As we wrote back in September, one of the thorniest issues in the rose bush that is Libor transition is whether you can find a proper replacement rate that, in market parlance, is “forward looking”.
To explain why a forward-looking, or term rate, is desired let’s quickly back up a little for all of you that have had better things to do than watch this sorry saga play out. (For those who have had the misfortune to be directly involved, skip to the cross-head.)
Libor is a benchmark that represents an average of what banks think it will cost them to borrow unsecured in money markets. It’s taken over a range of maturities in all the major currencies. In its purest and least corruptible form it measures overnight borrowing costs. But when it’s written into contracts, it’s usually one of the longer-term settings that’s used, like the three-month fix. Others, such as one-month and six-month settings, are also common. The reason why everyone likes using longer-term fixes so much is that you know at the start of the interest period on say, June 1, exactly what margin you’ll have to repay at the end of it in three months time, on September 1. And because Libor has been used in pretty much every floating rate contract there is for decades now, banks’ and companies’ systems have adapted to fit this pattern of knowing at the start of the borrowing period what will need to be repaid at the end of it.
But, up till now, officials in the UK, where the transition is most advanced, have called on parties to replace these term Libor settings with backward-looking benchmarks.
Broadly, these backward-looking benchmarks take, say, the past 90 days’-worth of readings for regulators’ preferred replacement, the Sterling Overnight Index Average (Sonia). As the name suggests, Sonia, which is produced by the Bank of England and — unlike Libor — based on actual transactions, represents the average cost of overnight loans. It’s long-established, having been around since the late ‘90s.
There’s valid reasons for using Sonia compounded in arrears. Not least that very few unsecured three-month loans are actually being made in the money markets. And, as those of us who followed the Libor scandal know only too well, that lack of liquidity meant fixings were susceptible to being, err, fixed.
The UK authorities would prefer to wait until there was far greater liquidity in Sonia derivatives markets before sticking their stamp of approval on a forward-looking rate. Even then, they would prefer parties to stick to using backward-looking measures that rely on actual transactions in highly-liquid overnight money markets wherever possible.
Backward-looking rates may be based on firmer foundations. But they remove the certainty that Libor provides. That’s because parties only find out what the margin on their loans will be a few days before an interest period is due to end. Rather than know on June 1 what you’ll need to repay on September 1, you’ll have to wait until late August to find out. That adds a lot of operational complexity into banks and businesses’ systems. It’s also far trickier to calculate compounded Sonia in arrears than it is to look up that days three-month Libor on Bloomberg or Reuters. Which goes some way to explaining why transition has proven so complex.
ARRC builds . . .
Got that? Right. So the situation in the US is different. Those involved in the transition, official and otherwise, are more open to using a forward-looking, or term, rate in a wider number of transactions. That’s in theory. In practice, however, there’s the same concern that the volume of transactions upon which a forward-looking rate will be based will be too thin for it to stand up to scrutiny.
Understandably, those who have lived through the whole process of Libor transition in the US share with their British counterparts a wish not to have to repeat the whole exercise upon discovering that the replacements are as flawed as the thing they set out to replace.
A further complication is that the players here have been a lot slower to switch financial contracts out of Libor and into new reference rates. So there’s even less liquidity in futures markets to base term rates on than in the UK.
The Alternative Reference Rates Committee, or ARRC, a public-private body which John Dizard describes here as “big enough to swamp a ferry boat”, is managing the transition from dollar Libor.
To try to spur progress on transition in the US, it has been laying out the characteristics of what it would consider an acceptable term rate.
(An important side note. ARRC has chosen the Secured Overnight Refinancing Rate, or Sofr, a rate based on repo market transactions, as its preferred replacement. But alternatives to Sofr are, while not officially endorsed, growing in popularity. Ameribor, one such alternative, has started to produce its own term rates. Expect more on this competition between rival Libor replacements in the coming weeks.)
ARRC made a statement on March 23 on what it would like to see in a Sofr term rate. But it left market players a little underwhelmed. On Thursday ARRC tried to rectify that by providing a specific list of three market indicators. Here they are in full:
The market indicators the ARRC will consider in order to recommend a term rate are:
1. Continued growth in overnight SOFR-linked derivatives volumes
2. Visible progress toward ARRC best practices designed to deepen SOFR derivatives liquidity:
a. Offering electronic market-making and execution in SOFR swaps and swap spreads
b. Changing the market convention for quoting USD derivative contracts from LIBOR to SOFR
c. Making markets in SOFR-linked interest rate volatility products (including swaptions, caps, and floors)
3. Visible growth in offerings of cash products, including loans, linked to averages of SOFR, either in advance or in arrears.
We managed to speak to ARRC’s Tom Wipf on Thursday afternoon, who said:
By identifying these indicators we are supplying clear guidance that would allow the ARRC to recommend a Sofr rate relatively soon . . .
. . . We have heard from the market that this is important and we are trying to be as clear as we possibly can about what that road map looks like.
. . . but will the market get onboard?
Wipf could not specify how soon “relatively soon” was, stressing that recommending a rate was more about state dependency than time dependency. Reaching that point would depend on how quick transition from Libor to Sofr took place:
When we look at all the numbers, pretty much every Libor trade that matures after [June] 2023 [when the last dollar Libor settings will cease to exist] will convert to Sofr. There is a massive amount of liquidity on the horizon, if we can just fill in the gap between now and the end of Libor.
If market participants continue to accelerate their move to Sofr derivatives then the ARRC should be in a position to recommend a rate shortly thereafter.
The statement is only just out, so we are not sure what the reaction will be like. We think it’s a pretty big carrot ARRC is offering here — get a move on with ditching Libor and you’ll get your term rate. We’re keen to see whether US financial markets agree.