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June 25, 2018 | Fixed Income Macro Views

Breaking Up Is Hard To Do: LIBOR’s Transition

Keeping Cash Simple

We recently discussed the latest developments with LIBOR, the introduction of new reference rates and what it might mean for clients’ portfolios. Here are the key takeaways.

What is LIBOR?

The London Interbank Offered Rate. LIBOR is a bellwether indicator of short-term borrowing costs and has been used as the reference interest rate for hundreds of trillions of transactions since the mid-1980s. A key drawback to LIBOR is that rates are based on estimates rather than actual transactions. These estimates are contributed by a panel of participating banks and rely on the judgment of market participants. In 2012, regulators announced that there had been significant manipulation in the process of estimating LIBOR rates.

What was the response to these developments?

Several regulatory groups have developed guidelines and standards for benchmarks to begin the process of transitioning away from LIBOR to rates based on real transactions. Regulatory groups included the Financial Stability Board (FSB), Financial Stability Oversight Council (FSOC) and the International Organisation of Securities Commissions (IOSCO). In the US, the Federal Reserve formed the Alternative Reference Rate Committee (ARRC) to determine an alternative rate based on transactions in a robust underlying market and compliant with principles established by the IOSCO.

What are the options for replacing the existing version of LIBOR?

Given the uncertainties around LIBOR in its current form, the market may transition to a variety of different short-term reference rates, including US Treasuries and alternative rates developed in different global markets.

There are multiple jurisdictions involved in finding an alternative rate. Here is an overview of the preferred alternative rate by jurisdiction:

Source: Working Group; Oliver Wyman analysis; WMBA: Wholesale Markets Brokers' Association.
 

Currently, the two leading approaches are:

1) Using a New Rate

The Federal Reserve’s approach was to create a new rate.
 

SOFR, the Secured Overnight Financing Rate, is a reference rate based on unsecured, overnight repurchase (repo) agreements. The overnight repo market is larger than the overnight bank-funding rate market.
 

SOFR references the prior day’s overnight repurchase agreement rates and is published at 8am EST.
 

SOFR is based on actual transaction data, has a wide range of coverage and is a representation of general funding conditions in the overnight Treasury repo market.

2) Sticking with LIBOR

The Intercontinental Exchange (ICE), which is also LIBOR’s administrator, has devised a ‘Waterfall Methodology’ approach to keeping LIBOR.
 

The proposed process is as follows:
Level 1: Banks look at their commercial paper (CP) and certificates of deposit (CD) issuance for different terms (i.e. 1 month, 3 month, etc) with a minimum size of $10mn.

 

Level 2: If banks have insufficient transactions for every term, they could derive a curve from those points on the curve where they have actual transactions.
 

Level 3: If banks have insufficient transactions overall, they would submit a rate where they could fund themselves at 11:00am London time with reference to the unsecured wholesale funding market.

SOFR, So Good? The Pros and Cons:

Pros

  • SOFR is a market rate based on actual transactions, not judgment.
  • The overnight repo market is deep and liquid, with more than $700bn in transactions per day.
  • SOFR is produced by the Federal Reserve, which implies impartiality and credibility.

Cons

  • SOFR is only an overnight rate. Historically, LIBOR captured term risk by offering reference rates at different maturities on the yield curve (e.g., 1-Month LIBOR, 3-Month LIBOR).
  • LIBOR was used as a proxy for credit risk, due to the implied risk of financial institutions’ involvement in a transaction. Overnight repurchase agreements would be based on Treasuries, which would imply no credit or spread risk.
  • SOFR has been more volatile than overnight LIBOR since the Fed introduced it, largely due to Treasury issuance and Fed policy.
  • Liquidity in the SOFR swaps market is currently very low and the SOFR cash market has not developed yet.
     

Where do we go from here?

LIBOR is not going away in the next year. To encourage the transition from LIBOR, the Fed began to publish SOFR daily in April 2018 to assess how the rate moves and prepare for a potential shift away from singular dependency on LIBOR by 2021.

The current timeline and dependencies are as follows:

Source: Oliver Wyman
 

What’s going to happen in 2021?

It’s too early to tell. LIBOR is not necessarily going away, although it seems at this point that SOFR would be the preferred rate by the Federal Reserve.

We may end up in a more splintered market with multiple paths that investors, clients and market participants can take with different reference rates. We are very early in the process where market participants work through the rate that is preferred for them and determine where LIBOR is embedded within different contracts or components of their bank.

What should investors do now?

Preparedness is key. We think investors should understand what transactions are attached to LIBOR, and what is intended to be captured by using LIBOR in contracts. As industry groups continue to work through market concerns around new reference rates, it’s important to be aware of LIBOR-related risks embedded within an investment firm. If concerns arise, we encourage our clients to stay close to their respective industry groups and make sure that any concerns about the migration from LIBOR are addressed.

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