Businesses cannot afford to push the pause button on LIBOR transition efforts.
The coronavirus has had a significant impact on financial markets as well as the way we work, much of these changes are likely here to stay. Businesses must adapt accordingly in order to progress with critical LIBOR transition transformations in preparation for the end 2021 deadline.
The novel coronavirus pandemic is, first and foremost, a public health issue with a devastating human toll. Its negative impact on the global economy and financial system is also undeniable, and unlikely to abate anytime soon. At the direction of government authorities enforcing social distancing, many businesses around the world have become paralyzed, cancelling any and all in-person meetings and events. Nevertheless, pre-coronavirus deadlines loom. One such case is the expected termination of LIBOR, the London Interbank Offered Rate, set to end daily publication at the end of 2021. Preparing for this event would be a monumental task in the best of times. Unfortunately, the risks to the global financial system are too great to wait out the coronavirus for a more practical moment to commence or restart the process. Any business or industry with exposure to LIBOR must act now.
LIBOR is, by far, the most important benchmark interest rate in the world. Libor rates are calculated for five currencies and seven borrowing periods, with the three-month US dollar rate being the most widely quoted. Roughly $370 trillion worth of financial products are linked to LIBOR globally, spanning a wide array of products. In the United States, that list includes derivatives, securitized products, business loans, consumer mortgages, and private student loans. Back in 2017, Andrew Bailey, the current Governor of the Bank of England and then Chief Executive of the UK’s Financial Conduct Authority (the regulator of LIBOR), announced an agreement with the panel of banks who submit Libor rates to continue posting through the end of 2021.
The responsibility to provide a substitute for LIBOR post-2021 falls on individual nations and/or regulators. In the United States, for U.S. dollar denominated products linked to LIBOR, that rate is likely to be the Secured Overnight Financing Rate, or SOFR. SOFR is economically different to LIBOR in several ways. First, it is secured by US Treasuries, while LIBOR is unsecured. Second, SOFR is an overnight rate whereas LIBOR is a term rate. For these reasons, market participants cannot simply substitute SOFR for LIBOR without making certain adjustments, which result in a great deal of operational complexity. Although industry-wide progress has been made in the transition to SOFR, the considerable disruption caused by the coronavirus pandemic has stalled efforts as businesses divert critical resources to crisis management initiatives. Recent discussions have centered around the possible need to extend the LIBOR transition deadline past 2021, subject to the negotiability of the agreement currently in place.
Even with a potential extension, businesses cannot afford to put LIBOR transition initiatives on hold, especially since there are no guarantees the reprieve will happen. The banks who comprise the panel that submits LIBOR rates have been seeking an exit from this commitment for years, in light of the associated conduct and governance risks that have already resulted in heavy regulatory fines for prior infractions. With less than 21 months remaining until LIBOR disappears, businesses must quickly adapt to this new social distancing paradigm by embracing remote work, online communications, and virtual meetings. Given the scope of the Libor transition project, compounded by the challenges of working remotely, programs need to resume immediately to ensure a smooth switch regardless of when it actually occurs.
One financial market effect of the coronavirus pandemic has been a stark repricing of unsecured funding markets, which has major implications for the basis between LIBOR and SOFR. As coronavirus infection rates and deaths skyrocketed, and the true scale of the crisis became apparent, credit spreads globally blew out. Due to the inherent credit component embedded within LIBOR, it followed suit, rising sharply. At the same time, the U.S. Federal Reserve sought to counter the financial turmoil by injecting liquidity through quantitative easing and a sudden reduction in the federal funds rate, which pushed SOFR lower.
“The central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet”Financial Conduct Authority, March 25th
This widening of the LIBOR/SOFR basis is problematic with respect to the LIBOR transition. If this wide, historically anomalous spread were to persist at the time of the switch, value transfers between counterparties could be increased, which would likely lead to disputes and litigation. Within derivative markets, industry consultations have taken place to avert this eventuality, settling on the use of the 5-year historical median spread between LIBOR and SOFR. Recent consultations that were highly anticipated by the market confirmed an analogous approach for cash products.
The recent divergence between LIBOR and the SOFR has brought renewed attention to the significantly different behavior of these rates in times of financial stress. As a result, a new working group has been convened to explore the issue further. One potential solution is the addition of a dynamic credit spread on top of SOFR, which would help to emulate a synthetic LIBOR while preserving the natural advantages of the more robust SOFR. This enhanced version of SOFR would greatly reduce LIBOR/SOFR basis risk in times of economic stress, present or future.
Another consequence of economic stress, which we’ve seen in spades because of the uncertainty around the coronavirus, is an increase in volatility. The VIX (Volatility Index) is one of the most popular measures of volatility in the equity markets. It recently eclipsed the highs seen during the 2008 global financial crisis. Likewise, and largely due to the surprise 100 basis point cut in the federal funds rate, we’ve seen higher volatility in SOFR as of late. While high volatility could be an impediment to SOFR’s widespread adoption for some, businesses must recognize that volatility has risen across the board and it’s not a sufficient reason to justify inaction on transition planning. Furthermore, the development of term versions of SOFR would likely result in more stable benchmark rates. As highlighted by Tom Wipf, the Chair of the Alternative Reference Rates Committee (ARRC) tasked with ensuring a smooth LIBOR transition, SOFR moving averages are generally less volatile than their three-month U.S. dollar LIBOR counterparts, across a wide range of market conditions.
The novel coronavirus, and its drastic effects on the financial markets, are likely here to stay and businesses must adapt accordingly. With regard to the LIBOR transition, that means the challenge is even greater now and progress must accelerate if the transition is to be a smooth one.
Mr. Burnett is the Director of SOFR Academy and is based in New York.