Investors and regulators worldwide are preparing for life after Libor. Thepredominant floating-rate benchmark index – which serves investors not onlyas a reference rate for a tremendous range of securities and derivativesworldwide but also as a signal for market liquidity and looming risks – mayno longer be available in three years. The role it plays across globalmarkets must then be taken up by one or more alternative reference rates.For American football enthusiasts, it’s akin to choosing and preparing abackup quarterback to take the leading role as a longtime veteran is aboutto retire.
The global banking community has agreed to continue to report Libor (whichis short for London Interbank Offered Rate; the index is administered bythe Intercontinental Exchange or ICE) until the end of 2021. Central banksand other public sector organizations are leading cooperative efforts withthe private sector to identify alternative reference rates and developtransition plans.
Back in August 2017, we escalated our concerns regarding a lack of concreteplans for an alternative to Libor (PIMCO Viewpoint, “No Room for Error”). Establishing a fair and appropriate construct to transition legacyderivative contracts and cash products from Libor to its successor(s)presents many challenges. In the past year, however, we’ve seen encouragingregulatory and industry-sponsored developments and practical initiatives tosupport liquidity in alternative rates. It won’t be easy and many key risksremain, but we believe the players and strategies are now in place totransition markets beyond Libor.
Background: Libor and reference rates
Libor represents the average interest rate that a bank would be charged byother banks for an unsecured loan over a specified term in a specificcurrency. It is used in determining periodic interest payments for over$350 trillion globally in derivatives, futures, corporate bonds, mortgagesand other financial products, according to ICE.
The market for pricing the underlying funding transactions represented byLibor is essentially nonexistent, and contributors to Libor often rely on“expert judgment” to estimate funding rates. Trust in this judgment iscrucial to markets that rely on Libor, and that trust was shaken in 2012when several banks were accused of manipulating it. In 2014, the FinancialStability Board (FSB) initiated efforts for global reform in referencerates, and in 2017 U.K. regulators announced their intention to phase outLibor by 2021 after a transition to a new reference rate (or rates).
At PIMCO, we believe that the banking community may continue to voluntarilysupport and publish a Libor rate beyond 2021, due to its widespread use.However, groundwork laid over the past year supports market liquiditygrowth in alternative reference rates. We expect that market participantswho seek greater transparency will increase utilization of thesealternative benchmark rates and reduce reliance on Libor given the concernsregarding the size and frequency of transactions in the underlying market.
SOFR and other alternatives to Libor: recent developments
Over the past year, industry leaders and regulators have articulatedtangible steps to implement alternatives to Libor, laying the foundationfor markets to reference and build liquidity around them.
Public-private working groups in each regional jurisdiction nominatedalternative reference rates: overnight funding rates that reflect themajority of funding activity. In the U.K. the unsecured SONIA (SterlingOvernight Index Average) rate was selected; it already sees robustderivative liquidity and market pricing.
The U.S., after analysis by the ARRC (Alternative Reference RatesCommittee) at the New York Fed, elected to “draft” a new benchmark – theSecured Overnight Financing Rate (SOFR) – as a broad measure of the cost ofborrowing cash overnight collateralized by U.S. Treasury securities. TheNew York Fed commenced publishing the SOFR rate daily beginning on 3 April2018, with the benchmark based upon data collected on over $700 billion insecured overnight repurchase (repo) transactions every day.
Similarly, alternative rates have been identified for Swiss and Japanesemarkets (among others) that are based on actual transactions, thus seekingto address the most troubling aspect of how the current Libor benchmark isset.
Since the launches of SONIA and SOFR, key market participants havebolstered the infrastructure to support derivative markets and increasetransparency of market-based estimates of future reference rates (seeFigure 1). The Chicago Mercantile Exchange (CME) launched futures based onthe SOFR rate in May 2018, and central counterparties (CCPs) recently beganaccepting overnight index and basis swaps for clearing. The public sectorhas issued floating-rate notes referencing the alternative rates to furtherencourage use of the rates in the cash market: In June 2018, the EuropeanInvestment Bank (EIB) issued a sterling-denominated floating-rate bondlinked to SONIA, and in July 2018, Fannie Mae issued a $6 billionSOFR-linked floating-rate note debt transaction.
Continued issuance in notes that reference SOFR should help build marketconfidence and drive investor demand for hedging in derivative markets,providing the SOFR market the depth and reputation it needs to be regardedas a viable reference rate. We believe that for SOFR to be universallyadopted (like Libor), issuers must quickly adopt and issue liabilities(notes) based upon these alternative benchmark rates. One way to encouragemarket acceptance is for issuers of short-dated instruments (money markettranches, for example) to issue inaugural SOFR-based instruments to testSOFR market pricing, increasing the issuance base while building marketconfidence.
The changing landscape for risks
With the development of robust alternatives to Libor underway, one ofPIMCO’s largest concerns is the handling of nonderivative legacy securitiesor loans. These securities include agency adjustable-rate mortgages (ARMs),asset-backed securities (ABS), mortgage-backed securities such ascollateralized mortgage obligations (CMOs), and collateralized debtobligations (CDOs) and corporate floating-rate notes (FRNs).
Proprietary PIMCO research finds that certain products and individualsecurities do not, in our view, provide adequate fallback provisions shouldLibor resets cease. Some other securities do articulate fallback provisionsin their indentures that provide certainty of treatment, but may presentthe risk of a material change in the valuation or functioning of thesecurities as we approach the likely end of Libor in 2021. Specifically,some notes make the coupon equal to the last available Libor print, whicheffectively toggles the security in question from a floating- to afixed-rate obligation.
Broadly speaking, we see four categories of fallback provisions in legacycontracts:
1) converting to a fixed-rate obligation by setting the floating rate equalto a rate available in the preceding period;
2) providing determination agent discretion to estimate Libor withcomparable sources;
3) allowing the determination agent flexibility to switch to a successor oralternative rate and
4) not providing explicit detail on how the security will perform if Liboris not readily available.
Each of these presents potential disadvantages in addressing a permanentLibor discontinuation, but it is typically impractical (even impossible) toamend the legacy securities’ contracts. In most cases, investor consent isrequired to make changes that would have a material effect on any interestrate calculation. Although recent new issues have included disclosureshighlighting the risks to Libor continuing in the future, they oftenprovide expansive flexibility and discretion – leaving investors at themercy of the issuer’s judgment.
Risk management and investor advocacy
We believe a proactive approach is key: It is imperative that investorsassess and manage the risks associated with legacy positions, while havingan eye on the future of SOFR. On behalf of our clients, PIMCO’s riskmanagement, legal and portfolio management teams have undertaken acomprehensive review of existing portfolio holdings to uncover any legacylanguage that may impact market liquidity and valuations as we graduallytransition from Libor to SOFR.
Furthermore, we suggest that investors proactively advocate for andcollaborate with issuers, securitization firms and other members of theindustry to propose replacement or fallback language for nonderivativecontracts in order to reduce the risk of disruption when Libor isdiscontinued. The ARRC has established joint public-private working groupswith the goal of reaching consensus on suggested fallback language. Asagreement is reached across market participants in each cash product, webelieve any issuance of new obligations must outline and adopt specificlanguage that offers certainty to investors and limits discretion in ascenario where a fallback may be triggered in the future. Moreover, inorder to ensure the efficacy of derivative hedges and reduce basis riskacross products, the market should strive for consistency in fallbacklanguage where feasible and appropriate.
In the derivative markets, the International Swaps and DerivativesAssociation (ISDA) has launched a market consultation to collect feedbackon the approach to amending the fallback provisions for new trades in swapsgoverned by the ubiquitous contract language. Any market participant mayprovide feedback on the approach for applying spread adjustments to accountfor the differences in methodology and terms between alternative rates andLibor. The consultation will collect responses through October 2018 and theresulting decisions on fallback provisions are expected to be included innew swap trades starting in 2019. The Fed’s paced transition plan for SOFRanticipates continued transition in cleared markets, which will provide forthe creation of a term reference rate based on sufficiently liquidSOFR-benchmarked derivatives by the end of 2021. We expect that liquidityin derivatives referencing alternative rates will grow over the next yearas the rates are utilized in wider contexts, which could increase hedgingdemands.
Advocacy will help shape the market environment after Libor: Over the nextyear, we expect that market participants also will be able to providefeedback on potential approaches to hardwiring fallbacks into securitycontracts. The ARRC will likely solicit market feedback on standardizedfallback language for nonderivative products. It is crucial for a widerange of investors to participate in the discussion and debate of thevarious proposals. PIMCO as always is a voice on behalf of our clients, andwe remain closely involved with regulators and industry groups who helpmanage the risks and shape the ongoing evolution away from Libor.
PIMCO is supportive of market initiatives to establish alternative ratesthat are robust and representative of actual transactions. We expect thatas the market develops, new issuance and derivative market participantswill voluntarily transition to the alternative rate. Market participationin support of the alternative rate will help inform fair fallbackmethodologies that can step in when Libor is finally retired.