The reign of the most popular floating rate benchmark, the London Inter-Bank Offered Rate (LIBOR), is coming to an unceremonious end with the phase out looming at the end of 2021. The transition from LIBOR and its non-U.S. dollar inter-bank equivalent indices (IBORs) to an alternative floating rate index is expected to produce significant operational headaches for market participants. LIBOR is used as the reference rate in more than $200 trillion of financial instruments. Although the notional amount of derivatives accounts for 95% of the total, an estimated $2 trillion in legacy LIBOR-linked cash instruments will expire after 2021. For many financial market practitioners, the scope of the LIBOR transition has evoked nightmares, including repressed memories of the Y2K implementation scare, with some warning of a pending “contractual Armageddon.” The reference rate transition will impact a range of constituents, from investment banks that underwrite, issue, and make markets in floating rate instruments to investors holding portfolios of bonds, loans, and swaps to institutional and consumer end-users who borrow via corporate or municipal debt or home mortgage loans and student loans that reference LIBOR.
The first major concern is the need to transition existing financial instruments (floating rate corporate bonds and loans, consumer mortgage loans, structured products, and derivative instruments) away from LIBOR based on the fallback provisions set forth in the legal contracts. In many cases, the fallback provisions require coordination and consent from multiple stakeholders, and often, the switch from LIBOR to an alternative floating reference rate is not a zero-sum proposition. The second major concern is related to the market risks inherent in restructuring hedged financial contracts. As with any financial hedging instrument, changes in the underlying asset must be offset by corresponding changes in the hedging instrument (usually a derivative contract). The third major concern is which rate or rates will replace LIBOR, and how these base rates compare. In this note, we focus on the last question by introducing the leading candidate to replace LIBOR and explaining the differences between LIBOR and its likely successor. We discuss the most significant factors relevant to corporate capital market practitioners rather than delve into the technical minutia of legal contracts or the fine points of derivatives trading.
The global regulatory initiative to replace LIBOR is primarily due to limitations in the mechanism for determining the rate. However, the phase out of this market barometer also coincides with a secular decline in inter-bank wholesale lending that underlies LIBOR. In the late 1980s, LIBOR began to replace risk-free reference rates such as U.S. Treasury bill-linked rates, as LIBOR provided a better match for banks’ assets and liabilities. This rate theoretically measures banks’ marginal borrowing cost. To set LIBOR, panel banks are asked to quote a rate at which the bank could “borrow funds…by asking for and then accepting interbank offers.”
The non-binding and self-reporting mechanism used to determine the LIBOR quotes and the increase in the use of qualitative measures determined using “expert judgment, not to mention the scandal of overt manipulation, led to global regulators’ sharp criticism of the benchmark. Additionally, banks and other financial market participants have transitioned away from the inter-bank financing market to secured financial alternatives offered by central banks and non-bank market participants. A shrinking number of panel banks provide LIBOR quotations which has led the Financial Conduct Authority (FCA), the U.K. regulator that oversees LIBOR, to note that it has needed to exert its influence to keep banks in the panel. The FCA announced that it would no longer compel banks to make LIBOR submissions after 2021, and that the regulator may deem the index to be “not representative” in any case. To further motivate market participants to action, Andrew Bailey, the chief Executive of the FCA warned that the LIBOR transition will occur, and therefore should not be considered a black swan event.
Replacing LIBOR requires an evaluation of the desirable properties for a benchmark rate. The ideal replacement should include the following properties: a robust and accurate representation of interest rates in core money markets, serve as a reference rate for financial contracts, and represent a benchmark for term funding and lending for market participants. In the United States, the Alternative Reference Rates Committee (ARRC), a committee of large banks, investors, and regulators, was established in 2014 to select a replacement. The committee criteria included a measure that captured the risk of short-term lending, was derived from a liquid market, and was a predictable metric. The ARRC identified the Secured Overnight Financing Rate (SOFR) as the recommended alternative in June 2017, and the rate remains the likely heir to LIBOR.
SOFR is a broad measure of the cost incurred by financial market participants (including non-bank counterparties) to borrow cash, collateralized by U.S. Treasury bonds, overnight. Therefore, SOFR belongs to a class of secured overnight reference rates, in this case, tracking the activity in the Treasury repurchase-agreement market. One of SOFR’s main advantages is that the deep and liquid repurchase market allows for a robust measure, whereas the self-reporting LIBOR fixing mechanism is subject to is manipulation and expert judgment. SOFR is published each business day by the New York Federal Reserve Bank with the first publication in April 2018. The calculation of SOFR is driven entirely by observed transaction data in a market with transaction volumes of $1 trillion in daily volume. In sum, the key characteristics of SOFR are that the measure is transaction based, collateralized, and representative of wholesale borrowing (not inter-bank).
Apart from the rate-setting mechanism, there are two significant differences between LIBOR/IBOR benchmarks and SOFR and the class of overnight risk-free rates. First, SOFR is a collateralized rate in which the securities pledged for collateral, U.S. Treasury securities, represent the most liquid available financial instrument. Therefore, the counterparty and credit risk embedded in LIBOR inter-bank rates is not a factor in SOFR and other risk-free measures. Second, SOFR is an overnight or daily rate, whereas LIBOR is a term rate with high liquidity for one-month and three-month tenors and beyond. For the purposes of transacting in the derivative markets, a common method for converting a daily rate into a term rate equivalent is to average the daily fixings. For example, the three-month SOFR equivalent is calculated by determining the geometric mean or daily compounding of the overnight rate.
As proponents of SOFR have argued, the averaging tends to smooth out the volatility of daily rates. However, converting the daily rate in this manner is, by necessity, a backward-looking exercise. In the parlance of derivatives contract language, the equivalent three-month SOFR rate is set in arrears as the rate can be known only at the end of the period. In contrast, LIBOR-based derivatives, with term rates as the underlying instrument, are set in advance. We note that term rates offer important features to users. Because term rates are known at the start of the period, it is possible to lock in a borrowing or lending rate a priori. Additionally, term rates reflect market expectations about future interest rates compared to calculated averages of daily rates that tend to lag movement in the underlying rate. With the introduction of SOFR-based futures and swaps in May 2018, a growing number of over-the-counter (OTC) and exchange-traded derivatives products can be used to express a forward view on SOFR. The evolution of a full complement of SOFR-based derivatives, including futures, options, and swaps, is seen by many market observers as an important step in the transition process. Regulators are tracking the volumes in these products (and comparing them with the evolution of the LIBOR-based Eurodollar and swaps markets). In addition, at the time this article is written, the development of a liquid SOFR-based term rate remains a high priority for the ARRC.
For market participants recognizing that the end of LIBOR is coming, and that SOFR is emerging as the likely replacement, the next logical question is, how do we swap out our LIBOR exposures for SOFR-linked instruments? The voluminous research notes from leading law firms show that “swapping out” legacy floating-rate exposures across a range of derivative positions and cash holdings is not simple. However, the development of SOFR-based futures and swaps allows to quantify the difference between LIBOR and SOFR floating-rate instruments. The most direct measure of the difference is expressed as the basis, or the difference between two rates expressed as a running rate. An example is futures contracts that are paid by referencing the basis between key rates that allow for hedging and for the construction of equivalent pricing curves. The concept of the rate basis also forms the foundation for proposed default contractual fallback provisions for the OTC derivatives markets, in which a spread is added or subtracted from the replacement rate so that the resulting nominal rates are approximately equivalent.
The first step in understanding and quantifying the LIBOR/SOFR basis is to examine the historical behavior of the spot rates.
Figure 1 provides a comparison of the three-month LIBOR rate with the SOFR overnight rate.
In the next step, we can leverage existing financial contracts to express a view on the basis or to hedge exposures to differences in the underlying rates. For this example, we reference a SOFR versus a three-month LIBOR basis swap denominated in U.S. dollars. The terms of this float to float contract are shown in Figure 2.
The quoted or traded price for the sample three-month basis swap contract outlined in Figure 2 is a measure of the spread required by the counterparties to achieve economic equivalency between the two sets of cash flows. Over the last 18 months, the basis contract trading primarily within a range of 15-35 basis points indicates that a spread of between 15 and 35 basis points, quoted as the annual rate, must be added to the SOFR leg base rate for equivalence. As an example, a basis quote of 25 basis points means that the hypothetical counterparty in this example will agree to pay LIBOR in exchange for receiving the SOFR leg plus a spread of 25 basis points per year.
Combining basis contracts with futures contracts (Eurodollars and SOFR futures) allows the basis swap example in Figure 3 to be extended to a multi-period set of cash flows that resemble many legacy LIBOR-linked cash and derivative payment streams.
This approach can be used to quantify the difference between a LIBOR-based derivative or cash instrument and its proposed SOFR-based replacement contract. Mechanically, the difference between the contracts can be paid by either applying adding or subtracting a spread to the replacement rate on a periodic basis, or by paying or receiving a one-time payment that represents the present value of the basis. We illustrate this approach using a hypothetical two-year basis swap with a $100 million notional amount. In this example, as shown in Figure 4, the payment terms of the one-period swap set forth are extended to a two-year contract with eight quarterly swap payments. One counterparty pays the three-month LIBOR (set in advance) and receives the SOFR overnight rate averaged over the previous quarter’s daily rate fixings.
In the two-year term basis swap calculated here, there are two measures of equivalent fair value. In the first case, agreeing to pay the three-month LIBOR and receive SOFR calculated over the previous three months represents a liability for the LIBOR payer. The reset rate for LIBOR is expected to be higher than the rate calculated for the SOFR leg such that the LIBOR payer must be compensated via an up-front payment of $372,160, which represents the present value of the difference in the expected cash flows. As one would expect, the size of the compensating up-front payment is related to the relative magnitude of the basis, the notional amount of the contract, and the time remaining until the contract matures.
Alternatively, the swap terms can be adjusted to fair value by applying a spread to the floating-rate coupon for the SOFR floating leg. In the example used here, we can backsolve for the constant incremental rate that results in a present value of zero for the aggregate net cash flows. As shown in Figure 4, a spread of approximately 19 basis points is expected to compensate the LIBOR payer for the difference, or the basis between the two floating rates over the term of the contract. Although we present a simplified example for illustrative purposes, a similar methodology can be used to calculate fair value equivalents for a range of derivative instruments and cash securities.
Whether the transition from LIBOR takes the form of a “paced transition plan” or a full stop discontinuation on a certain date, market participants should be aware of the potential operational and financial consequences. In this overview, we highlighted the significant differences between LIBOR and its likely successor, SOFR. Substituting an overnight risk-free rate for a term rate with a credit risk component introduces basis risks which must be quantified to fairly restructure existing contracts. End-user constituents in the investment management sector and corporate debt issuers and consumer borrowers’ representatives should be particularly wary of relying on the default fallback provisions embedded in contracts that may not be well suited to the structure and terms of the individual positions. Additionally, these users should be cautious about allowing their counterparties to drive the process for renegotiating and restructuring existing contacts. Regulators are watching for investment banks taking advantage of customers in restructurings.
Lastly, although we have identified SOFR as the likely successor to LIBOR based on the leadership of the ARRC and the nascent development of a SOFR-based derivative market, significant obstacles to full implementation of an alternative reference rate remain. A successful transition from LIBOR will require coordination and buy-in across a range of market participants to achieve liquidity in the derivatives (swaps, futures, options) and cash markets (corporate and consumer bonds and loans) that rival the LIBOR regime. Practitioners’ criticisms of SOFR include that it is not a term rate, does not include credit risk, and can be volatile and subject to technical factors are legitimate. Market participants are also rightly concerned with basis risk. Basis risk occurs directly in the form of floating-rate mismatches for legacy cash and derivatives positions. For commercial banks and other spread lenders, SOFR and other overnight rates that introduce basis risk at the enterprise level do not capture banks’ marginal funding costs and may not provide the best instrument for managing enterprise assets and liability interest rate risks.
At the current juncture, regulators and other governing bodies have heard these arguments and have continued to push for risk-free alternative reference rates as the best path forward. In its most recent Annual Report to Congress, the Financial Stability Oversight Council delivered this warning: “Market participants who do not sufficiently prepare for this inevitable transition could face significant legal, operational, and economic risks. Market participants should not wait for future developments, such as the introduction of a possible forward-looking SOFR term rate, to begin the transition process and instead should begin their transition process immediately.”
Regardless of the eventual path and timing of the transition away from LIBOR, we encourage end users to take an active role, and to be vigilant, in quantifying the impact of any proposed changes to a floating reference rate to the fair value of their financial instruments.
On April 2, the Financial Stability Board said the transition to new benchmark interest rates remains a priority “as firms cannot rely on LIBOR being produced after end 2021,” noting the “benchmark transition will help to strengthen the global financial system.”