A distinguished panel of experts met via video conference on February 2, 2021, to provide the CFA Society Chicago with an update on the transition away from the use of LIBOR as a reference rate in global capital markets. The event was hosted by the Society’s Education Advisory Group.
Christina Ochs, president and CEO of the Corporation for Interest Rate Management (CIRM) which provides tailored interest rate hedging strategies and interest rate derivative products to corporate borrowers to help them manage interest rate risk.
Alex Roever, CFA, head of US Interest Rate Strategy for J.P. Morgan Securities LLC, covering US government securities markets, interest rate derivatives, and money markets. In addition, he coordinates research on the impact of regulations on financial markets.
Dr. Richard L. Sandor, entrepreneur, economist, and inventor of new markets. He currently is chairman and CEO of the American Financial Exchange (AFX), an electronic exchange for direct interbank/financial institution lending and borrowing. AFX’s flagship product is the AMERIBOR benchmark index which reflects the real borrowing costs of thousands of banks across the U.S. He has served on the board of directors of leading commodities and futures exchanges such as the Chicago Mercantile Exchange, Intercontinental Exchange, Chicago Board of Trade, and the London International Financial Futures and Options Exchange.
Meredith Coffey–moderator, executive vice president of the Loan Syndications and Trading Association (LSTA). As a member of the senior leadership team at LSTA, she manages the Research Department and is co-head of the LSTA’s public policy initiatives, which facilitate the continued availability of credit and the efficiency of the loan market. In addition, Coffey heads efforts to analyze loan market developments, helping the LSTA build strategy and improve market efficiency.
Coffey began by describing the current state of the transition away from LIBOR. As of late 2020, US banking regulators had established December 31, 2021, as the latest date for initiating new contracts using LIBOR as a reference rate. They should also include hardwired fallback language to change to an alternative benchmark in the future. Existing financial contracts may continue using LIBOR until June 30, 2023, by which time a substitute must be phased in. This gives banks and their borrowing clients time to work out a thoughtful remediation plan. Coffey expects hardwired fallback language (i.e., defining a substitute reference rate) to become a standard feature in new contracts established during 2021. In the second half of the year, new reference rates will become increasingly common to smooth the lead-in to the deadline on December 31. Collateralized Loan Obligations (CLO’s) may face increased basis risk during the transition period because their assets are likely to adopt different reference rates sooner than their liabilities will change. This risk will have to be managed.
Roever continued the discussion by describing the most likely replacement rates. They fall into two categories:
- Risk fee—of which there is one main alternative, SOFR (Secured Overnight Funding Rate)
- Credit Sensitive—of which there are several candidates provided by various sponsors
- ICE Bank Yield Index
- BSBY—Bloomberg Short-Term Bank Yield Index
- IHS Markit SOFR Adjustment
SOFR has the inside track currently because it is favored by the US Federal Reserve Board. It is derived from the market for overnight repurchase agreements (Repo) using U.S. Treasury Securities as collateral. That market is very deep giving the rate transparency and credibility. However, because of the high-quality collateral, the rate doesn’t include any credit spread, and the market for terms longer than one day are much less liquid. In addition, the supply/demand dynamics of the Repo market can add volatility to the rate that isn’t reflective of general economic conditions. U.S. Government Agencies have been the biggest users of SOFR, primarily as the reference rate for floating rate debt. It has been used very little so far in corporate loan agreements.
Of the various credit sensitive rates, Ameribor is the only one currently in use. Sandor described it as a volume-weighted average of the rate on unsecured loans traded on the AFX. It has several advantages:
- It is based on real transactions among a heterogenous mix of financial institutions (large, small, money center, regional, non-bank, higher and lower quality, etc.)
- It is transparent (the transactions are recorded on an exchange)
- It is calculated by a third party, the Chicago Board Options Exchange (CBOE).
- It is entirely a domestic American rate—the first of its kind.
- It will have a full term structure of rates (although not yet developed).
Ameribor is already used for commercial loans, floating rate deposits, subordinated debt, interest rate swaps, and (as of June 2020) interest rate futures (based on the thirty-day average of the daily rate).
The other credit sensitive rates all purport to measure bank funding costs, by various means. All remain under development, and therefore at a disadvantage to Ameribor.
Ochs added here that the lack of a viable term rate is a big disadvantage for SOFR. Her corporate clients need that feature to allow for better matching of their cash flows, and to reduce their interest rate risk (and the consequent need to hedge). The current method of determining a term SOFR rate by averaging the overnight rate in arears doesn’t work well with the accounting systems of either the corporate borrowers or the lending institutions. Roever said the term Repo market is too thin to support a viable term SOFR rate structure, but one can be derived from futures and swaps. This, however, adds a layer of complexity which clouds the transparency of the process and also raises questions of mechanics.
Ochs went on to list the primary concerns of her clients:
- What is the timing and logistics (e.g., cost in time and money) of implementation across both debt and hedge portfolios?
- Will the cost of funding increase relative to using LIBOR?
- Will the replacement rate be more volatile than LIBOR?
- What will be the effect on existing loan agreements and hedge positions (i.e., the hardwired fallback language)?
- What will be the impact on the liquidity (availability and cost) of OTC hedge products?
She expects the cost of SOFR-based options to be higher because of lower liquidity, at least to start.
Roever admitted that these are all very good questions with the answers yet to be determined. Sandor pointed out the importance of educating key influencers and decision makers on the importance of LIBOR alternatives. That is why he spends time speaking with educators and corporate executives on the topic. He’s following the method the CME used when it introduced futures on the S&P 500 Index. They focused first on institutional asset owners and relied on them to convince their managers to adopt the product.
The Q&A session revealed several other tidbits:
- Roever noted that volatility in the SOFR market could flow through to the underlying market for U.S. Treasuries, the opposite of what one might consider the normal relationship.
- Most countries with large credit markets have an alternative for LIBOR, but they vary greatly, so there is no clear preference.
- Coffey predicted that there will not be an extension of the current deadlines. Regulators are firm in their desire to complete the transition. Despite this, she believes that LIBOR will continue to be published well past the 2023 deadline. Old institutions tend to fade away very slowly.