SOFR Replacing LIBOR
The London Interbank Offered Rate (LIBOR) is going away, and the international financial community is working hard to plan for and mitigate risks to make a smooth transition. In the United States, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) has recommended the Secured Overnight Financing Rate (SOFR) as the preferred replacement rate. The New York Fed began publishing SOFR regularly on April 3, 2018. In July 2018, Fannie Mae issued $6 billion in SOFR-denominated securities, leading the way for other institutions who have since followed suit. In November 2018, the Federal Home Loan (FHL) Banks issued $4 billion in debt tied to SOFR. CME Group, a derivatives and futures exchange company, launched 3-month and 1-month SOFR futures contracts in 2018. All of these steps to support liquidity and demonstrate SOFR demand are designed to create a rate more robust than LIBOR—the transaction volume underpinning SOFR rates is around $750 billon daily, compared to USD LIBOR’s estimated $500 million in daily transaction volume.
USD LIBOR is referenced in an estimated $200 trillion of financial contracts, of which 95 percent is derivatives. However, the remaining cash market is not small. USD LIBOR is referenced in an estimated: $3.4 trillion in business loans, $1.3 trillion in retail mortgages and other consumer loans, $1.8 trillion in floating rate debt, and $1.8 trillion in securitized products.
The ARRC has held consultations on its recommended fallback language for floating rate notes and syndicated business loans—the responses are viewable on the ARRC website. On December 7, the ARRC published consultations on securitizations and bilateral business loans, which are both open for comment through February 5, 2019.
Amid the flurry of positive momentum in the transition towards SOFR, anxiety remains that the broader market is not moving quickly enough. ARRC consultations and working groups indicate that these anxieties derive primarily from a few specific points of debate: development of term rates, consistency of contracts, and implementation timing.
Because the SOFR futures market remains immature, term rates cannot be developed without significant market engagement with the newly created futures. The ARRC Paced Transition Plan includes a goal to create a forward-looking reference rate by end-of-year 2021 – just as LIBOR is scheduled to phase out. In the interim, financial institutions must figure out how to build into existing contracts fallback language or amendments that include a viable alternative to LIBOR term rates.
The nascent SOFR futures market is growing quickly, with December 2018 daily trade volumes at nearly 16,000. However, they pale in comparison to Eurodollar futures volumes, which logged daily averages around 5 million per day at CME Group alone. This puts SOFR on track according to the ARRC plan, but means institutions remain in limbo until the futures market is more mature and term SOFR rates can be developed.
In July 2018, the Financial Stability Board (FSB) stated their support for employment of term rates primarily in cash markets, while arguing that spreads are tightest in derivative markets focused around overnight risk-free rates (RFRs), which therefore are preferred. An International Swaps and Derivatives Association (ISDA) FAQ document published in September 2018 explained the FSB’s request that “ISDA should develop fallbacks that could be used in the absence of suitable term rates and, in doing so, should focus on calculations based on the overnight RFRs.” This marks a major change, given that derivatives commonly reference 3-month LIBOR, and cash products are dependent on forward-looking term rates. Despite the magnitude of change, transition from LIBOR term rates to an alternative term rate based on limited underlying transactions would be undesirable.
The FSB explained:
Moving the bulk of current exposures referencing term IBOR benchmarks that are not sufficiently anchored in transactions to alternative term rates that also suffer from thin underlying markets would not be effective in reducing risks and vulnerabilities in the financial system. Therefore, the FSB does not expect such RFR-derived term rates to be as robust as the RFRs themselves, and they should be used only where necessary.
In a consultation report published December 20, 2018, ISDA stated the overwhelming majority of respondents’ preference for fallback language with a compounded setting in arrears rate for the adjusted RFR, with a significant and diverse majority preferring the historical mean/median approach for the spread adjustment.
Though ISDA’s consultation report noted some drawbacks to the historical mean/median approach for the spread adjustment, the diversity of supporters – in all regions of the world, representing many types of financial institutions – was a strong indicator of market preference. By comparison, there was no ambiguity about preference for the RFR in fallback language: In almost 90 percent of ISDA respondent rankings, the compounded setting in arrears rate was selected as the top preference for the adjusted RFR.
In the Structured Finance Industry Group (SFIG) LIBOR Task Force Green Paper, the group indicates strong preference for viable term rates and leaves the question of whether such calculations should be done in advance or in arrears as an open item, while indicating preference for continuing prospectively determining rates at the start of each term. They list their preference for waterfall options as first an endorsed forward-looking term SOFR rate, and second, a compounded or average daily SOFR. SFIG is currently drafting their response to the ARRC Securitization Consultation, which will be made public on the ARRC website after submission.
Despite stated preferences, working groups are making a concerted effort to follow the ARRC’s guidance to strive for consistency across cash and derivative products. Given the concerns about a viable term rate, some market participants in cash products are also exploring the realities of implementing ISDA’s recommended fallback language and intend to incorporate those considerations into their response to the ARRC consultations.
In the absence of an endorsed term rate, pricing of other securities such as fixed-rate bonds is difficult, if not impossible. Additionally, the absence of an endorsed term rate creates issues of consistency within the rate itself (i.e., market standards will need to developed around how and over what periods the rate is compounded). The currently predominant recommendation of a compounding in arrears overnight risk-free rate would also have added complexity when compared with any forward-looking rate, which is exacerbated in the cash markets with consumer products where changes must be fully disclosed and explained. Compounding in arrears would require a lock-out period at the end of a term to allow institutions time to calculate the compounded interest. Market standards and consumer agreement around the specific terms governing the lock-out period would be difficult to establish.
While ISDA has not yet completed formal consultation specific to USD LIBOR and SOFR, and their analysis is only applicable to derivatives and swaps, there are several benefits to consistency across cash and derivatives markets. Consistency of contract terms across all asset classes during the transition away from USD LIBOR lowers operational, accounting, legal, and basis risk, according to the ARRC, and makes the change easier to communicate and negotiate with stakeholders.
Though it is an easy case to make that consistency is advantageous, achieving it is not. For example, the Mortgage Bankers Association points out that the ISDA-selected compounding in arrears approach to interest accrual periods “would be a very material change from current practice as period interest expenses would not be determined until the end of the relevant period.” The nature of the historical mean/median spread adjustment does not come without drawbacks. ISDA’s consultation acknowledges that the approach is “likely to lead to value transfers and potential market disruption by not capturing contemporaneous market conditions at the trigger event, as well as creating potential issues with hedging.” Additionally, respondents acknowledge that relevant data may not yet be available for long lookback periods with the newly created overnight risk-free rates.
The effort to achieve some level of consistency across the transition away from LIBOR poses several challenges related to timing. Because LIBOR will only be unsupported (rather than definitively discontinued) by the Financial Conduct Authority (FCA) at the end of 2021, some in the market retain a small hope that production of LIBOR rates could continue. The continuation of LIBOR is possible, but betting a portfolio of contracts on its continuation is an unnecessarily high-risk decision. That said, transition plans remain ambiguous about timing, and implementation of any contract changes is ultimately at the sole discretion of the contract holder. Earlier ARRC consultations acknowledged two possible implementation arrangements:
- An “amendment approach,” which would provide a streamlined amendment mechanism for negotiating a replacement benchmark in the future and could serve as an initial step towards adopting a hardwired approach.
- A “hardwired approach,” which would provide market participants with more clarity as to a how a potential replacement rate will be identified and implemented.
However, the currently open-for-comment securitizations consultation has dropped the “amendment” and “hardwired” terminology and now describes what amounts to the hardwired approach as defined above – a waterfall of options that is implemented upon occurrence of a predefined set of “trigger” events. Given that the securitizations consultation is still open for comment, it remains possible that market respondents will bring the amendment approach back into discussions.
Importantly, in the U.S. there are currently no legally binding obligations for organizations to plan for the cessation of LIBOR, nor policy governing how that plan be made. In contrast, the European Union has begun to require that institutions submit written plans to governing bodies.
Because the terms of implementation remain open for discussion and organizational preference, there is some ambiguity about when organizations will begin transitioning contracts away from LIBOR to the preferred risk-free rates. In the structured finance market, this compounds the challenge of consistency with timing. For commercial real estate securities, for example, there is possibility of mismatch in the process and timing of transition for rates in the index and for the underlying assets and resulting certificates or bonds. This potential challenge has not yet been addressed by the ARRC or other advisory bodies.
The mortgage market is still awaiting formal guidance. While the contributions by Fannie Mae and the FHLBanks to the SOFR market signal government sponsored entity (GSE) support for the newly selected reference rate, none of the GSEs has issued any commentary about recommended fallback language specific to mortgages or guidance on how to navigate the fact that SOFR does not yet have a viable term rate. An additional concern for consumer loan products, including mortgages, is the need to explain the contract changes to consumers. As a result, the ARRC Securitization consultation hypothesizes that consumer products are “likely to be simpler and involve less optionality and complexity, and any proposals would only be made after wide consultation with consumer advocacy groups, market participants, and the official sector.”
For now, the Mortgage Bankers Association has recommended institutions develop a preliminary transition plan, beginning with a detailed assessment of exposures to LIBOR.
How can RiskSpan Help?
At any phase in the transition away from LIBOR, RiskSpan can provide institutions with analysts experienced in contract review, experts in model risk management and sophisticated technical tools—including machine learning capabilities—to streamline the process to identify and remediate LIBOR exposure. Our diverse team of professionals is available to deliver resources to financial institutions that will mitigate risks and streamline this forthcoming transition.