The London Interbank Offered Rate (LIBOR) has been a mainstay of the financial markets since its inception in the 1980s as an underpinning of the then nascent swap market. Since then, LIBOR has gained fame, and more recently notoriety, and is the reference rate for over $240 trillion in securities globally.
The shortcomings of LIBOR were not initially apparent, hence the exponential growth in securities that used LIBOR as a reference rate. However, throughout its lifetime, two LIBOR shortcomings arose.
First, the daily LIBOR fixing was designed to represent the average funding rate of the interbank market, which included the largest banks in the world—Bank of America, Bank of Tokyo-Mitsubishi, Barclays, Citi, Credit Agricole, Credit Suisse, Deutsche, HSBP, JPMorgan, Lloyds, Rabobank, Royal Bank of Canada, Societe Generale, Sumimoto, Norichukin, Royal Bank of Scotland, and UBS.
However, some of these banks realized that they could actually lock in a funding rate that was lower, and sometimes significantly so—particularly for collateralized swaps, where the true funding rate is the overnight index swap (OIS) rate (for instance, the fed funds rate in the U.S.). This was famously exploited by Goldman Sachs soon after the global financial crisis of 2008, when it figured out that discounting plays a central role in determining par swap rates. Based on this insight, Goldman was able to enter into swaps that appeared to be at par based on LIBOR discounting, whereas the swap was an asset based on OIS discounting. Once the market dislocation occurred, and the market accepted OIS discounting as the standard, evidence emerged that Goldman indeed capitalized on this change, reporting 132% greater collateral postings than the previous year.
The second shortcoming is that the LIBOR fixing is determined by a poll, which means it is possible for banks to misrepresent their funding rates. Unfortunately, this occurred in the early 2000s (some say this had been happening since as early as 1991). In 2012, civil charges related to the manipulation were investigated, culminating in billions of dollars of fines leveed by the U.S. Department of Justice and the UK Financial Services Authority.
Therefore, in 2014, the Alternative Reference Rate Committee (AARC) formed to determine a rate that will succeed LIBOR as the reference rate for USD denominated bonds, mortgages and interest rate derivatives. The decision actually came as a bit of a surprise to the market, which expected the U.S. fed funds rate to be the successor, albeit in modified form. In fact, this is exactly the choice taken by the Bank of England, who chose a modified SONIA rate as the successor to GBP LIBOR.
In the U.S., the ARRC chose the Securitized Overnight Financing Rate (SOFR), a new rate that blended bi-party and tri-party U.S. treasury repo transactions. SOFR began daily quotations by the NY Fed in April of 2018, and the underlying market volume is over $800 billion. This enormous underlying market volume is a strong indicator that the SOFR rate is immune to manipulation—but time will tell. LIBOR quotations are currently scheduled to cease at the end of December 2021.
In terms of SOFR market size, as of October 2018 there has been over $11 billion of bond issuance, led by Fannie Mae who has a $6 billion bond issuance, and the World Bank with a $1 billion issuance. The swap market has not picked up significantly, although notably the World Bank has entered into the first SOFR/LIBOR basis swap. The Chicago Mercantile Exchange (CME) and London Clearing House (LCH) both have started to clear SOFR swaps, and the CME has issued both one-month and three-month SOFR futures. Interestingly enough, the LCH mandates the fed funds rate as the collateral interest rate, so it seems that we are not going back to the single curve world, at least in the short term.
There are still many open questions on this topic. Perhaps the largest open question is “will LIBOR continue to be quoted in some form after the December 2021 deadline?” As yet, there is no consensus answer to this question, although some market participants are discussing “zombie” or “synthetic” LIBOR. Andrew Bailey, CEO of the Financial Conduct Authority, warns not to rely on any such LIBOR fallback, saying “fall backs are not designed as, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt.”
By and large, the interbank market will adequately manage this transition. However, there are trillions of securities in the hands of retail investors with bank loans and mortgages tied to LIBOR. How the retail banks will manage this transition is far from obvious. Education of the retail investors is paramount, but also equally important is to manage the optics of switching reference rates in a period of rising interest rates.
As a final thought, Bailey also recommends that “the discontinuation of LIBOR should not be considered a remote probability ‘black swan’ event. Firms should treat it as something that will happen and which they must be prepared for.”
On the bright side, the transition away from LIBOR is not unprecedented, as the Intercontinental Exchange (ICE) discontinued the LIBOR polls for Danish Krone, Swedish Krona, Canadian Dollar, Australian Dollar and New Zealand Dollar in 2013. Although Denmark, Sweden, and Canada kept the polling system, both Australia and New Zealand switched to a market-transacted rate. The transition was smooth, although the size of the markets tied to these reference rates was far less than the $240 trillion associated with USD LIBOR.
In the coming months, the market expects to see an increase in the volumes and liquidity of the SOFR swap market, which should clear up questions around term lending—that is, how to set an unsecured forward loan for a period longer than one day. As this market liquidity increases, so will trading in SOFR caps, floors and swaptions, and thus a common understanding of volatility. FactSet will be keeping abreast of these transitions—check back in the coming quarters for an update on the evolution of SOFR markets.
Dr. Tom Davis joined FactSet in 2014 as the Global Head of Derivatives Research. In this capacity, Tom is focused on ensuring FactSet is providing the highest quality derivative analytics and growing the coverage across all asset classes. His team also conducts cutting edge research in the models and methods of quantitative finance. Tom earned a Doctor of Philosophy in theoretical physics from the University of British Columbia in Vancouver, Canada.