Theme for 2018: Debt and derivatives players set out on long road away from Libor
It is six months since Andrew Bailey, head of the UK financial regulator, set the clock ticking on a transition from the London interbank offered rate to an alternative. But if credible replacements are to be ready by his 2021 deadline, there is still a mountain of work to do. Ross Lancaster explores the risks of phasing out the old benchmark and asks if it could yet survive.
Libor’s demise has been much exaggerated. In July 2017, Andrew Bailey, chief executive of the UK’s Financial Conduct Authority, signalled an end to the FCA’s oversight of the reference rate, but not its abolition.
Despite a public image tarnished by rigging, the rate has in fact been firmed up from its scandal-ridden nadir. Systems and personnel have been improved to capture a maximum of actual transaction data to calculate the benchmark. Less rigging, more rigour, it would appear.
Meanwhile, moving away from Libor is fraught with risk. Negotiating a smooth transition is one of the trickier challenges capital market operators will face this year and beyond.
The scale of the task required for its phase-out is enormous and a seamless shift looks improbable.
But momentum is fast heading away from Libor. The assumption is spreading across capital and derivatives markets that a majority of the $350tr of financial contracts Libor underpins will move on to different benchmarks.
“Unsecured loans and deposits are — for the majority — a thing of the past,” says Richard Bigwood, senior managing director, rates, at ICAP in London.
“The wheels of finance used to be well greased, but after the crisis during 2007/2008 Libor moved away from implied future strips, which widened the basis between actual Libors and implied Libors. The unsecured money markets are not functioning as they did pre-financial crisis, so it is a healthy move to change from Libor to a more heavily tradeable rate. It is also an easier way to value a derivatives or deposit book.”
Disruption seems inevitable along the transition, though, and most likely in the primary markets. Existing bonds’ fall-back provisions vary from issuer to issuer and do not provide for a full transfer from Libor. Bailey’s announcement has made a big splash in floating rate debt markets, where fall-back provisions and legacy contracts have become an urgent question with no easy answer.
“Since Andrew Bailey gave the unofficial 2021 deadline, the focus has quickly switched to products linked to Libor such as FRNs, syndicated loan issuance and fall-back provisions,” says Subadra Rajappa, head of US rates strategy at Société Générale in New York. “Market participants want risk language that appropriately reflects exposure to issuers. There is special attention on FRNs, which have always had fall-back language that varies from issuer to issuer.
“The ultimate question is if Libor ceases to exist, do trustees have the right to call two or three banks and take an average of their estimates of the rate? FRNs’ fall-back language was written for the temporary, not permanent, disappearance of Libor. The language now is inadequate.”
Adjusting floating rate debt contracts to a new reference rate will be complicated. As things stand, the most obvious way of doing this would trigger a wave of bondholder meetings as issuers sought to amend the term sheets of their debt.
While that would be good for liability management bankers’ fees, issuers and investors stand to spend a large part of the future dealing with documentation in their existing portfolios.
“Some kind of liability management transaction would be required to rewrite the reference rate on floating rate debt, such as a consent solicitation, a buyback, tender offer or exchange,” says Catherine Wade, associate at Linklaters in London.
“Usually changing the terms and conditions for interest rate provisions would be a reserved matter for bondholder meetings, with higher thresholds required for consent than other measures. If this is required, it would be a huge liability management exercise across the market.”
The longer uncertainty drags on, the greater the risk to Libor-linked instruments. Issuers are still writing debt and swaps referencing the rate, but these products’ future is unsure unless the pace of progress picks up substantially.
“We are particularly concerned about long dated swaps and FRNs, as a lot of existing loans do not have good fall-back language and do not mature before the 2021 phase-out date,” says William De Leon, global head of portfolio risk management at Pimco in Newport Beach, California. “So there is uncertainty as to how they perform after that date and the value ascribed to them. We are already seeing some new issuance language inserted to make things clear. But this is on a proportionally small amount of deals and things are moving too slowly.”
Derivatives market ahead in search for alternatives
At this stage, a clear-cut alternative to Libor does not exist, which increases the chance of banks voluntarily sustaining it beyond 2021. Many banks that submitted to the Libor panel did so reluctantly, wary of the compliance cost and reputational risk of doing so. But until alternatives firm up, it remains the most credible benchmark.
“Libor is very entrenched into banks’ framework and it is going to be hard to move away from it quickly,” says Rajappa.
“Even for internal processes the banks have an interest in maintaining Libor.”
In the derivatives market, more progress has been made in finding a replacement than in debt. Even before Bailey’s speech, committees in the US, UK and Switzerland had decided on the Sofr, Sonia and Saron rates as respective benchmarks for the future.
But much work remains to be done and proposed risk-free rates are far from being easy replacements yet. They are based on overnight rates, so do not align with term funding needs, and will tighten in flights to safety, so will not reflect risk aversion in credit markets.
“One of the challenges is that the relevant risk-free rate can only be a starting point for a fall-back, as it doesn’t include the credit and term premium that is embedded within a term Libor rate,” says Deepak Sitlani, partner at Linklaters in London.
Between credit risk and term rates, the latter is a priority for loans bankers and indeed most market participants. David Clark, chairman of the European Venues and Intermediaries Association* in London, believes that a Sonia curve will emerge this year, but that in the long term more than one curve may be used as a replacement or supplement to Libor.
“The work being done to develop overnight risk-free rates is very important, but does not solve the problem of how to create a benchmark along a curve for different maturities,” says Clark. “This is essential for pricing credit and debt capital market products used in the swaps and FRN markets that require a curve that is so widely accepted it can be used for loans as well as repricing portfolios.”
As work progresses, there is also a danger that liquidity will fragment. Even with Bailey’s impetus, a lot of effort is needed to create fully formed and vibrant markets. Active trading will be needed in futures and swaps markets for the rate, new hedging systems will need to develop and a cleared product will be required.
“A key risk is liquidity, and the rule is: ‘build it and they will come’,” says Rajappa, who represents Société Générale on the Alternative Reference Rate Committee (ARRC), which picked the Sofr rate for US markets.
“Libor is good because people understand its dynamics as a rate, but there is very little understanding of the new benchmark and little comfort with how it trades in stress scenarios,” she says. “It will really need market participants to sponsor the new product. If that doesn’t happen, it will be very hard to get the new rate up and running.”
There are early signs that the market is making positive strides, though.
Experience with Saron, the most developed of the alternative rates, has been promising. LCH now clears Swiss franc interest rate swaps referencing the benchmark and that achievement shows that markets for the new rates can be accelerated.
“OTC markets up to now have seen a development of liquidity and user base through bilateral trading, with clearing entering as a later requirement,” says Philip Whitehurst, head of service development, FX and rates derivatives, at LCH in London. “In trying to launch markets for new reference rates we won’t have some of the traditional evidence used to determine whether a product is suitable for clearing.
“Liquidity is an important consideration before starting to clear a product. However, markets are increasingly looking for an instrument to be cleared in order for participants to adopt the new product.
“Our internal governance and external regulators displayed a positive and pragmatic approach in supporting the transition,” adds Whitehurst. “As a result, the migration from TOIS to Saron at LCH was achieved very quickly, and without any compromise to our risk standards.”
* The Wholesale Markets Brokers’ Association changed its name to the European Venues and Intermediaries Association on December 20, after the initial publication of this story. The article has been changed to reflect this.