LIBOR Transition: The Tide is High
Ksusha McCormick
June 17th, 2021
One of the most pressing things happening in rates markets is the imminent discontinuation of Libor. Understandably, much of the discussion over the past few years has centered on the operational, “Y2K”-style issues of the transition. However, the real story is in the market risk implications of the change. To paraphrase Warren Buffet, the tide is about to go out, and even some of the largest market participants do not have their shorts on.
How Did We Get Here?
Relatively soon after the ARRC anointed SOFR to be Libor’s successor rate, several large commercial banks began voicing their objections to the lack of a credit component in SOFR. The Fed convened a working group at the beginning of 2020 to explore these issues, but in October of last year released a statement, signed by Fed Chair Powell, Treasury Secretary Mnuchin, and heads of the SEC, CFTC, and FDIC, that market participants were free to incorporate credit sensitivity into new and existing contracts as they saw fit, and that the Fed would not throw its weight behind any one method. As a result, several credit-sensitive alternatives have now emerged, in the form of both new reference rates and add-ons meant to be layered on top of SOFR. There has been some recent jawboning to encourage SOFR adoption, but given the rapid development of alternatives, the idea of a monolithic new rate may be difficult to return to at this point.
Aren’t Choices a Good Thing?
The fact that credit sensitivity is important to some market participants but not to others poses a problem if one’s view is that a universally accepted rate is best for liquidity and market efficiency. ISDA’s fallback spread is being set during a moment of historic tights in credit spreads, so locking in this rate favors borrowers over lenders. Therefore, it’s no surprise that regional lenders have been most vocal in opposing wholesale adoption of SOFR. If credit spreads were to widen, SOFR, being a secured rate, may well go down in a flight to quality, and borrowers whose floating rate loans are tied to SOFR plus a (modest) spread may find their borrowing costs going down just as their credit worthiness in the lender’s eyes decreases. At the same time, regional banks may see their own borrowing costs going up, devouring their margins just at the moment when they would need to shore up their financial position.
However, simply amending existing contracts to build in a bigger margin of safety for lenders is nearly impossible. Any instrument referencing Libor, whether it’s a loan or a derivative, is in its essence a contract. And changing contract terms without the consent of both parties is typically illegal. Thanks to the gravitational pull of the Fed’s imprimatur, two powerful forces have provided legal workarounds to this constraint, effectively shoehorning a large number of contracts into referencing SOFR. The first is swap clearinghouses. 95% of the Libor universe is derivatives, and of these, more than half are centrally cleared. When two counterparties agree to clear their swap, they give the clearinghouse certain rights, including the right to change the floating leg reference rate in the event of the original rate being discontinued. So once the ARRC decided to back SOFR, the major clearinghouses announced that they would switch all centrally cleared contracts to the new convention. The second force has been the tough legacy legislation recently passed by New York State, and currently being contemplated at the federal level. The legislation provides safe harbor from litigation for counterparties who unilaterally change the reference rate, so long as the new reference rate reflects the ISDA protocol fallbacks. So even though the fallbacks originated as an “airbag” for counterparties who cannot come to an agreement, the zero-sum game dynamics of rate amendment have made it difficult for an alternative to take root.
What Could Go Wrong?
So even forgetting for a moment the quandary of choosing a reference rate for new contracts, the near-impossibility of amending existing contracts to anything other than the ISDA fallback protocol means that market participants are essentially stuck with huge amounts of money tied up in contracts that will no longer do what they’re supposed to do. Who stands to suffer the most from this besides lenders? Asset managers, since many hedge their bond portfolios by paying fixed / receiving floating in swaps. They could hedge using CDS, but total CDS notional outstanding has shrunk since the 2007 peak, and since there are fewer people writing large amounts of insurance, there may not be enough of it out there for the biggest players.
In addition to credit spreads widening, there are of course two other possibilities to worry about with SOFR: namely, SOFR going up and SOFR going down. At least moves in credit can be modeled and hedged in some way, mitigating potential losses for those at risk; when a reference rate is based on GC repo, huge winners and losers may emerge for reasons that have nothing to do with the credit cycle. I am perhaps biased as a former front-end trader, but the front end, particularly in times of market stress, is driven by supply and demand, not fundamentals. One can easily imagine a situation where the overnight rate spikes by nearly 10% as it did in the fall of 2019, and stays there long enough for the LIBOR-SOFR basis to go deeply negative, hurting commercial borrowers, insurance companies, and anyone else who needs to receive fixed and pay floating. One can also imagine a scenario where repo trades super special and rates go into negative territory, with the LIBOR-SOFR basis consequently blowing out. Certainly, the Fed can step in to manage the Fed Funds rate, and there are ongoing discussions about creating a standing repo facility, which should dampen repo market volatility. However, SOFR calculation specifically excludes Fed transactions, so the manipulation mechanism is not direct and leaves room for basis risk. And while market volatility is something that anyone with floating rate risk should be prepared for, the problem here is that the volatility may be uncoupled from moves in either rates or credit.
What Are the Implications?
Taken together, the current situation can be described as this: large amounts of legacy contracts will be locked into the ISDA fallback protocol. As a result of swapping credit sensitivity for repo rate sensitivity, half of the contract holders will lose some degree of protection from widening credit spreads, and the other half will be happy to lock in a historically tight spread. Repo rate volatility may impact all market participants in ways that are difficult to predict, difficult to hedge, and unrelated to moves in either rates or credit spreads. Given the structural and “gravitational” barriers to amending legacy contracts, compression or unwinding risk wherever possible seems like one straightforward risk mitigation approach. The other is of course carefully choosing an appropriate reference rate for any new contracts. The pros and cons of different approaches to re-inserting credit sensitivity into contracts will be discussed in Part 2 of this blog. Stay tuned!
