LIBOR, one of world's most widely used financial benchmarks, is being phased out -- but what will replace it? Western Asset examines the consequences and impact for investors.
- LIBOR is one of the world’s most widely used financial benchmarks for short-term interest rates and determines the rate for unsecured short-term borrowing between banks.
- LIBOR will be phased out at the end of 2021 and the transition to a new reference rate will be a major undertaking for many financial institutions.
- Due to the vast number of financial vehicles tied to LIBOR, it will be replaced by several different indices that will serve the same function going forward.
- Several working groups around the world have been researching their respective recommendations to replace LIBOR for their local markets.
- Western Asset is monitoring the situation closely, and providing this summary of the status of the LIBOR retirement to help investors and financial professionals best prepare for the transition ahead.
Western Asset, like all asset managers, is dependent on the development of new market conventions and associated liquidity. We are closely monitoring the proposed alternatives, as well as efforts by issuers to replace LIBOR-related language and update fallback provisions. We fully expect the pace of market developments to increase significantly over of the course of 2020 and into 2021.
Western Asset’s working group is also committed to ensuring that any operational processes dependent on LIBOR will work as intended with replacements reference rates. Preliminary analysis of Western Asset systems have not identified any large gaps in handling LIBOR replacements.
Background and Scandal
Interbank borrowing declined significantly during the financial crisis and its aftermath. Central banks have since flooded the market with liquidity and interbank borrowing has become more of a theoretical exercise. Given that the rates submitted by some banks were based on a theoretical exercise rather than on actual transactions, the risk of manipulation of the rate increased. Banks were suspected of reporting fraudulent rates that were advantageous to their current trading positions. An international investigation into LIBOR that began in 2012 revealed that many banks had in fact manipulated interest rates going back a number of years. In July 2017, UK regulators announced that banks would no longer be required to participate in LIBOR calculations by the end of 2021.
Coordinating the Transition Away From LIBOR
Exhibit 1: Replacing LIBOR Around the World
United States: Secured Overnight Funding Rate (SOFR)
SOFR determines the cost of borrowing cash overnight while posting risk-free assets such as Treasury securities as collateral in a reverse repurchase agreement (repo). The scale of these types of repo borrowing transactions is massive, averaging nearly $1 trillion per day according to the FRBNY. There are three repo sectors included in the SOFR calculation (1) the Tri-Party General Collateral Rate collected by the Bank of New York Mellon, (2) the General Collateral Financing (GCF) repo rate from the Depository Trust & Clearing Corporation (DTCC) and (3) the bilateral Treasury repo transactions cleared at the Fixed Income Clearing Corporation (FICC). The FRBNY pools the data from these three sources and solves for the median transaction-weighted repo level, which in turn becomes the SOFR rate.
SOFR was selected by the ARRC to be the alternative reference rate because (1) it is compliant with the principles of the International Organization of Securities Commissions (IOSCO), (2) is a transaction-based rate, (3) it relies on a robust daily volume and (4) is an overnight rate which closely tracks other overnight rates.
The IOSCO is an international body that includes the world’s securities regulators and is recognized as the global standard setter for securities regulation, oversight and enforcement. IOSCO covers more than 90% of the world’s markets and is considered to be the defining source in establishing standards for benchmarks for security markets worldwide. In June 2018 the New York Fed issued a statement that SOFR was in compliance with regard to the IOSCO’s principles for financial benchmarks.
Exhibit 2: Comparing SOFR and LIBOR
LIBOR and SOFR: Key Differences
There is approximately $200 trillion in identifiable notional value of financial instruments that currently utilize US LIBOR as a reference rate. It’s important to note that 82% of these instruments mature before the end of 2021.
Exhibit 3: US Dollar Transactions That Reference US LIBOR
United Kingdom: SONIA
Europe: Euro-Short Term Rate (€STR/ESTER)
Switzerland: Swiss Average Rate Overnight (SARON)
Japan: Tokyo Overnight Average Rate (TONAR)
1. How can an overnight rate replace a term rate as a reference rate for financial instruments?
2. What is the rate history between the new reference rates and LIBOR?
Exhibit 4: Daily Rates: SOFR vs. 3-Month LIBOR
3. Given that SOFR typically is a lower rate than LIBOR, how will investors be made whole in the event their reference rate is switched from LIBOR to SOFR?
4. How can an overnight rate replace LIBOR as a benchmark for performance?
As mentioned earlier, a move from LIBOR to alternatives such as SOFR will likely result in a systematic decrease in the interest rate to reflect the decrease in inherent risk. This is why any portfolio that seeks to outperform LIBOR by a set margin (or alpha), will need to restate this objective after the transition in order to maintain the investment strategy and expected level of total return. For many investment managers of short-term funds, such as money market fund providers, the intention will be to keep the investment objectives and strategy of funds unchanged after the decommissioning of LIBOR. This will ensure that investors in such funds will not experience a significant change in their investments. Similarly, any fund that charges investment management fees based on performance referenced to LIBOR will need to restate this objective in order to minimize the level of disruption to investors.
5. What will happen to LIBOR-referenced instruments that remain outstanding when LIBOR is discontinued?
Exhibit 5: What Happens to LIBOR-Referenced Instruments After LIBOR Transition
Alpha is a measure of portfolio performance vs. a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.
An Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities.
The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate, its recommended alternative, the Secured Overnight Financing Rate (SOFR).
The Bank of England is the central bank of the United Kingdom.
The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency.
A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
Bloomberg Barclays is a leading provider of fixed income indices.
The Chicago Mercantile Exchange (CME), colloquially known as the Chicago Merc, is an organized exchange for the trading of futures and options.
A collateralized loan obligations (CLO) is a security backed by a pool of debt, often low-rated corporate loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, and it dictates who will be paid out first when the underlying loan payments are made.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
Correlation refers to a relationship existing between mathematical or statistical variables which tend to vary, be associated, or occur together in a way not expected on the basis of chance alone.
The Depository Trust and Clearing Corporation (DTCC) is a company which provides trade settlement services to a wide range of financial institutions.
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index).
Eonia is a daily reference benchmark rate for overnight lending between euro-area banks.
The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.
The euro short-term rate (€STR) reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area.
The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess.
The Federal Reserve Bank of New York is one of twelve regional banks that make up the Federal Reserve System.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Fixed Income Clearing Corporation (FICC) is a company that specializes in the settlement of fixed income trade transastions.
A floating interest rate, also known as a variable or adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the instrument.
A floating rate note (FRN) is a bond that has a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread, which remains constant.
A futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future.
Generalized Collateral Financing (GCF) refers to transactions between banks for the repo market which do not require the specificaiton of securities used as collateral until the end of the trading day.
The Intercontinental Exchange (ICE) is an American company that owns exchanges for financial and commodity markets, and operates 12 regulated exchanges and marketplaces.
An interest-rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount.
The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives.
The International Organization of Securities Commissions (IOSCO) is an association of organizations that regulate the world's securities and futures markets.
Liquidity refers to the degree to which an asset or security can be bought or sold in the market without affecting the asset's price.
The London Interbank Offered Rate (LIBOR) is the interest rate determined daily by a specific group of London banks for deposits of certain stated maturities.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Repo is a form of short-term borrowing for dealers in government securities.
A reverse repurchase agreement, or "reverse repo", is the purchase of securities with the agreement to sell them at a higher price at a specific future date.
SARON stands for Swiss Average Rate Overnight and represents the overnight interest rate of the secured funding market for the Swiss Franc (CHF).
The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
The SIX Swiss Exchange is Switerzland's primary stock exchange, located in Zurich.
The Sterling Overnight Index Average, abbreviated SONIA, is the effective overnight interest rate paid by banks for unsecured transactions in the British sterling market.
The Tokyo Overnight Average Rate (TONAR) is an unsecured interbank overnight interest rate and reference rate for Japanese yen.
A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less.
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