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LIBOR: In Search of Stability

A high-level overview of the situation with LIBOR today and where to go from here.

What is the situation today?

Countering the transition’s momentum are key technical issues that are becoming magnified asinstitutions of all types review their trading books with a fine-tooth comb. As financial instruments continue to evolve and become more diverse, the mechanics associated with the use of LIBOR have diverged, complicating the process to unwind transactions with LIBOR exposure. At this point, the requirements to approach an operational transformation (including updates to technology, reference data, and amending existing contracts) are clear, however, managing the economic impact remains a critical challenge.

In the US and elsewhere, the core issue is the prescribed use of a secured, overnight rate as a successor to LIBOR. From a historical perspective, during the 1960’s and 1970’s, institutions found themselves in need of a rate which tracked the business environment, and LIBOR emerged as the standard because of its ability to track the mark through the implied credit risk found within the rate. Now, as sell-side institutions transition debt issuance and swap transactions to reference SOFR, a basis is forming on balance sheets due to the absence of credit risk embedded in SOFR. Developing a term structure for SOFR has its own obstacles. Aside from the commercial challenges associated with developing a deep futures and swaps market to create the forward-looking term rate, the forward curve will still lack the term transactions needed to reflect term premium, as such a LIBOR curve behaves today. Further complicating the adoption of SOFR is the window dressing exercise banks perform on their balance sheets at month and year end in response to Basel III requirements. During these times, liquidity is pulled from the repo market causing volatility and further destabilizing the alternative risk-free reference rate (RFR).

How do we solve this issue?

For some transactions a forward-looking term structure may not be necessary. Derivative markets have been using a reference rate based on overnight economics with a backward looking, compounded term structure akin to the amended fallback language proposed by ISDA. For other products, notably cash products and forward rate agreements, this will prove operationally challenging and limit abilities to budget, forecast cashflows, and properly manage risk. Nonetheless, the need for a credit sensitive, forwardlooking term structure is certain. While the market for unsecured funding has decreased since the financial Crisis, it does still exist. To find such term and liquidity premiums, solutions may be derived from a variety of unsecured and term funding sources – such as central banks, sovereigns, and wholesale non-bank lenders. The ICE Benchmark Administration (IBA) has created a methodology to account for the credit and term sensitivities in their US Dollar ICE Bank Yield Index (BYI). While this may not truly mirror the desired characteristics for a reference rate (as non-banks don’t have access to central banks discount windows and therefore rates may move outside of target ranges) it could satisfy the market needs for cash products.

Towards a multi-benchmark solution? 

Segmenting the market with a multi-benchmark approach is not ideal, but it will provide for financial stability and avert economic disruption. Certain jurisdictions where LIBOR reform was deemed acceptable have already adopted a two-pronged approach, advocating for both an overnight rate and a reformed LIBOR rate. While this approach will provide for a forward-looking term structure that includes marginal funding costs, the industry will still have to tackle other inherent risks in SOFR. There will be operational challenges associated with backward-looking term rates, SOFR’s behavior will require more scrutiny during times of crisis or when supply and demand assumptions derail from the norm. Some institutions may feel the burden less, especially those that are backed by deposits and less reliant on marginal funding requirements. But still, as the transition unfolds for global institutions, other complexities will need to be monitored for cross-currency risk, and timing basis as alternative RFRs are rolled out across other jurisdictions.

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