There are many things to worry about in the capital markets, but the sluggish pace of the transition to new risk-free rates (RFRs) must be pretty high on everyone’s agenda at this stage.
It is certainly high on the agenda of Matthew Lieber, director of capital markets and institutions, markets group, Federal Reserve Bank of New York.
“Systemic risk is growing with each new contract entered into under Libor,” he declared at the ICMA AGM in Stockholm in May.
At mid-2018, around $400 trillion of financial contracts referenced Libor in one of the major currencies, according to the Bank for International Settlements.
Banks will no longer be required to submit Libor rates after 2021 and the scale of the challenge is eyewatering.
Experts tell Euromoney that market participants will need a minimum of six to 12 months on the negotiating process when they transition to a new RFR, but they can’t even start those negotiations until there is a stable market in the rate that they want to transition to.
Libor is due to be discontinued in 30 months’ time, so you do the maths.
Sofr and Sonia
A key hurdle is the transition to the secured overnight financing rate (Sofr), the replacement for US dollar Libor.
In March, US trade repository data showed Sofr swaps volume to have halved from the previous month, with only $3.2 billion gross notional for the month. According to Risk.net, only 24 trades were reported by US persons – 16 were Sofr versus fixed overnight indexed swaps (OIS), and six were Sofr versus Fed funds basis swaps.
According to Lieber, $100 billion of cash products linked to Sofr have been issued so far. One of the big drivers of demand for Sofr-linked derivatives is to hedge Sofr-linked cash products, so that number needs to grow.
Progress in the sterling overnight interbank average rate (Sonia) is more encouraging. A record $3.9 trillion in single-sided gross notional was traded in November 2018.
The use of overnight rates in a compounded form in cash markets is a key challenge- Harriet Hunnable, FCA
Harriet Hunnable, manager, benchmarks policy at the UK’s Financial Conduct Authority (FCA), told the Stockholm meeting that she is now seeing equivalent levels of trading and liquidity in Sonia as in Libor, due to floating-rate-note market adoption.
Some £25 billion of OIS has been done, which is drying up the Libor need in that market.
The derivatives industry has been far quicker to adopt new risk-free reference rates than its cash counterpart, but it is vitally important to have the same principles on cash and derivatives.
Sofr and Sonia are both overnight rates, and cash products need some way to get to monthly or quarterly rates. Because derivatives use compounding, market participants argue that the cash market should too.
Historically, with three-month Libor, borrowers have known the rate they will be paying three months in advance. But with compounding this will not be the case. They can address the problem by compounding in arrears – multiplying every day’s interest rate over the period and taking the average.
This seems straightforward, but it would be a backward-looking rate and what borrowers that are used to Libor want is a forward-looking one. They want to know in advance what their payments will be.
“The use of overnight rates in a compounded form in cash markets is a key challenge,” admits Hunnable.
The challenge for Libor transition is consistency. Markets want a high degree of standardization and consistency across markets and that is exactly what they won’t get. Libor was uniform, but things will be more complex now. They are also taking a long time to develop.
The likelihood of that 2021 deadline being pushed back is growing by the day.