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On July 27 2017, nine whole years since the tampering scandal reared its ugly head, the CEO of the Financial Conduct Authority (FCA), Andrew Bailey, announced that Libor will be phased out by 20211. While some commentators have said that the announcement may be somewhat premature, efforts to replace Libor have been in the works for some time.
Back in July 2014, the Financial Stability Board (FSB) published its report on interest rate benchmark reform2. This prompted the commissioning of working groups across the G20 and in November 2014, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC). Similarly, the Bank of England commenced a working group on Sterling Risk-Free Reference Rates, the Swiss National Bank convened the National Working Group, and the Bank of Japan convened the Japanese Study Group on Risk-Free Rates.
On June 22 2017, the ARRC’s working group announced that it had decided on the Secured Overnight Funding Rate (SOFR) as its preferred near risk-free interest rate benchmark for use in certain new U.S. dollar derivatives and other financial contracts3.
What is the SOFR
The SOFR has yet to be published but is to be based on the cost of overnight loans that use U.S. government debt as collateral, with an average daily volume of $660 billion5. The Federal Reserve Bank of New York has proposed publishing the SOFR in cooperation with the Office of Financial Research starting in the first half of 2018.
After more than two years of research, the ARRC selected the SOFR based on underlying market depth, likely robustness, usefulness to market participants, and alignment with the intent of regulations and international best practice as encapsulated by the IOSCO Principles for Financial Benchmarks. The choice of the SOFR, a secured risk free rate, is different from the U.K. (SONIA) and Japan (TONAR), both of which are unsecured rates. However, it is similar to Switzerland and possibly the Eurozone6. The ARRC met on August 1, 2017 and the agenda included discussion of the ARRC’s timeline going forward and work plan for the rest of the year7. The ARRC has previously proposed a paced transition in the May 2016 Interim Report8 with parallel markets in Libor, Fed Funds and SOFR and is not in favor of a ‘big bang’ approach.
The International Swaps and Derivatives Association (ISDA) is one of the international bodies that is helping coordinate transition from existing inter-bank offer rates (IBORs). As Scott O’Malia, ISDA Chief Executive, outlined in a speech4 on June 15 2017, they have established working groups to agree fall-backs in the event that Libor is unavailable and to assist with the transition from Libor in the derivatives markets.
What are the key differences between SOFR and Libor?
SOFR is by definition an overnight rate, whereas Libor fixes for a range of tenors.
• SOFR will most likely fix daily in arrears, whereas Libor fixes in advance for the given tenor, for example 3-month.
• SOFR will purely be an overnight rate, which may cause more issues for many end-users, particularly smaller derivative end-users and borrowers. For example, as a borrower looking to manage cash flow within your business it can be valuable to understand what your interest expense for the quarter will be at the beginning rather than at the end of the quarter.
• It may be possible to utilise short-term swaps and futures that reference SOFR (similar to Overnight Index Swaps) to generate a mechanism that will both fix in advance and provide fixing values for different tenors. However, this may re-introduce liquidity issues in the benchmark (i.e. if there is limited trading in a particular tenor) and it would need to be determined who would calculate and produce these indices.
SOFR is a near risk-free-rate, whereas Libor captures a credit risk component.
• This may not actually be a desirable feature of Libor and many participants in the U.S. market welcome the move to a near risk-free rate. However, the credit component of Libor will need to be a consideration for legacy instruments and their migration.
• It is expected that ISDA’s working groups will decide on the relevant risk free rate as the fall back for each currency, with the addition of a spread to incorporate residual term bank credit premiums. Figure 1 below shows the historical difference between three-month USD Libor and SOFR as calculated by the New York Fed’s staff9 based on data from Bank of New York Mellon, JPMorgan Chase, and DTCC Solutions, LLC.
SOFR is a transaction-based benchmark, whereas Libor is a judgement-based benchmark.
Fundamentally, it is this point that has written Libor’s death certificate. As Mark Carney outlined, a lack of unsecured term deposit transactions and a continuing reliance on judgement, represents a serious structural weakness in Libor. A situation in which a judgement-based benchmark underpins an estimated US $350 trillion-worth of contracts is not desirable.
Figure 1 – Historical 3-month USD Libor – SOFR Spread
Source: New York Fed
Impact on Interest Rate Derivatives?
From a technical or pricing perspective, the eventual10 move to a single benchmark will make derivative pricing simpler and more efficient. We have been operating in a multicurve environment (the Libor forward curve is bootstrapped from market swaps whose cashflows reference Libor but are discounted using the Effective Fed Funds Rate) for the last decade and it is evident that it adds to the complexity of derivative pricing and risk management. The move to a single benchmark will be a change welcomed by many and will lead to improved pricing for the market.
On July 26, 2017, the CME announced11 its intention to develop futures and options on the SOFR benchmark. It is clear that there are concerted efforts from regulators, industry bodies and market participants to implement the new risk free rate. The ARRC believes that a transition to alternative rates is in market participants’ own long-term interest, despite the costs and complications that it may pose in the near term.
The FSB Official Sector Steering Group believes that current fall-back provisions incorporated into market contracts (ISDA Master 1992/2002, ISDA Definitions, trade confirmations, etc.) were neither intended nor sufficiently robust to withstand a permanent discontinuation of Libor12.
As a result, ISDA have established four working
groups split by currency as follows:
These working groups have been tasked with amending the ISDA 2006 Definitions to incorporate the fall-backs (once defined) and developing a plan and protocol mechanism to facilitate multilateral amendments.
Amendments to the ISDA 2006 Definitions incorporating new fall-backs will apply only to contracts executed after the amendment date. Legacy contracts will continue to reference existing IBOR until a permanent discontinuation occurs.
Triggers to signal the switch from IBOR to the fallback could be:
• The insolvency of the IBOR administrator (IBA for USD Libor)
• A public statement by the administrator that it will cease publishing IBOR
• A public statement by the administrator’s supervisor (FCA for USD Libor) that IBOR has been permanently discontinued
• A statement by the administrator’s supervisor that the use of IBOR was legally prohibited.
Impact on Floating Rate Debt?
Currently, the provisions in many credit agreements do not provide for an automatic switch to a different public rate. Given that the choice of SOFR as a risk-free benchmark is relatively recent, this may be a development that will come into place over the next year or two. However, it is clear that SOFR and Libor are very different so a simple switch may be inappropriate without some adjustment to the rate or margin. For end-users, it will be important that any transition take place across both debt and derivative instruments in a similar fashion, and on a similar timetable to avoid introducing new risks that would be difficult to manage efficiently.
Many corporate end-users of derivative instruments seek to apply hedge accounting in order to prevent volatility of reported profit and loss. A material amendment to an existing derivative could result in a requirement to dedesignate an existing hedging relationship and re-designate a new one.
Even if the change of reference rate is the same on the debt and the derivative instrument, this could still lead to ineffectiveness as the re-designated hedging relationship may be off-market. Further ineffectiveness would occur if the changes to the reference rate for the debt and derivative are different or happen at different points in time.
Under Dodd-Frank, some market counterparties are required to clear or post Initial and Variation Margin for new derivative instruments. However, to soften the impact of this change there has been some grandfathering of legacy swaps. Any ‘material amendment’ to an existing trade would bring it into scope for clearing/margining – a rule intended to avoid participants perpetually modifying trades to avoid the rules. The change of reference to the relevant risk-free interest rate could result in a material amendment to legacy swaps, which may prevent the grandfathering that many market participants have relied upon. This is already on the agenda for market participants and ISDA, amongst others, is likely to lead on the lobbying with regard to this area.
While it is a little early to give specific direction on commercial or documentation points that will arise from the transition, JCRA will continue to monitor developments and provide updates on Libor as the story evolves however, if you have any additional questions regarding Libor that you would like answered or addressed, we would love to hear from you.
6 While the FSB noted that EONIA is a viable RFR, EMMI, the administrator for Euribor, concluded it would not be feasible to move to a fully transaction based benchmark due to a lack of eligible transactions
10 See https://www.newyorkfed.org/arrc/faq#1 - efforts to move Libor trades to the SOFR will likely have to wait until the OIS market is moved from Fed Funds to SOFR.
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