Updated: Jun 5, 2020
“Do I wait for LIBOR contractual fallbacks or actively transition, and if I do actively transition when should I do it?” This is a question asked by many of our clients, and the answer is not as straightforward as it might seem. Clearly, from the perspective of a trader, it is preferable to wait for the fallbacks to kick in in the event of LIBOR cessation (still expected by the end of 2021) to avoid bid/offer spreads. However, there are several other factors to consider, not least the regulators desire for institutions to be actively transitioning their back book of trades from LIBOR to the new Alternative Reference Rates (ARRs).
If we look at the GBP market and the transition to SONIA, the Working Group on Sterling Risk-Free Reference Rates (RFRWG) made it clear last January that market participants were expected to have:
Indeed, many institutions have been active in transitioning their GBP bonds with consent solicitations to investors amending the coupon calculation to be based on SONIA rather than GBP LIBOR. In terms of trying to time the market, it has been more a case of “getting it done” rather than trying to “make a profit”. SONIA, as we know, is the most developed of the ARRs, having been around since 1998 and reformed to include a broader population of transactions in 2018. So, it is not surprising that it is leading the pack. But what about the other ARRs?
The situation is a lot less clear with other ARRs, particularly SOFR, where it appears to be a case of waiting for liquidity and not wanting to be the first person to make a move. It is also much more difficult with consent solicitations for bonds based on US law, requiring 100% of holders to agree to a change to coupon calculations. UK bonds, for example, often have a hurdle rate of only 51%.
So, where are we with SOFR liquidity, undoubtedly the most important of all ARRs? A quick look at the swaps market tells us we have a long way to go, with still under 1% of USD cleared swaps referencing SOFR. The situation wasn’t helped either when the Fed’s Main Street lending programme tried to reference SOFR, but under pressure, had to perform an embarrassing U-turn and switch the reference to USD LIBOR. It looks like we may have to wait for the discounting switch by the major clearing houses in October for liquidity to start picking up.
The recent market turmoil due to the COVID-19 pandemic also showed the dislocation of SOFR to LIBOR. The fallback spread represents the credit and liquidity component of LIBOR relative to ARRs. ISDA published the results from their fallback consultation back in November 2019 which showed a consensus of using a 5-year median of the spread between LIBOR and the ARRs. If this was to be applied during the pandemic, the current 5-year median of 25bp spread would be added to SOFR, in comparison to where the actual spread is trading to USD LIBOR at 140bps.
This would lead to a massive step change and valuation difference. It’s worth noting that for consumer products (mainly loans), a one-year transition period is intended before the 5-year median is added. How would this work? If we imagine the transition happening with the spread at 140bps, on the day of cessation this spread would be applied. Over the next year, this spread would reduce down each day (using straight-line interpolation) until it reached the 5year median of 25bps. A similar approach in the derivatives market will help to ease this step change if we end up with a move to fallbacks in times of market stress. The ARRC (Alternative reference rate committee) believes that this step change should be brought in line as banks will trade the LIBOR/SOFR basis until it converges to (in the example above) 25bps. This remains to be seen and is reliant on big banks actively trading the spread which is currently not the case.
If the prospect of a potentially significant step change in valuation and likely liquidity risk wasn’t enough to make some think more prudently about transition, there is now some added uncertainty of what the fallback index might be. The Federal Reserve Board overseeing the transition has said that it would support any active benchmark (not just SOFR) as long as it meets three criteria:
1. It is robust
2. IOSCO 2013 benchmark compliant
3. Available to be used before LIBOR cessation
This now opens the door for other benchmarks to be used, such as Ameribor, which may well suit the risk profiles of small and medium US banks better. This could cause valuation risks on remaining positions at institutions if they end up using a non-SOFR fallback.
I think institutions need to be classifying their book of trades and identifying LIBOR terms in contracts and those which are likely to be harder to transition, known as “tough legacy”. However, if possible, they should be using portfolio compression and then trying to transition positions actively where it makes economic sense. Timing-wise, firms should be actively monitoring the ARR developments and, as with the SONIA market, when there is enough liquidity, try to transition as much as possible. As mentioned above, waiting till the end, whether that is a cessation or a pre-cessation trigger where the index is no-longer “representative”, is likely to be fraught with risks and uncertainty.