By Robert Lynch
This year is mission-critical for the migration away from LIBOR as regulators push to discontinue it by 2022. But with less than 18 months left, COVID-19 challenges, and liquidity being slow to develop in alternative reference rates, the market is limping toward that target.
When the COVID-19 market panic deepened in March, the Federal Reserve put together a $600 billion Main Street lending program to help small- and medium-sized businesses cope as the U.S. economy was tumbling into recession. But there was a wrinkle.
Initially, the loans were set to be priced off a new interest rate, SOFR, to help the market transition away from the scandal-hit London Interbank Offered Rate (LIBOR). Then, it turned out the loans had to be tied to LIBOR after all because lenders told the Fed they were not ready to issue loans in SOFR, or the Secured Overnight Financing Rate.
The issue brought back familiar fears about the push to end LIBOR, the world’s most commonly used interest-rate benchmark, by the end of 2021, and since then new worries have surfaced that are heaping fresh uncertainty on the roughly $400 trillion worth of financial contracts linked to it.
First-quarter volatility related to COVID-19 also highlighted how different benchmarks react to market selloffs. LIBOR surged as the cost of obtaining credit from banks rose, while SOFR rates fell because they track overnight loans based on U.S. Treasuries that remain in high demand, as well as base rates that the Fed cut to near zero during the March meltdown.
These recent episodes are underscoring yet again the enormous difficulty of moving away from LIBOR in favor of new, robust reference rates and also highlighting how tricky it is to embrace the alternatives. Industry efforts are helping generate clarity and coordinated action in certain areas, but significant challenges remain that will need more focus and attention.
The transition is further complicated by the fact so many financial market professionals are working in isolation during the pandemic. Some firms are addressing more urgent tasks as the health crisis has evolved into a make-or-break financial strain on their businesses.
In spite of COVID-19, regulators across the globe continue to emphasize that LIBOR cannot be relied upon past the end of 2021, in part because there is no guarantee the rate will be published after that point. Today, banks voluntarily submit quotes into an administrator that publishes LIBOR rates daily, but banks are not expected to do that after the end of next year.
While regulators are reaffirming the ultimate phase-out deadline, however, some interim deadlines have been moved in a handful of countries. In mid-March, for example, the U.K.’s Financial Conduct Authority (FCA), the Bank of England and others set a September 30 deadline for banks to stop issuing sterling-based loans referencing LIBOR, but by April they had shifted that to the first quarter of 2021.
The onset of haircuts that will make it less desirable for banks to post LIBOR-linked collateral at the Bank of England has also been delayed. Originally set to be introduced in October 2020, haircuts to LIBOR-linked collateral maturing after 2021 are now set to be phased in between April 2021, when 10% of the assets’ value will be cut, and December 2021, when the haircut becomes 100%.
Meanwhile, the Fed-sponsored U.S. Alternative Reference Rates Committee (ARRC) has created staggered deadlines between now and the third quarter of 2021 for vendor readiness, launching alternative products and, ultimately, the cessation of LIBOR products. “We have increased the frequency of our meetings and continue to create helpful materials and tools to aid market participants in their transition,” says Tom Wipf, chair of the ARRC.
The U.S. Federal Housing Finance Agency (FHFA) announced last September that by the end of 2019, Federal Home Loan Banks should stop purchasing investments referencing LIBOR that mature after 2021.
In February, the FHFA also said that government-sponsored entities Fannie Mae and Freddie Mac would stop accepting adjustable rate mortgages (ARMs) priced off LIBOR by year-end. ARMs based on SOFR will start to be accepted by Fannie Mae on August 3 this year, and Freddie Mac will accept them as of November 16.
“The industry is generally making progress from an operational and legal perspective, but liquidity hasn’t developed all that significantly in alternative reference-rate products. ”— Jim Wiener, BNY Mellon
Lawmakers are also trying to move things along, worried that some legacy contracts will be too tough to transition without legislation. A plan for proposed legislation in New York was developed by market participants to address contracts that are difficult to amend, but that initiative was not sponsored by a legislator into the state’s budget for 2020. Meanwhile, the U.K. government said legislative steps giving the FCA new powers over how it handles the discontinuation of LIBOR could help deal with the pool of contracts that cannot be transitioned easily away from LIBOR.
Some pockets of the industry are having success with coordinated action. ARRC is close to finalizing recommended conventions for how to calculate the replacement interest rate on syndicated loans no longer based on LIBOR. The problem is that, while banks and trade associations are working steadily at the targets set by regulators, most other market activity is not following along at the same pace.
In the U.S., SOFR issuance is consistently less than a tenth of LIBOR issuance, and SOFR swap volumes are less than 1% of overall LIBOR swap volumes. Liquidity in a new benchmark in Europe called €STR is also quite poor, says Julien Rey, global lead for LIBOR transition at IHS Markit.
For its part, BNY Mellon has a dedicated in-house team to help the bank prepare for the transition, track industry developments and update key systems. That team is also answering client queries and supporting clients on new products, such as debt issuance in new reference rates.
“The industry is generally making progress from an operational and legal perspective, but liquidity hasn’t developed all that significantly in alternative reference-rate products,” says Jim Wiener, senior executive vice-president responsible for the LIBOR program at BNY Mellon.
COVID-19 has made it especially hard for some firms to meet their transition goals, while not putting the overall plan to end LIBOR in jeopardy. With only 18 months left, one urgent focus is amending legal terms called "fallback provisions" for LIBOR-linked contracts that will help provide contract clarity should the benchmark go away.
This summer, the International Swaps and Derivatives Association (ISDA) plans to publish amendments to its 2006 definitions for interest-rate derivatives to incorporate new fallback language. These terms will also be adopted by the major clearinghouses for interest-rate swaps—LCH Group and CME Group—for U.S. dollar LIBOR-based swaps.
“This will significantly reduce the potential for market disruption in the event [LIBOR] ceases to exist, as the fallbacks would automatically apply to those derivatives that include the changes,” says Ann Battle, head of benchmark reform at ISDA.
For legacy derivatives contracts, counterparties will be able to voluntarily adhere to an ISDA protocol to seamlessly switch the legal wording in their existing contracts by the end of this year. Major broker dealers will have to accept the LIBOR cessation protocol but the risk is that not all market participants will do so. Some non-dealers may wait, see where the market moves, and potentially profit in the process on LIBOR-linked contracts others are mandated to close.
“Traditionally, buy-side and corporate customers do not adopt ISDA protocol changes and take up is spotty. On this occasion the protocol affects [contract] values so there is industry pressure for a consistent response,” says Adam Schneider, a partner at consultancy Oliver Wyman.
“We have increased the frequency of our meetings and continue to create helpful materials and tools to aid market participants in their transition. ”— TOM WIPF, ARRC
ARRC is also working on fallbacks, having issued recommended language for floating-rate notes, bilateral syndicated loans, student debt and adjustable rate mortgages. To support SOFR liquidity specifically, the ARRC also wants to select an administrator that can begin publishing forward-looking SOFR term rates by the end of June 2021. All prospective term rates will have to meet the criteria set out by the International Organization of Securities Commissions (IOSCO) to be viable for use on new transactions.
Data vendor IHS Markit is already developing term rates in GBP, EUR, USD and other currencies. In Japan, an industry committee chose Quick Corp, a Nikkei-owned vendor, to develop the methodology for producing prototype term rates locally. And in the U.S., Bloomberg LP was chosen to calculate and distribute term and spread adjustments to fallback rates for SOFR, €STR and SONIA. “Robust benchmark fallbacks are an essential ‘safety belt’ that will allow derivatives contracts to continue to mechanically perform in the event of index cessation,” says Umesh Gajria, global head of index-linked products at Bloomberg.
Some experts say that having such an outlook on rates might help market participants transition to alternative reference rates more quickly. But many believe that it is wishful thinking to have term rates in place by ARRC’s suggested June 2021 deadline. Additionally, they note that the longer it takes to build traction in rates like SOFR, the more likely others—such as PRIME, Fed Funds and Ameribor—will gain a following too (see Alternative Reference Rates box).
Market participants are free to use such existing alternatives, but there is also some discussion of the need for new alternatives to capture the risk of a counterparty’s declining creditworthiness in the context of loans, as LIBOR does. According to minutes from a June 4 Fed workshop on that subject, the COVID-19 crisis showed activity in SOFR-linked products could be high during periods of stress, but it also showed its greatest weakness: that it has no dynamic credit component. “It's clear that some institutions need an additional credit component to complement SOFR,” says Rey at IHS Markit. “Regulators are actively exploring solutions with banks and market data providers to ensure that a viable benchmark add-on will be developed.”
Another critical part of the transition effort is how to discount the value of cleared derivatives tied to LIBOR. In the U.S. today, CME and LCH use the Effective Federal Funds Rate (EFFR) for calculating interest payments on the collateral that is posted to their clearinghouses. The EFFR is also used to calculate the present value of future cash flows on those swaps.
But those discounting methodologies will need to change. In U.S. dollar contracts, it will switch from EFFR to SOFR on October 19, and in euro-based ones, it will switch from the EONIA rate to €STR on July 27 (see Timeline).
The switch should encourage more SOFR swaps exposure, some experts say, because it should help encourage firms to issue new debt tied to SOFR further out on the interest-rate curve. IHS Markit says the euro swaps switch in July will be an easier task due to the fact EONIA is a fixed 8.5 basis point spread above €STR, so the two rates move in tandem.
The ARRC’s Wipf says discounting cleared LIBOR swaps with a SOFR curve at clearinghouses could help boost liquidity in SOFR-based products because many firms will rebalance and re-hedge with new trades. “We are certainly looking to the discounting switch in October to be a watershed moment for SOFR derivative liquidity, particularly in longer-dated tenors where trading today is sparse,” he says.
Both the euro and U.S. dollar tweaks are still on track to be completed before the end of this year, and most of the important issues have been ironed out, meaning a large number of industry participants can get on board with the discounting changes. But the valuation changes will create winners and losers. It will also alter the risk profile of many portfolios, meaning new hedging trades may have to be executed to neutralize the risks.
As a result, both CME and LCH have launched proposals for compensating market participants. LCH will be offering cash to offset valuation changes and EFFR-SOFR “basis” swaps for the risk changes—although it is possible there may be some clients who cannot or will not accept the swaps. CME plans to compensate in cash when adjusting a contract to SOFR from EFFR and to help restore participants back to their original risk profiles.
The compensating swaps work by providing a hedge for the risk of switching between one rate and another, should either rate change the value of cash flows received on the swap. Cash payments are to be calculated using mid prices from dedicated auctions, expected to begin this fall, but clearing members must first determine if they will participate in these auctions and consider the financial implications of doing so.
The issue is that even if firms select to receive cash and swaps, or straight cash, clearinghouses need to wait to determine the exact compensation until the switch occurs because customers may adjust their positions right up to that point. “We’re working hard on communicating our approach, particularly regarding the client choice over the discounting risk swaps, and we’re seeing very strong customer engagement,” says Philip Whitehurst, head of service development for LCH’s rates business.
All in all, the LIBOR transition remains a significant challenge, in part because the timeline was developed by regulators and market participants in a comparatively benign market environment. COVID-19 has disrupted this sense of calm, and even LIBOR has not been immune. As such, any short-term extensions should come with the recognition that the timeline is now compressed and milestones will likely be met shortly before the ultimate deadline itself.
While the desire to meet these targets is strong, there are plenty of unresolved line items. As teams grapple with remote working, transition efforts will take longer than previously anticipated, and organizations will have to budget time and resources in creative ways to avoid getting off track. Transitioning will also require a significant technological lift, and participants will have to procure, implement, test and train staff on new technology—all while working in remote, resource-constrained environments.
Either way, the regulators are not budging on the original time frame. “The limited development of liquidity in the alternative reference rate markets has not impacted the timeline for transition,” says Oliver Bader, executive program director for the LIBOR transition program at BNY Mellon. “Market participants have to assume this date will not move, and they have to work toward resolving some of these challenges prior to December 2021.”
James S. (“Jim”) Wiener is a Senior Executive Vice President of BNY Mellon and the Chief Investment Officer. He is also a member of the Company’s Executive Committee. ReportingLEARN MORE ABOUT JIM
Jeanne Naughton-Carr is a Managing Director and Associate General Counsel in The Bank of New York Mellon’s (“BNY Mellon”) Legal Department where she manages the Legal Department teams responsible for supporting BNY Mellon’s Issuer Services, Treasury Services, Commercial Lending, and Letter of Credit activity.LEARN MORE ABOUT JEANNE
Sam Schwartzman, Managing Director, is the Global Head of the IMG Cash Solutions Group (‘IMG’) at BNY Mellon. He and his group oversee the cash/investment-related agenda for Investment Services and BNY Mellon Markets.LEARN MORE ABOUT SAM