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.
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.
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.
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:
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
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.
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.