The discontinuation of LIBOR is “something that will happen and which firms must be prepared for”, Andrew Bailey made this clear during his speech in July 2018. “Ensuring that the transition from LIBOR to alternative interest rate benchmarks is orderly will contribute to financial stability. Misplaced confidence in LIBOR’s survival will do the opposite”.
In response, on 19th September 2018, the FCA and PRA jointly issued a Dear CEO letter to banks and insurers asking firms to respond in writing by the 14th December, providing their assessment of the key risks relating to LIBOR discontinuation and detail of their plans to mitigate all associated risks.
Yet despite the repeated warnings from regulators, there has been little progress, with only 12% of firms having developed a preliminary plan. Perhaps a part of firms’ reservations is due to the lack of liquidity in the market for alternative reference rates (ARRs).
With underlying market infrastructure still in construction, investors will not adopt the new ARRs until there is sufficient liquidity to support hedging and risk management. But at the same time, liquidity will not build without the market adopting alternate rates. This is the catch 22 facing financial services firms. To escape from it, new, innovative products referencing ARRs need to be constructed quickly, if the transition is ever to build momentum.
Several market participants have pioneered with the launch of ARR-linked products. As an alternative to GBP LIBOR, the European Investment Bank (EIB) have issued a 5-year SONIA-linked bond for £1.3bn. Bertrand de Mazières, director of general finance at the EIB, called out greater certainty as the drive for this issuance: “the choice of referencing the SONIA benchmark removes the need, for both issuers and investors, to consider any future changes to LIBOR for this bond”. In the US, Fannie Mae has issued a $6bn floating-rate securities based on SOFR and represents the largest trades linked to ARRs, to date.
However, markets for transactions referencing ARRs remain small in size and uneven in progress. For example, such transactions accounted for less than 5% of total Interest Rate Derivatives (IRD) traded notional during the third quarter of 2018. While SONIA swaps represented the majority of the transactions referencing risk-free rates (RFRs), trading volumes of IRD referencing SOFR were minuscule. These are expected as SONIA is currently used as the reference rate for sterling overnight index swaps (OIS), while with SOFR published only in April this year, the effective federal funds rate (EFFR) is still widely used as the reference rate for US dollar OIS. These highlight the importance of regulatory mandate in building markets for ARRs.
Also of importance is greater innovations around cleared products referencing ARRs to drive further investor demand and to facilitate risk management. To this end, some progress has been made in Exchange Traded Derivatives (ETD) markets, including the launch of 1-month and 3-month SONIA futures on CME and ICE exchanges and also a 1-month contract on Global Curve. To date, the shift in liquidity has been slow with less than 1.3% of LIBOR Futures open interest traded on SONIA Futures as of the end of October. SOFR futures have also been launched on CME and ICE and there are early positive signs of liquidity starting to build.
More crucially, increased international regulatory co-ordination will be required to build the market transition momentum. In contrast, the lack of global coherence in the publication of official, forward-looking ARR term structures has been quoted as a main reason behind the delays in product innovation to date. This lack of consistent guidelines on term structures poses operational challenges impacting both loans and debt capital markets, particularly when it comes to ensuring the consistency of cash flow forecasting and interest rate risk management modelling. The continued uncertainty has knock-on effects on the finalisation of market standards on key topics such as settlement conventions.
As important as building market liquidity, considerations over how the transition from LIBOR to ARRs will affect the financial ecosystem as a whole, and the businesses of individual financial firms, will be key. The scale of challenge is clear from the current trading levels across the financial services industry. There are $370tn of investments across derivatives, bonds, loans and other instruments. Furthermore, the impact of transition is not simply a front office matter. It also has tendrils across all business functions and activities: Treasury / Finance; Credit Risk; Market Risk; IRRBB; Operational Risk; Counterparty Credit Risk; Enterprise Risk Management; Retail & Commercial Banking; Quants; Legal; Assurance and Governance.
We anticipate that there will be much legal disruption caused by the ARR transition. This is especially acute for trades that mature prior to 2021. Consequently, the value transfer process will lead to the creation of winners and losers and that transition P&L impact analysis should be key to firms’ business planning.
But there will also be a silver lining to the mammoth task of LIBOR transition. The nascent market for ARRs offers ample opportunities for participants to be market leaders through product innovation – if only they can break free from the “liquidity catch 22”.