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Response to CME’s SOFR futures contracts may provide early signal.

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Capital Markets

Libor Is Not Going Down Without a Fight

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June 26, 2018

By John Hintze

Battle brews as Intercontinental Exchange vows to maintain Libor. 

Regulators may want to shift to new benchmark rates for floating-rate debt, but the Intercontinental Exchange (ICE) isn't giving up on the London Interbank Offered Rate (Libor), which it took over in 2014, setting up a potential clash between rates and a maelstrom for users of floating-rate debt and derivative products.

"ICE is actively trying to maintain Libor," Yon Valtchev, fixed-income specialist at Bloomberg, told NeuGroup's Assistant Treasurer Leadership Group at a recent meeting. "The ICE website says Libor will continue to be published past 2021."

That's the target date for adopting the Secured Overnight Financing Rate (SOFR), which the Federal Reserve Bank of New York began publishing in early April. The CME launched SOFR futures in early May, and Bloomberg anticipates OTC products giving market participants exposure to SOFR by year-end, and cleared products in 2019.

Following the 2008 financial crisis, when banks lost trust in one another, the Libor market was essentially broken, and banks relied on commercial paper to fund themselves. Given the lack of interbank transactions, banks submitted non-market-based rates to the British Bankers' Association (BBA), which at that time calculated Libor, and it later became apparent that some were submitting rates skewed in their favor.

As a result, US regulators have sought a Libor replacement in SOFR, a rate calculated from three existing indices stemming from overnight Treasury repurchase agreements (repos). European regulators, meanwhile, have launched the Sterling Overnight Index Average (Sonia) that similarly aims to replace Libor.

A primary benefit of SOFR is that it is calculated from actual transactions whose volume has hovered around $800 billion daily since the new rate's launch, offering transparency Libor cannot provide. Libor has been calculated using submissions from major banks, which have based their estimates on the following question: "At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?"

Following the scandal, administration of the benchmark was moved from the BBA to the ICE, which has sought to strengthen confidence in it by developing a more thorough approach for bank submissions. The benchmark still relies on submissions by a limited number of global banks, but they now follow a "waterfall" methodology starting with submissions based on actual transactions, then transaction-based data, followed by the banks' expert judgment.

"The use of expert judgment … is designed to ensure that Libor submissions can be made, and consequently that Libor can be published, on every applicable London business day, even when liquidity and transactions in particular currencies and tenors are such that a Panel Bank has insufficient eligible transactions or transaction-derived data to make a Level 1 or a Level 2 submission," the ICE noted in a report published April 25 titled "ICE Libor Evolution."

The ICE Benchmark Association (IBA) began testing Libor rates under the new methodology in mid-March, and on April 25 it announced that it intends to transition the panels of banks on a gradual basis for each of the five currencies in which Libor will be produced, to minimize operational and technology risk.

So now the competition begins, and market participants will ultimately determine the winner. Libor starts with several advantages, given that $200 trillion in transactions currently reference Libor, including derivatives, bonds and commercial loans, and consumer lending products such as mortgages and student loans. Shifting those markets to an entirely new benchmark such a SOFR presents many challenges and risks (see "Switch to Libor Will Be Challenging," iTreasurer, May 2018).

In addition, it will continue to be a global rate, unlike different the Libor substitutes that are emerging regionally. Also, Libor is a wholesale funding rate that aims to be anchored in wholesale funding transactions, while SOFR stems from secured repo transactions, requiring a basis adjustment to compensate for different credit spreads.

Nevertheless, the new ICE Libor, while more rigorous in terms of methodology, still retains concerns. For example, the number of banks making submissions remains limited, and at times those submissions will be based on bank estimates, even if more systematized and in the method approved by the IBA, rather than actual transactions.

Whichever rate prevails, corporates must now prepare for the possibility of a shift to SOFR when considering existing or new Libor-based debt and derivatives that have maturities extending past the 2021 target date for SOFR adoption. In particular, they should make sure a transaction's fallback language doesn't leave them in a bind if the Libor benchmark fades.

"There's currently no obligation for companies to swap out of Libor. That said, it's very important for corporates to speak to their ISDA lawyers and ensure their contracts include substitution language," Mr. Valtchev said.

The Waterfall Methodology

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