary responsibility.

The latest action by UK regulators makes it highly likely that US regulators in coming months will ask banks and insurers for their LIBOR transition plans, too.

The transition process in the US started this spring (described here) and continues to accelerate. The US Alternative Reference Rates Committee or ARRC recently released proposed language for new floating rate notes and syndicated loans (here) detailing the process for falling back from LIBOR to the US Secured Overnight Financing Rate or SOFR, and plans to take comments through November 8. The International Swaps and Derivatives Association or ISDA is currently finalizing proposed transition plans, and SIFMA, the trade group representing securities broker-dealers and investors, expects to put out proposed plans in October.

Network effects and liquidity

The latest action by regulators highlights the potential difficulty in breaking the network effects in the LIBOR market. Network effects show up in any system—software, financial markets and elsewhere—where rising participation makes the system more valuable. LIBOR now enjoys broad participation and deep liquidity. SOFR is in its infancy, and trading volume in SOFR futures is anemic. ARRC acknowledges that some of their proposed replacement rates in the benchmark waterfall do not currently exist, as they presume development of a SOFR term structure. Forward-looking term SOFR rates require a SOFR futures market similar in liquidity and depth to the Eurodollar futures market that underpins swaps and LIBOR.

Liquidity has to transfer from LIBOR to SOFR, and perhaps only the government and regulatory agencies can compel that. One way may be by strongly encouraging participants to issue SOFR cash liabilities and encourage hedging with SOFR futures and other derivatives. This may already be happening with the issuance of SOFR debt by major banks and by Fannie Mae. The debt should encourage natural use of SOFR derivatives, creating the liquidity and pricing needed for other participants to eventually transition.

A LIBOR market beyond the reach of regulators

ICE Benchmark Administration Limited, the administrator of LIBOR since February 2014, has announced (here) its intention to continue publishing LIBOR after 2021, raising the possibility that contracts referencing the rate could remain in place. The most likely participants in a legacy LIBOR market would be institutions outside the jurisdiction of bank and insurance regulators. Depending on the details of any LIBOR transition, these parties may choose to keep the contracts in place.

Transition risks across products

The loans, securities and derivatives markets clearly hope to have tightly aligned LIBOR transition plans so cash positions hedged with derivatives can adopt a new reference rate smoothly. This reduces operational, legal and basis risk. This is especially important for complex financial institutions such as the Federal Home Loan Bank system and other organizations that have assets, liabilities and hedges that reference LIBOR. For example, FHLBank assets include agency residential and commercial MBS and FHLBank advances; liabilities include fixed and floating rate bullet and callable debt; derivative hedging instruments include interest rate swaps and swaptions.

ARRC has focused on getting a consistent approach across markets in a few key areas:

  • Trigger events that start the transition from LIBOR
  • A successor rate waterfall to pick from possible replacements
  • A spread adjustment waterfall to outline the credit and term pricing adjustments for the new reference rate

Ideally the transition will occur simultaneously across products, with predictable rate and spread adjustments that maintain alignment across the balance sheet and reduce operational and basis risks.

Lawyers for Sidley Austin recently highlighted (here) the approach that ISDA is taking for both new and existing derivatives contracts:

The ISDA Consultation indicates that standard ISDA documentation will be amended to implement fallbacks for certain key IBORs. ISDA will amend rate alternatives in the 2006 ISDA Definitions, which will apply to new swap contracts, and it expects to publish a protocol that will permit market participants to amend existing swap contracts to incorporate the new fallbacks. The fallbacks will be tied to alternative risk-free rates that are identified for the relevant IBORs.

In addition to amending rate alternatives for use in future swap contracts, ISDA expects to publish a protocol to establish a LIBOR fallback for existing swaps contracts governed by ISDA master agreements. However, any protocol is unlikely to be a one-size-fits-all solution, given the large volume and wide range of commercial terms in existing derivatives transactions that reference LIBOR.

Complexity and conflict-of-interest creates liquidity and pricing risk

Some existing contracts have LIBOR fallback language that gives clear control to a few parties with aligned interests. The best example might be two counterparties to offsetting bilateral swap contracts. In that case, any transition to a new index nets to zero. The Fannie Mae and Freddie Mac securities and debentures markets also generally give clear control to the GSEs to make a transition to another reference rate.

In other situations, however, including private securitizations of residential and commercial loans and other assets, rules for transition vary widely. Some require unanimous consent for a change in index. As ARRC notes in their proposals for new fallback language in outstanding securities contracts:

The extent to which any market participant decides to implement or adopt any suggested contract language is completely voluntary. Therefore, each market participant should make its own independent evaluation and decision about whether or to what extent any suggested contract language is adopted.

In situations where parties may have conflicting interests in transitioning away from LIBOR, lack of clear authority or fallback language that gives effective veto power to any one party could reduce the willingness of investors to trade these securities and soften pricing as 2021 approaches.


The view in rates

The third quarter came to a close with a straight by the numbers FOMC hike, a late week grinding rally probably due to modest month-end extension in the benchmark Treasury index, and the 5s30s curve stopping roughly in the middle of the summer’s 20 to 30 bp range. The inaugural week of the fourth quarter has top tier data releases every day, with “payroll Friday” consensus projecting another strong report including a downtick in the unemployment rate to 3.8%. Barring some sensational news or event, volatility should remain muted as rates leak higher and the curve continues to flatten. Expect inversion in 5s30s before year-end.

The view in spreads

Investment grade credit spreads tightened steadily through September, despite it becoming the highest issuance month for 2018 at $122 billion. Comcast and Disney could both potentially announce large new issues in October which could result in a modest back-up within the Communications sector as they are digested. Otherwise the trend tighter for investment grade will likely remain intact over the near term. Mortgages bucked the trend and widened a few basis points into month-end, which is a bit puzzling.

The view in credit

The longer-term view across credit generally is more cautious. Fed policy is no longer judged accommodative and rate hikes are projected to continue next year amid a slight softening of growth. The out-performance of high yield corporates could reverse if the mountain of BBB-rated debt begins to develop cracks. Household balance sheets look strong which argues for a gradual reallocation from corporate into consumer debt.

john.killian@santander.us 1 (646) 776-7714

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