RIPPLE EFFECT: THE IMPACT OF MOVING AWAY FROM LIBOR
Ripple effect: The impact of moving away from LIBOR
Andy Ross – CEO, CurveGlobal
The shift from LIBOR to an alternative risk-free rate will require considerable cost and effort, and the sooner the market takes action the fewer and lesser the risks associated with transition will be. A forum of industry leaders discusses key topics, including the impact of the shift on market pricing and risk management models, the drawbacks with alternative rates and the potential longevity of LIBOR once a mainstream alternative has been adopted.
Q) What are the key challenges associated with moving away from LIBOR to alternative benchmarks?
a) The ability to hedge risk effectively is of paramount importance for ensuring a smooth, orderly transition away from LIBOR. As a result, it is vital that participants have access to a liquid and active futures market, which in all cases needs to align with regulatory requirements while supporting competition and choice, and enabling best execution.
Fortunately, growing endorsement of new benchmarks by market participants is prompting competitive innovation. This includes the launch of new futures contracts referenced to the Bank of England’s (BoE’s) reformed SONIA benchmark, and products that make it possible to trade the spread between SONIA and LIBOR with no legging risk.
Q) Do you anticipate LIBOR remaining ‘alive’ after 2021? Why?
a) It’s hard to imagine everyone completely abandoning a reference rate that includes bonds and swaps not due to mature for decades and, over time, it will become less feasible to quote LIBOR rates as they become less liquid. But, ultimately, it is in the hands of the LIBOR administrator, which will need to secure long-term commitments from a large number of panel banks to continue beyond 2021.
If LIBOR and a new RFR such as SONIA coexist in a multi-rate regime after 2021, it’s possible they will each be used for very specific products and transactions. For example, SONIA might be the best choice for derivatives, while a term LIBOR benchmark – perhaps with a new name and structure – might continue to be used in other circumstances.
Q) Who do you think will be the first to move away from LIBOR?
a) Based on first-hand experience, buy-side institutions and liability-driven investment managers in particular are already actively moving away from LIBOR. They recognise that, given the shrinking support for the legacy benchmark, the shift to an alternative RFR such as SONIA is inevitable. As they don’t want to have to rely on fallback mechanisms, they are keen to be on the front foot, so they can mitigate any arbitrary and unhedgeable downsides.
Q) What are the drawbacks with the new RFRs sponsored by global regulators?
a) Although SONIA may not have all of LIBOR’s currency and tenor pairs, it is robust and underpinned by significant transaction volumes. In contrast, LIBOR is now more fragile and suffers from a dearth of qualifying transactions. According to the FCA, in one currency-tenor combination there were just 15 qualifying transactions in all of 2016. I struggle to see how anyone can credibly build a daily benchmark by averaging multiple quotes from a dataset such as that.
However, unlike LIBOR, which is most frequently referenced in three- and six‑month tenors, SONIA is an overnight rate with no obvious forward-looking term rate. While this will merely be an inconvenience for some participants, for others – such as corporate treasurers – it may cause difficulties for firms used to interest rates being set at the beginning of an interest accrual period.
Despite these potential challenges, however, there’s no reason why anyone in the interest rate market needs to trade on anything other than real, transaction-driven rates.
Q) Will some participants be unlikely to ever move away from LIBOR?
a) Some participants have a commercial interest in preserving LIBOR’s dominance. In a recent industry survey conducted by ISDA, 60% of respondents indicated they would continue trading IBORs – excluding short-term instruments – if they were to be published after 2021, with 18% indicating that they didn’t plan to use alternative RFRs at all.
However, participants in the derivatives markets should ask themselves if a rate with so few underlying transactions is their best option, and be encouraged to use SONIA as fully as possible. It’s also important to remember that there’s a regulatory imperative – driven in the UK by the FCA and the BoE – to transition away from LIBOR.
Q) How safe a benchmark is LIBOR today?
a) Trading risk that depends on a fixing based on the input from a small group of ‘experts’ is a cause for concern. LIBOR has been irreversibly weakened and is in precarious health – perhaps even on life support – so the risks are now considerable.
The markets that underpin LIBOR are extremely thin, hence the reliance on so‑called ‘expert judgement’ rather than actual transactions. Trading decisions in the trillion-dollar markets in which we operate need to be firmly rooted in fact.
Q) What will be the impact of the move away from LIBOR on market pricing and risk management models?
a) Effecting change in financial markets invariably involves cost and considerable effort, and this is certainly the case with the shift from LIBOR to an alternative RFR. But it’s worth remembering that the new benchmarks are robust, backed by central banks globally and based on actual transactions.
When trading over-the-counter (OTC) or listed derivatives with a maturity over 2.5 years, there is a risk associated with changing the underlying benchmark. The challenge facing market participants is how to assess what risk premium to pay or receive for changing the rate to SONIA from LIBOR. When weighing up the decision to trade futures or OTC, how do you choose where and what to execute for best execution?
There are signs that the market recognises the need to move quickly, including robust adoption of the CurveGlobal inter-commodity spread (ICS) and SONIA futures contracts.
Even so, participants are still figuring out how to assess best execution on the same benchmark between two similar risk products. But choice is important here – let firms choose what is best for them. For example, are they better off trading the ICS between SONIA and LIBOR, or the forward rate agreement (FRA)/OIS International Monetary Market (IMM) package OTC? The answer will clearly depend on factors such as market access, fees and liquidity, but choice is preferable to forcing every client down the same one-size-fits-all route.
Q) Is there enough time to move the industry away from LIBOR before the end of 2021?
a) LIBOR is deeply entrenched, and market participants need to have a solid grasp of the extent of their exposure, as a transition could have a material impact on the profit and loss of their businesses. The market has been given adequate notice but needs to take action sooner rather than later – now, in fact – to minimise the risks associated with the benchmark transition.
Products referencing alternative rates, such as SONIA, which allow participants to migrate from LIBOR in both the OTC and exchange-traded spaces already exist. Adoption is increasing, and liquidity continues to grow on a daily basis. In the swaps market, for example, there has been more than 100% growth (year to date) on LCH-cleared GBP swaps notional with a SONIA underlying rate to over £32 trillion notional outstanding (as of August 2018).