The transition away from the London Interbank Offered Rate (Libor) is picking up steam in the United States and United Kingdom, with the UK’s Sterling Overnight Index Average (SONIA) taking the lead as the first Libor replacement benchmark used to price a cash product. However, both SONIA and the Secured Overnight Funding Rate (SOFR) in the U.S. are still taking baby steps, and liquidity in the derivative products considered necessary for the benchmarks to succeed remains a trickle.

THE SONIA/SOFR DILEMMA

SONIA has actually been an active benchmark for 20 years. The Bank of England (BOE) launched a revamped version of it in April that now includes bilaterally negotiated unsecured sterling transactions as well as brokered ones, fortifying it as a risk-free reference (RFR) rate and Libor replacement.

So far, financial products tied to the SONIA and SOFR risk-free rates (RFRs), so called because they’re designed to remove the bank credit risk inherent in Libor, have yet to emerge for corporates. Sarah Boyce, associate director, policy and technical for the Association of Corporate Treasurers, said that the trade group’s ongoing survey of corporate constituents has made it clear so far that SONIA-based loans and derivatives meeting their needs are not yet available. “Banks haven’t started offering anything yet,” she said.

According to Boyce, that’s not terribly surprising given the chicken-egg dilemma they face, since engaging in RFR-based debt or derivatives is highly risky unless there’s liquidity, and that liquidity simply hasn’t arrived yet. That’s not to say it won’t, and perhaps soon, since the financial regulators and major financial institutions see the writing clearly on the wall for the Libor benchmark.

That was discussed at length in the Commodity Futures Trading Commission’s (CFTC) July 12 Market Risk Advisory Committee meeting. Tom Wipf, vice chairman of institutional securities at Morgan Stanley and a member of the Alternative Reference Rate Committee (ARRC), which devised SOFR, noted that submissions of the interbank borrowing rates by major banks to calculate Libor have fallen off significantly. In fact, banks will no longer be obligated to make those submissions at all after 2021, and there are concerns they may stop altogether, leaving legacy Libor financial products without a benchmark to calculate interest payments.

Regulators, who have recently been putting more pressure on financial institutions to speed up their transition away from Libor, have also expressed worries. Those issues include finding ways to convert the RFRs from a backward-looking rate to a forward-looking one, and creating contractual language for new and existing financial products to enable them to convert to a different benchmark rate, should Libor no longer be viable.

The RFRs are look-back rates because they settle overnight, and borrowers only know their final interest payment when the transaction expires, compared to a forward-looking term rate in which borrowers know at the start of each term exactly what they will owe at the end.

“The biggest challenge is that the characteristics of SOFR and SONIA are fundamentally different from Libor, which is a forward looking term rate,” Boyce said. “That’s very useful for corporates, because they know what due in three months and can better manage cash flows.”

LOOKING AHEAD

Term RFR products are expected to arrive sooner on the derivative front, if only because derivative markets are more flexible and, compared to corporate loans and bonds, there’s far more liquidity. In fact, one- and three-month futures contracts based on SONIA and SOFR began trading in April across the CME, LCH and ICE futures exchanges. The daily volume so far has been erratic, with each of the exchanges seeing spikes where several thousand contracts have traded. The trade volume most days is below 1,000 contracts, although the average appears to be creeping higher.

Post summer doldrums, volume in the futures contracts may increase significantly. LCH has cleared some SONIA swaps since 2009 and continues to do so, and it started clearing SOFR swaps on July 16. The CME said it will start clearing SOFR swaps in September, though it has yet to announce clearing SONIA swaps.

Liquidity in SOFR futures and cleared swaps will be critical for banks building RFR-based term products, a point noted repeatedly at the CFTC meeting, and those derivative products will play a key role in ushering in RFR-based cash products. Corporates regularly use swaps to adjust their mixes of floating- and fixed-rate debt, and loans are often structured with hedge requirements.

“In many of those loan agreements, it shouldn’t be dismissed that there are hedging requirements—often a covenant with terms that govern what that derivative needs to look like,” said Robert Mangrelli, director on Chatham Financial’s global real estate hedging and capital market team, at the CFTC meeting.

Transitioning away from Libor is anticipated to be easier on the derivative side than the cash side, in part because the International Swaps and Derivatives Dealer Association (ISDA) is developing amendments and protocol to its swap definitions by first half 2019. Adherents to those definitions should be able to efficiently adopt standard fallback language in their derivative contracts.

If Libor or one of the other interbank offering rates (IBORs) permanently ceases to exist, “it is vital that market participants have certainty that their existing IBOR contracts will fall back to a robust and clearly defined reference rate,” said Scott O’Maglia, ISDA’s chief executive, at the CTC meeting.               

The longer market participants continue to price transactions over Libor instead of SONIA, SOFR or one of the several other RFRs in works around the world, the more important such fallback language becomes as 2021 approaches. The fallback issue is particularly problematic for cash products, which make up $10 trillion of the estimated $200 trillion of financial products based on Libor, because those deals typically are bespoke and their contractual language will have to be adjusted case-by-case. The Loan Market Association and other trade groups are working on documentation language that will be helpful, but corporates will have to review each of their loan and derivative transactions to ensure adequate fallbacks are in place.

For more insights, be sure to visit AFP's Libor Transition Guide.