Richard Berner wrote the following column for the Bipartisan Policy Center as a contribution to BPC’s joint event with ISDA “”.
London Inter-bank Offered Rate (LIBOR) and other interest rate benchmarks are fragile. So regulators globally are working with industry to identify and transition to sturdy alternatives.
While there are legitimate concerns that the transition to these new reference rates will be disruptive, LIBOR’s persistent fragility makes reform critical. And because the transition to resilient reference rates requires a lot more work, the time to act is now.
LIBOR (now known as ICE LIBOR, after its new administrator) is a reference rate that plays a central role in global financial markets and the economy. U.S. dollar-denominated LIBOR is the benchmark for some $200 trillion (gross notional value) in derivatives and more than $10 trillion in domestic loans to consumers and businesses.
LIBOR is fragile for two reasons. First, LIBOR was intended to reflect the (unsecured) benchmark cost of bank funding. Following the financial crisis, such unsecured lending virtually disappeared. Second, published LIBOR rates are largely based on a voluntary survey of banks, not on actual transactions; but because of fines for manipulation, banks are wary of participating in the survey. So, recent improvements in the governance and processes for publishing ICE-LIBOR are insufficient to assure its viability. Given LIBOR’s continued widespread use, shocks to it can threaten both individual institutions and the stability of the financial system.
Identifying and implementing alternatives. Fortunately, LIBOR’s fragility has promoted efforts to identify alternatives. In the United States, supported by the Federal Reserve and other U.S. authorities, the private-sector Alternative Reference Rates Committee (ARRC) has worked to identify viable alternatives to U.S. dollar LIBOR. Similar initiatives are underway in the euro area, the United Kingdom, Switzerland, and Japan.
Relying on the International Organization of Securities Commissions’ (IOSCO) Principles for Financial Benchmarks, the ARRC developed criteria against which to evaluate the alternatives to LIBOR as reliable measures of market activity. Among them: quality based on market liquidity, transaction volume and resilience to shocks; processes and governance to ensure compliance with the principles and benchmark integrity; and ease of implementation.
After considering several alternatives, the ARRC settled on the secured overnight financing rate (SOFR) – the rate based on the deepest and strongest underlying market, with the largest daily volume of transactions – about $750 billion. SOFR blends secured transactions from the various segments of the U.S. repurchase agreement market (triparty, General Collateral Financing (GCF) and bilateral) into a composite. Last spring, in cooperation with the Office of Financial Research, the New York Federal Reserve began daily publication of SOFR.
The launch of SOFR is only the first step in providing alternatives to LIBOR. The transition to an alternative rate will require acceptance by the end users of derivatives who “cannot be expected to choose or transition to trading a benchmark that does not have at least a threshold level of liquidity” according to an ARRC Interim report. In October 2017, the ARRC adopted a “paced” transition plan to provide this threshold level of liquidity.
The immediate challenge is to create sufficient liquidity for derivatives contracts based on SOFR. ARRC foresees building the infrastructure for futures and/or overnight index swap (OIS) trading in SOFR and gradually widening the coverage to other derivatives referencing SOFR. Next, the plan envisions that central counterparties (CCPs) will clear swaps, enabling users to make the transition from LIBOR and the Effective Federal Funds Rate (EFFR) to SOFR at progressively longer maturities. Finally, the plan contemplates the creation of a term reference rate (with a maturity to be determined) based on these derivatives. A key challenge is whether there will be enough volume in term derivatives referencing SOFR to form a robust basis for rates at maturities greater than overnight that may serve as a reference in certain cash products.
The good news is that these changes are ahead of schedule. Originally projected for the latter half of 2018, the Chicago Mercantile Exchange (CME) launched one- and three-month futures contracts in SOFR on May 7. LCH (the London CCP) and CME began clearing SOFR-OIS, SOFR-LIBOR, and SOFR-EFFR basis swaps in July and on October 1, respectively. These should all add liquidity to SOFR and facilitate the transition to it from LIBOR and from the EFFR. Nevertheless, there is much more to do―in collaboration with end users―to move a significant portion of the derivatives markets away from LIBOR and to the new reference rate.
In addition to executing the ARRC’s plan, there are two further challenges to making a smooth transition to SOFR. First, there must be better contract or “fallback” language for both derivatives and cash products to allow for an economically appropriate successor rate if LIBOR stops. There is progress here, too. Most important, the International Swaps and Derivatives Association (ISDA) is drafting fallback arrangements for new LIBOR derivatives contracts that will specify a robust mechanism for determining payment obligations if LIBOR ceases to exist, and ISDA will offer a protocol to amend legacy contracts to include this new language. Market participants are playing a significant role in helping to develop such protocols for both derivatives and cash markets. The ARRC in July published Guiding Principles for More Robust LIBOR Fallback Contract Language in Cash Products, and on September 24 released consultations on U.S. dollar (USD) LIBOR fallback contract language for floating rate notes and syndicated business loans for public feedback.
Second, transitioning from LIBOR in legacy or existing contacts is not simple. To help the transition, authorities globally have announced that they and participating banks will support LIBOR until 2021. While the publication of LIBOR may continue past this date, there is no guarantee. Authorities are urging market participants to stop writing new contracts referencing LIBOR, and to provide fallback language for all contracts that contain references to LIBOR, especially those maturing after 2021.
The authorities are warning those firms that haven’t engaged about the risks of delay. And they are prodding all firms to report on their progress in moving to the transition. For example, on September 19, the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) wrote to CEOs of major banks and insurers supervised in the UK asking for the preparations and actions they are taking to manage transition from LIBOR to alternative interest rate benchmarks. No one can say they haven’t been told.
Richard Berner is an Executive in Residence and Adjunct Professor at the Center for the Global Economy and Business, NYU Leonard N. Stern School of Business, and he is also the former Director of the Office of Financial Research.