The Financial Standards Board (FSB) insisted on November 19th that the Secured Overnight Financing Rate (SOFR) replace LIBOR in derivatives deals if the FCA decides LIBOR is no longer "safe."
The Financial Conduct Authority (FCA) will permit LIBOR to live on only if the large panel banks that support LIBOR determination by submitting LIBOR estimates to ICE LIBOR Administration agree.
But the panel banks objected to this role earlier. Why would they change their minds?
Large bank support hinges on these banks' rediscovery of the need to keep LIBOR alive, to support Eurodollar futures and LIBOR-based interest rate swaps markets.
CME Group and OTC swaps dealers will get stung if LIBOR ends. SOFR futures and SOFR-based swaps volume will fall far short of LIBOR- based derivatives volume.
The give and take between market participants and regulators over LIBOR replacement is suddenly pointed. The US Regulators have nominated the secured overnight financing rate (SOFR) to replace LIBOR. While at first SOFR seemed to be a suggestion, lately the regulators are more insistent.
Despite concerns expressed by smaller banks in the United States that writing SOFR-indexed credit will be less profitable for banks than LIBOR-indexed credit, resulting in lower loan supply (discussed here), the regulators' plan to calculate backward-looking three-month SOFR term indexes will work just fine for the banks, if a risk adjustment is added to the SOFR index. SOFR will reduce the interest rate risk of bank cash operations compared to LIBOR, at the cost of slightly greater credit risk and a decline in loan demand.
However, the survival of the enormous Eurodollar futures and LIBOR-based interest rate swaps markets depends fundamentally on the existence of a forward-looking liquid three-month term market. Backward-looking three-month indexes, manufactured from overnight rates like SOFR, won't suffice to save these hedging instruments.
These derivatives' success depends fundamentally on hedgers' ability to tie up the cost of money in advance. To do so they need a forward-looking term rate like LIBOR. Without a liquid source of term funds, LIBOR's derivatives won't be successfully replaced.
Regulators increase the pressure to use SOFR in derivatives trading
The Financial Stability Board (NYSE:FSB) said on Tuesday, November 19th, in a letter to the global derivatives industry representative body, The International Swaps and Derivatives Association (ISDA), that derivatives market participants should insert a "pre-cessation trigger" into terms for derivatives contracts that still reference only LIBOR today. Specifically, the agency asked ISDA to
“include a pre-cessation trigger … as standard language in the definitions for new derivatives and in a single protocol, without embedded optionality, for outstanding derivative contracts.”
What?... What does “a pre-cessation trigger … without embedded optionality” mean? This awkward phrase means that derivatives market participants will have no discretion. If the regulators decide that LIBOR is “no longer safe” to use, market participants must switch to SOFR, no matter whether ICE Benchmark Administration continues to provide daily LIBOR values or not. Moreover,
“In case a determination of non-representative is made by FCA, market participants should expect to see their cleared derivatives move from LIBOR to the risk-free rates identified by the National Working Groups for each LIBOR currency.” [My italics].
This in US dollar-based markets would mean a change from LIBOR to SOFR. Is the die cast?
Why do regulators push SOFR?
Are the regulators [FSB (representing the G-20), the FCA (representing the UK), and the Federal Reserve (NYSE:USA)] concerned that multiple fallback rates other than SOFR will lead to systemic risk? Possibly. That would be a mission-consistent objective for FSB.
Alternatively, it might be that regulators want to prevent the division of the banking system into two parts using different indexes. The large banks and the agencies, funded primarily by Treasury-collateralized (or implicitly government-protected) credit; the others, funded by unsecured debt.
The two ways LIBOR replacement might be resolved.
There are two potential outcomes of the tiff over LIBOR; two ways the banks and their regulators could agree on LIBOR replacement.
LIBOR dies. If regulators make a non-representative determination, all dollar-denominated debt instruments and derivatives using LIBOR will switch to SOFR, using an industry-standard method that adjusts the SOFR-based index yield upward to reflect LIBOR’s uncollateralized status.
LIBOR lives. If the panel banks that produce LIBOR decide it is in their interest to continue to produce daily estimates of LIBOR, a second outcome is possible. Despite FCA’s release of the panel banks from the obligation to submit LIBOR estimates, and despite the regulators’ new plan to designate LIBOR non-representative, regulators might then bow to the industry’s request and find LIBOR is representative. Users could choose either LIBOR or SOFR. And later other indexes.
The most likely outcome is that LIBOR ends. The regulators will not find LIBOR to be representative of costs unless the panel banks that estimate LIBOR ask them to. Since the panel banks objected to LIBOR in the first place, LIBOR seems doomed, unless preserving Eurodollar futures and LIBOR-based interest rate swaps matters enough to the panel banks that estimate LIBOR to change their minds.
The switch to SOFR is unappealing to interest rates swaps traders as well. The complexity of the daily valuation of SOFR-based interest rate swaps boggles the mind. SOFR replacement will reduce interest rate swap market liquidity too.
What is different if SOFR replaces LIBOR?
There is an apparent consensus that two once-and-for-all adjustments will best resolve the issues created by the change to SOFR. The first adjustment is the averaging (or compounding) of overnight rates to convert three months of consecutive overnight rates to a single three-month term rate. The second adjustment is to add an increment to Treasury-collateralized SOFR for the greater risk associated with unsecured lending.
In arrears term rates. Three-month index construction will average end-of-month overnight SOFR with overnight rates from the previous three months, describing the history of the overnight rate. SOFR is about the past, instead of the market’s expectation of the future values of short-term rates, as captured by LIBOR.
The cost of collateralized three-month money will thus necessarily be unknown until after borrowing by market participants during each three-month period. For a much-expanded description of the in-arrears calculation of term rates from overnight rates, read this.
This backward-looking method sounds more problematic than it is. It won't have a significant negative effect on financial institution interest rate risks. In fact, banks' interest rate risk will be less once the adjustment for collateral effects is made.
The problems will be in derivatives markets. Why? SOFR-based derivatives won't support hedgers, the basis for the success of derivatives.
The important difference between in-arrears and in-advance rate determination is this. In-advance rates like LIBOR are useful to hedgers with risky real operations. Hedgers try to take the risk out of the funding side of their operations at the beginning of the period since the real risks of the operating side cannot be eliminated in advance.
In other words, hedgers want to gain from astute management of operating risks they understand, avoiding financial risks they don't understand. LIBOR lets them do that. Backward-looking indexes like SOFR don't.
Instead, in-arrears interest determination benefits parties that match daily accrued interest income to interest costs of overnight borrowing. The use of a backward-looking index assures that earnings from indexed loans cover the actual cost of money. Interest rate risk of indexed loans will be reduced for lenders once a risk adjustment is added if the source of bank funding is overnight money.
Risk adjustment. Treasury-collateralized overnight repurchase agreement rates inadequately capture variation in the cost of bank debt used to finance index-based bank loans during periods where systemic risk is affecting rates more than usual. At such times, a flight to quality will cause collateralized yields to move relatively lower than uncollateralized yields. This might push earnings on SOFR index-based loans below levels necessary for the banks to continue to profitably write index-based credit.
To prevent losses due to changing risk premiums, the Fed (or ICE) will likely estimate a backward-looking risk adjustment for the index period at the time the SOFR index is set. That will assure healthy net interest margins for financial institutions. The cost of looking backward will be "surprises" to borrowers resulting in greater credit risk to lenders and lower loan demand.
Again, the end-of-period adjustment for risk affects borrowers/hedgers and lenders differently. If the risk adjustment is calculated in advance, the method permits hedgers to choose projects by comparing the known cost of risk embedded in the forward-looking rate to their estimated real cost of risk in each cash market project they want to fund. Lenders, on the other hand, would prefer backward-estimated risk adjustment since it assures their earnings on risky loans are adjusted by the same risk factor that the market has charged them for uncollateralized overnight funding over the previous period.
What are the unintended effects of SOFR-only?
Effect on credit markets. If most US dollar-based loans are indexed by SOFR, the large banks have a leg up in the competition for customers with smaller banks. Basis risk, the risk that the costs of funding a bank diverge from the earnings of bank assets, would be borne primarily by smaller banks funded by uncollateralized liabilities.
Thus the ultimate result of SOFR-only is that smaller banks will be at a disadvantage to their larger brethren, losing the competition either gradually because the higher cost of managing basis risk for smaller banks makes them less competitive than the large banks; or suddenly, when a liquidity crisis forces the regulators to merge some smaller banks with larger banks.
Effect on derivatives markets. The trading volume of three-month SOFR futures will be a weak reflection of the current volume of Eurodollar futures listed by CME Group (CME). SOFR futures, like the regulator's term SOFR rates, are settled three months after the contract term ends. June term SOFR, for example, is not known until September, so that the daily rates that determine the three-month cost of money during the quarter beginning in September may be collected. Such backward-looking costs of money are of no use to forward-looking hedgers.
What estimate of risk?
Trading issues are raised by SOFR's risk adjustment. At present no liquid market provides the risk adjustment factor at a three-month tenor. In other words, the switch to SOFR has not solved the problem resulting from illiquid LIBOR markets. A three-month risk adjustment carries the same illiquidity baggage LIBOR does. There is no term market with sufficient liquidity to provide a transaction-based risk estimate if LIBOR doesn't.
The weird trading of in arrears futures.
This screenshot of the CME three-month SOFR futures trading screen on November 26th shows the weird effect of in arrears settlement on SOFR futures trading.
The September contract is still listed in November because the daily values of the SOFR index that are compounded to find its value won't be known until the business day before the December contract three month calculation period begins. Obviously, there is little interest in trading a contract that is already two months in the past. The September contract volume is zero. In-arrears contract pricing creates a zombie contract month.
Futures trading of in-arrears contracts leaves much to be desired. The daily forecasts of rates that determine December Eurodollar futures prices are reflected in the December Eurodollar futures price. But repo rates that determine values of three-month SOFR futures for the same period are being reflected in the March SOFR futures. In other words, December Eurodollar futures price yields over the same time period as do March SOFR futures. Confusing.
A second gloomy fact is that the problem of LIBOR's illiquidity has not been resolved by SOFR. The only way to get a liquid three-month quote for the risk adjustment factor is from a liquid forward-looking three-month market. SOFR and other overnight rates like AMERIBOR must look backward to estimate term risks. They cannot successfully replace LIBOR.
The end of LIBOR will be catastrophic for the CME's Eurodollar futures complex and for interest rate swaps dealers as well. Thus there is an outside chance the panel banks will continue supplying LIBOR estimates for the ICE LIBOR Administrator solely to keep Eurodollar futures and LIBOR-based interest rate swaps alive and liquid.
Absent this helping hand from the LIBOR panel banks, the only way CME can successfully save its three-month money futures franchise at its current volume level is by creating its own liquid three-month uncollateralized cash yield. Only a futures market like the CME can create an instantly liquid three-month uncollateralized debt instrument. How? I provide a method here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.