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What will life after LIBOR look like?

On January 15, 2020, CFA Society Chicago held its event SOFR: Life After LIBOR, where a distinguished panel gathered to explain why the interest rate was going away and how potential alternatives are being developed. LIBOR has been described as “the world’s most important number” and is scheduled to be sunsetted at the end of 2021. Without a fully suitable substitute rate to take its place and thousands of floating securities in need of a new rate to set coupon payments, it may be a mad dash at the end of 2021 to ensure that the investment industry is ready for a LIBOR successor.

Agha Mirza, MD and Global Head of Interest Rate Products at CME Group said “We believe that SOFR, a transaction-based benchmark, to be highly useful.” At the CME, they see the transition to SOFR from LIBOR as a tremendous opportunity to create new products, while asset managers see the transition as more of a risk to be managed. Jerome Schneider of PIMCO said that they in the process of learning about replacements for LIBOR similarly to all institutions with the aim of understanding and mitigating potential risks of shifting to a LIBOR replacement on behalf of clients.

So why is LIBOR going away anyway? Many market practitioners will remember the LIBOR rigging scandal that emerged in summer of 2012 on the back of a settlement from Barclays Bank and a report from the Financial Times stating that LIBOR manipulation had been taking place since the early 1990s.

Given that LIBOR is and was a benchmark created from an aggregated view of banks’ best estimates of their costs of funding, it was prone to manipulation because the rate affected the price of trillions of dollars’ worth of securities and moving the rate, even by a small amount, could materially impact banks’ bottom lines.

Manipulation aside, there are several other reasons why LIBOR is scheduled to wind down. For one, banks typically no longer fund themselves through interbank lending, and instead rely on a variety of other funding sources. Thus, LIBOR today isn’t a good reflection of banks’ actual funding costs. The UK FCA has determined that it will no longer require member banks to submit their LIBOR quotations as of December 31, 2021. According to the panel, banks generally aren’t keen on submitting LIBOR anyway, because it opens them up to potential liability, so without the UK regulator compelling them to do so, they likely will cease providing LIBOR data, so market participants need to start planning now on what to do when LIBOR is no longer available. “Don’t bet your business on the government forcing an extension of LIBOR,” urged one panelist.

There are several choices to replace LIBOR, and SOFR, a measure of bank funding from the repo market, has emerged as a frontrunner. As of now, the three main substitutes include: The Federal Funds rate, SOFR, or other rates such as the Chicago-developed AMERIBOR (more on that later). The panel deemed that a good LIBOR replacement ought to offer two features: a cost of funds, or credit spread component that should increase in times of market stress, and b) term structure (such as the various tenors of LIBOR like 30 day, 90 day etc.).

If a security has a floating rate component that is benchmarked to LIBOR, and LIBOR goes away, then what happens? Investors must consult the security’s prospectus to be sure, but the security will likely be bucketed into one of three categories: 1) the security already has a LIBOR alternative interest rate curve specified in its prospectus 2) the security will essentially shift from floating rate to fixed rate terms and will use the LIBOR rate as of the last reset date prior to LIBOR’s termination in perpetuity 3) the security prospectus doesn’t specify an alternative rate and the trustee will have some discretion on how to select the new floating rate. SOFR tends to favor debt issuers as it is a lower rate than LIBOR that currently doesn’t include a spread component. Part of the process will be issuers figuring out what sort of terms lenders will accept.

So, what exactly is SOFR? It is an interest rate based upon overnight repo transactions that began its life in April 2018. While securities linked to LIBOR typically utilize term structure of either 3 or 6 months, whereas SOFR is an overnight rate. Adding a tenor component to SOFR will be a bit of a challenge, but the working panel already has thought of 5 possible solutions. The benefit of using an observable rate, which is calculated based on actual transactions instead of estimates like LIBOR is clear: it should be much less prone to estimation error and manipulation. Another issue is that it is a collateralized repo rate repo, whereas LIBOR is an uncollateralized rate. There also isn’t a spread component to SOFR as there is with LIBOR, so the SOFR rate could potentially decline in a crisis scenario, when at the same time banks’ funding costs would presumably rise (as LIBOR did during the 2007-2008 recession when bankers were reluctant to lend and liquidity was scarce).

This counter behavior of the replacement rate during a crisis does pose some serious challenges for SOFR to fully replace LIBOR. Ultimately, several different rates might need to be used that are fit for purpose instead of using an all-purpose rate like LIBOR that had been used for a wide variety of applications. The volatility of SOFR has also been a big topic following the repo rate fiasco of the fourth quarter of 2019 when repo rates unexpectedly spiked and no one is exactly sure why. Proponents of LIBOR say that its much less volatile nature makes it a better rate for most purposes, but detractors reckon that the lack of volatility of LIBOR shows you that it was clearly gamed. The volatility of SOFR can also be reduced by using a moving average of the rate.

Ameribor would be another potential replacement. Ameribor rates are determined by a similar overnight rate that banks use for funding short term liabilities. Yet it is a much smaller market overall than LIBOR with far less liquidity. It also does not offer term structure, but that is being worked on as it is with SOFR as well. One benefit of Ameribor compared to SOFR is that its rate would likely increase in a crisis as the rates banks would charge other banks would likely go up, so it makes it more reflective of actual funding costs. SOFR would potentially have more basis risk than LIBOR did too.

ISDA is working on standard fallback language, the terms that specify which interest rate curve will be used to compute coupon payments if LIBOR goes away. But existing securities with contracts that aim to use LIBOR post 2021 will need to go through a process of determining the new rate, which could get convoluted and protracted.

The good news is that some new credit issuances lately have included language that spells out which rate to use for floating rate coupons if LIBOR were to cease, and some securities’ prospectuses explicitly state SOFR as the alternative rate. Shell recently did a SOFR-linked $10 billion debt offering that gives them the option to shift to SOFR down the road. This was an uncommon practice as early as six months ago. Some loans specify the prime rate as the fallback rate, which is some 300 bps higher than LIBOR and could pose some serious challenges for borrowers. Most fallback language was inserted into contracts in order to protect from natural disasters; it was assumed that LIBOR would be available perpetually.

Security prospectuses that don’t specify a fallback rate must be amended prior to 2022. There is an expedited process that seeks to get approval to switch the reference rate in just 5 days. Given that there are approximately 15,000 syndicated loans using LIBOR in existence, it would be challenging to get them all through this process so quickly. Instead of this fast-track process, the committee recommends that investors use what they termed a “hard wired approach” where the current LIBOR rate is translated into SOFR plus a spread, and these terms are written into a prospectus amendment.

One panelist semi-jokingly urged younger attendees to “go back to law school and become a securities attorney” because a lot of people are going to get sued as a result of the transition from LIBOR to an alternative rate.

Will the buy-side seek out SOFR-linked securities and accept the rate as a substitute for LIBOR? That will depend on each specific security on offer and if owning it is compatible with an advisor’s role as a fiduciary – if it isn’t good for the client, then asset managers simply won’t do it.

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