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Capital Markets

Replacements for Libor Have Ways to Go

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July 02, 2018

ACT: True Libor-replacement yet to emerge as challenges mount

Mon Market - DowndraftEarly steps to institute a brand-new Libor replacement have just begun in the US, while the UK is on a similar path after modifying existing rate that market participants are already familiar with. Nevertheless, UK corporates are still waiting for signs of new financial products from their banks to aid in the transition.

Sarah Boyce, associate director of policy and technical at the UK-based Association of Corporate Treasurers (ACT), noted that recently one corporate with a revolving credit line up for renewal asked its banks about the availability of products based on the Sterling Overnight Index Average (SONIA). The company was uncomfortable continuing with a longer-term Libor-based loan given regulators globally have set 2021 as a deadline beyond which banks no longer have to contribute to Libor panels.

“The banks said, ‘We don’t yet have a SONIA product available,’” Ms. Boyce said.

She noted that the ACT has been repeatedly checking with corporates and banks about any indications of cash products that use benchmark, risk-free rates (RFRs) coming to market, to help kick start the transition to the alternative benchmarks. However, she added, there’s been nothing notable thus far, beyond the offering June 22 by the European Investment Bank, which is owned by member states to help bring about European integration. The £1 billion, five-year bond deal, reportedly a year in the works, priced at 35 basis points over SONIA.

Banks’ lack of progress is understandable given the newness of the RFR benchmarks, Ms. Boyce said. In April, the New York Federal Reserve began publishing its Secured Overnight Funding Rate (SOFR) and the Bank of England (BoE) its modified version of SONIA, but the longer it takes to develop such products, the greater the number of legacy Libor-based loans that will have to be dealt with somehow. And the concern is becoming increasingly urgent, especially for corporate borrowers, given replacing Libor is a massive undertaking and fraught with challenges.

“The problem for the real economy is that corporates need to borrow and manage the interest rate risk on those borrowings. Bank are grappling with finding solutions,” Ms. Boyce said.

She noted that Libor was created in the late 1970s specifically for the syndicated loan market to reflect banks’ cost of funds. It provided a floating rate that reset every specified term.

“Libor being a forward-looking term rate, borrowers know at the start of the period exactly what expense they will incur—not the case with the RFRs, which are a backward looking overnight rates,” Ms. Boyce said.

SONIA, SOFR and other backward-looking “risk-free rates,” so called because unlike Libor they have no credit risk, instead settle overnight. Hence borrowers and derivative users don’t know the interest payable until the end of the term. In a report published a year ago, the Working Group on Sterling Risk-Free Reference Rates, which ultimately made the decision to use SONIA, partly because it was already the rate for sterling overnight index swap (OIS) contracts, noted two potential methods for calculating the forward-looking reference rate. The methods use pricing data from derivative markets SONIA references.

One takes the fixed leg of a set-maturity, overnight-index-swap (OIS) contract, say three or six-month contracts, as the term reference rate, perhaps generated from executable quotes for OIS on regulated electronic trading platforms. The other method involves the term fixings being derived from SONIA futures order-book data. Clearly easier said than done, given banks’ dearth of products so far.

Another major challenge is that the risk-free rates are developing regionally and will be derived from different types of transactions. SOFR, for example, is calculated from three existing and transaction-based indices directly related to overnight Treasury repurchase agreements (repos), whereas as SONIA is calculated as the weighted average rate of all unsecured overnight sterling transactions. Ms. Boyce pointed out that the risk-free rates including those being developed in Japan, Switzerland, and the European Union, not only will be calculated based on different types of transactions but may be published at different times, complicating matters for borrowers with multi-currency loans.

Still another complication is that SOFR is a secured rate based on collateralized transactions while SONIA is unsecured, potentially resulting in the rates reacting very differently to financial-market stress. The BOE’s argument for going the unsecured route, outlined in its report, is that the market for wholesale unsecured deposits is conceptually straightforward and movements in the rate are likely to be stable and highly correlated with the bank rate.

Movements in the types of secured reference rates SOFR is derived from, instead, may be driven by technical or other less explainable factors. Secondly, SONIA was designed to evolve if the unsecured money markets experience a decline resulting from material structural change. Corporates and their service providers, however, will have to accommodate those differences.

In addition, under Libor corporates may have revolving credits facilities that allow them to draw down in the currencies they require and apply the same margin across the different currencies. Not so straightforward with differently calculated and timed benchmarks.

“We completely agree that Libor was not sustainable, and that’s fine. But whatever replaces Libor needs to be fit for the purpose, and how to make the SONIA- and SOFR-based offerings fit for corporate purposes? That’s the challenge,” Ms. Boyce said.

Complicating matters further is the Intercontinental Exchange’s (ICE) stated intent to continue supporting Libor, for which a more rigorous process to determine the rate has been developed after it emerged that major banks were skewing estimates of interbank borrowing costs to their benefit. Ms. Boyce said ICE is likely to face hurdles in maintaining Libor, given banks face significant reputation risk continuing to support the rate.

“When you talked to banks even before all this happened, most said that if they didn’t have to make submissions, that would be great. There’s no upside for them,” she said.

As more time passes before the market develops solutions for borrowers and derivative users, more and more transactions will have to be re-examined to ensure their fallback language permits the shift to a risk-free rate should Libor fade. The International Swaps and Derivatives Association (ISDA) is leading the charge to develop fallback language for new derivatives transactions that it anticipates publishing next year. Meanwhile, the Loan Market Association (LMA) is developing similar language for the loan market.

Changing the language in legacy transactions, however, poses an enormous challenge, especially for banks.

‘The sheer volume of transactions the banks have to work through will give them an enormous headache, particularly as the language in contracts for cash products is not consistent, so arguably every contract will need to be considered on its own merits” Ms. Boyce said.

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