Treliant Industry Insights
October 1, 2018
Graham A.D. Broyd and David E. Wagner
Note: This article is part of a continuing series of analysis and updates on the upcoming transition in LIBOR, one of the world’s most widely used interest rate benchmarks. Read Part I and Part II of the “LIBOR Is Going Away” series.
As our quarterly series on the London Interbank Offered Rate (LIBOR) continues to call attention to one of the most unrecognized risks to financial markets—the impending replacement of LIBOR as a leading interest rate benchmark— this installment analyzes scenarios for replacement. The LIBOR benchmark, against which $300 trillion of debt and derivatives are routinely reset, will be going away—soon, to be replaced by … well, it depends on your circumstances. But whatever the scenario, two immediate steps are recommended for nearly all financial services companies: a LIBOR risk inventory and a review of fallback mechanisms. And that’s just the start of it.
To recap the basics, the global financial system’s move away from LIBOR to a new standard will have far-reaching impact—not just on short-term, interbank lending, which is LIBOR’s mainstay, but also affecting mortgage banks, credit card issuers, corporate lenders, traders in interest rate derivatives and futures, and others. Nearly all financial services companies have debt linked to LIBOR, which is embedded as a reference rate in trillions of dollars’ worth of outstanding contracts.
The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve (Fed) and with representatives from participant banks, industry utilities, and trade associations, announced in June 2017 that LIBOR will be replaced by a broad Treasuries “repo” financing rate, the Secured Overnight Financing Rate (SOFR), reflecting the cost of banks borrowing cash secured against U.S. Treasuries.
LIBOR Replacement Scenarios: Most Likely
There are a number of scenarios for US Dollar (USD) LIBOR’s replacement and its timing. The most reasonable and robust is to follow the chronology of the Federal Reserve’s ARRC and its “paced transition plan.” At its core this plan has two key dates:
- Q1 2019. This marks the first use of the USD LIBOR replacement product SOFR, which will be used to calculate the interest earned on margin collateral on future contracts at the Chicago Mercantile Exchange (CME) exchange, starting in the first quarter of next year.
- Year-end 2021. LIBOR is most likely to go away. This eventuality was underscored in a recent statement by Andrew Bailey, CEO of the U.K.’s Financial Conduct Authority (FCA)—the primary regulator for the LIBOR benchmark. By the end of 2021, he said, the FCA will not be able to insist that banks under its supervision submit rates that will make up the LIBOR benchmark. It is reasonable to assume that banks, freed from the requirement, will cease submitting quite promptly. Setting LIBOR benchmarks is a bank function with very significant internal controls, compliance, and audit requirements. It is costly, subject to extensive regulatory policy and review, and yields banks no revenue—yet any misstep is liable to fines that have run into the billions.
LIBOR Replacement Scenarios: ‘Extreme’
The two other alternative scenarios most mentioned by our clients are:
- Everlasting LIBOR. This scenario has it that the LIBOR benchmark actually just continues, in some form or other. We just muddle through because change is too complex and too risky to the global banking system, and there is no way you will be able to get every outstanding contract with every individual consumer altered and effective by the end of 2021. This scenario drives toward the concept of a “LIBOR Plus,” reconstituted by the Intercontinental Exchange (ICE), which administers the LIBOR benchmark. The “Plus” involves consideration of additional market transactions for banks’ LIBOR submission methodology or, under certain conditions, a subjective bank-submitted rate. Then, after LIBOR Plus, a next step could be toward creating a “Synthetic LIBOR,” involving additional deals that could somehow qualify for an interest rate benchmark. All of these possible moves share the motivation of avoiding significant changes in contracts, systems, booking, and risk management away from LIBOR—and a hope that LIBOR in some form could be sustained for another five to 10 years.
- Sudden LIBOR Demise. In this scenario, someone challenges the veracity of LIBOR, which is then deemed “unrepresentative” as an interest rate benchmark. Such a challenge could come from an industry association, a country, or an aggrieved consumer who has just had their interest rate set to a new higher rate. Should the benchmark be defined as unrepresentative, as a precedent, it would open the possibility for any client, at any time, to challenge contractual terms and, in the case of debt instruments, potentially demand a lower interest rate benchmark that would be more “representative.” This scenario would be chaotic, although not unrealistic. It is clear that LIBOR does not conform to the International Organization of Securities Commissions’ (IOSCO’s) principles for benchmarks. Nor does it conform to the European Union’s Benchmark Regulation (EUBR), which went into effect in January 2018. In particular, LIBOR fails all these requirements due to the lack of underlying, qualifying transactions for a benchmark.
Everyone has an opinion on the likelihood of either of the extreme scenarios. The everlasting LIBOR scenario has a lot of supporters. But we would point to the letters signed by nine top US regulators (Powell, Quarles, Giancarlo, Clayton, McWilliams, Otting, Tonsager, Watt, and also Treasury Secretary Mnuchin1) encouraging the banks they supervise to establish fallback language in anticipation of LIBOR’s elimination. We’d also note a recent statement by J. Christopher Giancarlo, Chairman of the Commodities Futures Trading Commission: “The discontinuation of LIBOR is not a possibility. It is a certainty. We must anticipate it, we must accommodate it, and we must adapt to it.” Additionally, having spent a few years on the Federal Reserve’s ARRC, we have clearly heard the Fed’s message to get on with LIBOR’s replacement. LIBOR was not considered to be facing a seasonal or cyclical challenge, the message went, but is systemically broken and not to return. So, we find the everlasting LIBOR scenario unrealistic, and we recommend planning for the likelihood of a replacement for LIBOR. There could be qualifications, dependent on the products it covers and the timing. (Could that 2021 date get extended to 2022? Sure, but it’s still better to start the planning exercise now. There is a lot to be done.)
The scenario of a sudden, unplanned loss of LIBOR as a benchmark concerns us. It may be a low possibility, but it seems rational and could happen. Considering EU benchmark policy, IOSCO benchmark principles, and comments from Fed Vice Chair Randal K. Quarles, our takeaway is that one should not rule out a circumstance where a client, facing an increased interest rate reset, decides to challenge that the bank should not be allowed to use LIBOR, and must reset against a more representative benchmark. That precedent could be powerful and dangerous.
Interest Groups Get Engaged in Planning
The Federal Reserve Board’s (FRB) ARRC has “reset” itself as of March 7, 2108, with ARRC 2.0 engaging not just the 17 banks with the largest USD derivatives exposures, but now bringing in representatives of a wide array of clients. Among them are corporations, asset managers, hedge funds, mortgage companies, and federal mortgage agencies, as well as industry associations such as the Loan Syndications and Trading Association, Securities Industry and Financial Markets Association, and International Swaps and Derivatives Association (ISDA). There are enormous efforts being made by interest groups and their members to address many of the issues that the replacement of LIBOR has raised.
But the chronology of events, products, and dates currently in the ARRC’s paced transition plan is frankly very sparse. Price Alignment Interest (PAI), which is the interest reset on the margin valuation of CME futures contracts, can start to use SOFR in the first quarter of 2019. That is, however, only one part of one issue for one product. There have also been schedules announced for overnight index swaps, benchmarked against the Federal Reserve’s preferred replacement of SOFR, being acceptable as clearable swaps at central clearing counterparties.
It’s a great start. But our project spreadsheets presently include 80 different products that have their interest rates reset against a LIBOR Benchmark—from interest rate derivatives to mortgages and mortgage securities to student loans to syndicated loans and every sub-category thereof. Each of those distinct products has its own series of very specific issues as one attempts to transition away from the legacy benchmark to the replacement benchmark. (In discussions with one client, we are now identifying the varying issues within mortgage securities between Fannie Mae, Freddie Mac, Sallie Mae, pass-through certificates, and private label mortgage securities regarding the respective reset fallback language included—all different).
Additionally, our list of project items to be addressed when transitioning to LIBOR’s replacement includes all the system changes required to book the new benchmark, risk management and reporting modifications, legal and document changes, and communications requirements. In fact, we have over 140 separate items to be reviewed and potentially modified or actioned.
We hope the transition exercise is easier, but this list of challenges does point to how little is in the public domain for what needs to be addressed between today and 2021. The focus has appropriately been squarely on derivatives products, on SOFR as a new product, and on building SOFR’s liquidity and acceptance. Progress is clearly being made—but this is just one piece of a very broad and complex portfolio of issues.
Two Immediate Steps to Take
In all scenarios we recommend clients address two issues:
- Identify all the risks you have in your institution that could be reset against a LIBOR benchmark. Get an inventory of them. Please note, as per our previous article, that there are a lot of potential and conditional resets that may not be in your daily download to your treasurer for rate management today. Our list of products reset against LIBOR now totals 80 – this is not just a derivatives and futures exercise. And, as you do the inventory, get the maturity date of that reset risk. In particular, see if it goes beyond 2021. In our experience, this exercise has had some similarities to assessing Lehman Bros. risk at the outset of the global financial crisis. Banks had their numbers (credit risk, market risk, secured, unsecured, etc.) and checked them every day. Then, as Lehman went bankrupt, every day for months, someone would walk in with a new risk, linked to Lehman’s demise, that had triggered or would trigger secondary, tertiary, or conditional risks. Our early experience with LIBOR points to some similarities. No one has planned for its outright demise before, only for a delay or disruption (or a manipulation). There may be outcomes we have not yet considered. You may find reset risks hidden under many rocks. If you don’t know your risks—and cannot look at those risks in one place, across your organization—you cannot manage any of the scenarios.
- Review all your fallback contract language. If LIBOR is not available, then to which benchmark does the reset fall back? Early reviews have noted a mix of fallback contractual terms and language. Among them: no fallback language at all; falling back to the last available rate (which is reasonable for one day, but not too helpful three months after LIBOR’s demise); falling back to an equivalent or comparable rate (good, but subject to interpretation); and falling back to the prime rate (Ouch. The Federal Reserve’s prime rate is currently at 5 percent; three-month USD LIBOR is at 2.5 percent. We believe you would get a market and client reaction if you increased their rates 250 basis points from one day to the next!). Early experience is that each security class, each loan category, and each mortgage product have differences in language, terms, and interpretations. It’s time to flush all this out and get it in front of you.
Each product will have a different dependency for the renegotiation of the LIBOR fallback language. Fortunately, the biggest volume of outstanding contracts involves derivatives, and the industry association ISDA is deep in preparation and consultancy with its members to come up with one agreed, consistent set of fallback language and terms. Expected delivery for this language consensus is sometime in 2019. ISDA members make up the majority of derivatives outstanding, and so consensus and consistency will be enormously beneficial when concluded. Although, of course, one still has to “block change” all these contracts in the system—not a simple task done in a short time frame.
But LIBOR replacement does not stop at derivatives or ISDA. Just a few brief examples: Futures will likely be dependent on the guidance and requirements of the large futures exchanges—CME and London Clearing House (LCH). Mortgage loans could be dependent on the capabilities of the two largest mortgage service system providers. Syndicated loans are likely to be awaiting guidance from their industry association, the Loan Syndications and Trading Association, but will then have to execute, loan by loan, under the direction of the lead bank of each and every syndicate. Bilateral bank loans may have to be negotiated, client by client, loan by loan. All this is to be determined, but preparation and segmentation of your risks will help bring this into focus.
In all scenarios, a prudent risk and project management starting point is a comprehensive identification of LIBOR-triggered interest rate reset risk and a review of all related contracts and documents for the specific fallback language, in case the LIBOR benchmark becomes unavailable.
But we would certainly recommend that banks prepare themselves significantly beyond these “identification” and “contractual language” reviews. For other issues to address in preparation, we will be releasing two tools in the coming weeks on our website, www.treliant.com. One is our guide to the five core issues that we believe should be considered immediately in any LIBOR transition, including risk management, infrastructure, and communications. The second is a LIBOR transition preparedness questionnaire that will allow financial services professionals to self-assess their state of preparation.
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1 J. Christopher Giancarlo, Chairman Commodity Futures Trading Commission; Jay Clayton, Chairman Securities and Exchange Commission; Jelena McWilliams, Chairman Federal Deposit Insurance Corporation; Steven T. Mnuchin, Secretary Department of the Treasury; Joseph M. Otting, Comptroller, Office of the Comptroller of the Currency; Jerome H. Powell, Chairman, Board of Governors of the Federal Reserve System; Randal K. Quarles, Vice Chairman for Supervision, Board of Governors of the Federal Reserve System; Dallas P. Tonsager, Chairman, Farm Credit Administration; Melvin L. Watt, Director, Federal Housing Finance Agency.
Graham Broyd, Principal at Treliant, leads the firm’s Financial Markets Conduct and Compliance (FMC&C) practice, working with regulators, large regional and international banks, and law firms on risks related to their global markets activities. Graham was a member of the FRB’s Alternative Reference Rate Committee from 2014 to 2016. firstname.lastname@example.org
David Wagner has been a fixed income market practitioner for 29 years, in roles ranging from underwriter and investment banker to structuring, marketing, and trading complex derivatives. Most recently he spent 12 years with RBS including serving on the US management team, the Board of RBS Securities Inc, the Board of Tradeweb, and as the RBS representative to the ARRC since its establishment in 2014. David is building a consulting practice assisting all firms affected by the LIBOR to SOFR transformation, and is teaching Finance at Fordham University. email@example.com