SOFR, Yet So Near
By Tracy Rucker-Wilson, Global Portfolio Risk Manager, Vanguard, and Sam Priyadarshi, Principal and Global Head of Portfolio Risk & Derivatives, Vanguard
The capital markets industry started to prepare for an alternative rate to LIBOR more than three years ago, and now the buy-side must ready itself for several critical milestones ahead.
LIBOR, the most widely used interest rate benchmark in the world, is expected to phase out by the end of 2021. More than $350 trillion in notional of cash and derivative securities currently track LIBOR globally, approximately $200 trillion of which is linked to USD LIBOR. The industry started preparations for the transition to an alternative rate more than three years ago and a lot of progress has been made. But the next two years involve several critical milestones and it’s time for buy-side firms to prepare for the transition.
A new reference rate is selected
Since 1986, the London Interbank Offered Rate (LIBOR) has underpinned the financial industry and now serves as the benchmark for a variety of financial products that range from interest rate derivatives to variable rate loans and mortgages. But LIBOR manipulation, which was first reported during the 2008 financial crisis, led to a series of scandals and sizable fines for many notable panel banks.
Since then, working groups around the globe have focused on selecting alternative reference rates that meet IOSCO standards and can replace LIBOR. In the United States, the Alternative Reference Rate Committee (ARRC) was formed and recommended SOFR, the Secured Overnight Financing Rate, as the new USD benchmark.
SOFR offers many things that LIBOR cannot, most notably that it is a fully transactions based benchmark that more accurately and reliably represents the cost of financing for a wide array of market participants. While SOFR offers many benefits compared to LIBOR, there are some fundamental differences between these two rates which will have significant implications for legacy positions.
For example, SOFR is an overnight rate whereas LIBOR is typically a term rate and the development of a complete term structure will be required for a successful transition from LIBOR to SOFR. Equally as important, LIBOR is an unsecured rate, hence it includes a credit risk premium that SOFR does not.
The ARRC bends toward SOFR
To ensure the markets are prepared for this transition, the ARRC created the Paced Transition Plan which outlines the steps that are necessary for a successful transition. This plan has proceeded on schedule. The futures and swaps infrastructure is in place (1st half of 2018), SOFR futures and SOFR swaps – both cleared and uncleared – began trading (2nd half of 2018), and both CME and LCH are now working toward a target date of October 2020 when they will switch to SOFR discounting. The final step is creating a term reference rate and the necessary fallback language to complete the transition by the end of 2021.
Market participants have been working with the International Swaps Dealers Association (ISDA) to consider best practices for robust language for derivatives contracts. As long as all market participants adhere to the proposed ISDA protocol, there should not be significant issues for the derivatives markets.
Legacy cash securities indexed to LIBOR that will exist beyond the LIBOR cessation date may need to be addressed by legislation at the state level. This spans many different security types including adjustable rate mortgages, bilateral business loans, floating rates notes, syndicated loans, and securitizations such as CMO, CMBS, ABS, and CLO.
For new issuance of cash securities, issuers have been gradually incorporating appropriate fallback language in the event of a permanent cessation of LIBOR. Fallback language is essential for any new issuance of cash securities that track LIBOR because it will outline a LIBOR replacement waterfall for issuers to follow in the event of a permanent cessation of LIBOR. The USD preferred waterfall methodology will use the sum of a term-adjusted SOFR and a credit spread adjustment.
The term adjustment for SOFR is needed to align to LIBOR’s term-rate structure. That is, the 3 month-LIBOR rate is effective for a 3-month period until the next reset. Based on ARRC working group consultation, the replacement is widely expected to be either a market observed term SOFR or computed as SOFR compounded in arrears for a period of 3 months.
The credit spread adjustment for SOFR is needed to add the credit risk premium component that is present in term LIBOR. To derive the credit spread adjustment, industry consensus points toward using the median of the historical spread between the relevant LIBOR and the term-adjusted SOFR for a look-back period of either 5 or 10 years.
Impacts for the Buy-side
There is a lot happening across the industry and there are a number of important considerations that will affect a buy-side firm’s planning:
Market liquidity for SOFR linked cash and derivative product issuance is still developing. Less than $200 billion in SOFR debt has been issued, and it is concentrated among a few issuers, primarily GSEs (e.g. FHLB, FHLMC, FNMA), banks, and insurance companies. Open interest for SOFR futures is leading that of SOFR swaps, and both are still far below their LIBOR-indexed product counterparts. Until liquidity reaches a critical mass, markets are unlikely to make this voluntary transition. Factors that drive market uncertainty, such as tax and accounting treatment of legacy products, have held back some potentially willing participants. But other supportive actions, such as US Government agencies being directed to begin transitioning away from LIBOR or clearing houses switching to SOFR discounting (announced by LCH and CME as a “big-bang” switch date), are expected to act as catalysts for increased liquidity. Until then, the market will potentially face bifurcated liquidity during the transition, living with exposures to each rate.
Jurisdiction differences present another set of considerations. Different working groups around the world are creating their own new risk-free rate and developing their own fallback provisions, yet a successful transition is dependent on each set of local provisions functioning together seamlessly. Any differences in the terms or timing of fallback provisions could lead to mismatches between cash products and the derivatives used to hedge them. Similarly, cross-currency markets present a different cross-jurisdiction impact that is dependent on whether a secured or unsecured reference rate has been adopted.
Value transfer in existing cash and derivatives positions could come from many sources. If liquidity in LIBOR products decreases, bid-offer spreads would widen. Once swaps clearing houses switch the PAI discounting from EFFR to SOFR, a mark-to-market and risk transfer adjustment will be made to the security’s valuation. If fallback language is triggered, a one-time adjustment would impact the legacy LIBOR products. Each of these presents a certain level of risk and uncertainty that can only be eliminated if a buy-side firm no longer has exposure to LIBOR indexes at the time of a triggering event.
Preparing for a LIBOR-free world
Firms will need to develop a robust action plan to transition an existing portfolio of LIBOR exposures to ensure they will accurately value and trade SOFR products. An internal LIBOR governance program would help a firm navigate through the complicated transition of remediation activities as well as ensure effective communication across functional teams, internal stakeholders, external systems providers, data vendors, clients, regulators, and other counterparties.
The first step is to understand and monitor any existing LIBOR exposures and the potential value transfer due to the transition to SOFR. This includes creating an ongoing inventory of all cash and derivative exposures indexed to (L)IBOR in each respective currency and also includes securities that are conditionally indexed to LIBOR (e.g. total loss-absorbing capacity (TLAC) securities or options on underlying assets indexed to LIBOR).
It will also be important to inventory and catalog enterprise-wide legal contracts that reference LIBOR. For example, real estate and commercial loans tied to LIBOR or performance-related measures tied to LIBOR, will need to be amended to incorporate the alternative rate or appropriate fallback language. Additionally, online and print documents, such as a fund’s prospectus and offering documents may require amendment.
Finally, firms will need to determine accounting, tax, and regulatory considerations of the LIBOR transition and will need to evaluate the readiness of all internal and external operational systems that are used to handle cash and derivatives products that are indexed to SOFR. This includes portfolio and order management systems, execution management systems, valuation and accounting management systems, and collateral and margin management systems.
A practical implementation checklist summary can be found on the NY Fed’s website:
Despite significant challenges that remain, it would be prudent to use these steps as the building blocks to prepare for the cessation of LIBOR.
In his remarks at the 2019 U.S. Treasury Market Conference, John Williams, President and Chief Executive Officer of the FRBNY, delivered a wake up call when he said, “The clock is ticking, LIBOR’s days are numbered, and we all need to play our part in preparing the industry for January 1, 2022.”
As ISDA develops a protocol for derivatives, and ARRC working groups develop fallback provisions for USD cash products, buy-side firms need to develop their internal plans to ensure readiness for a future without LIBOR. Will you be ready?