In this post, the fourth and final of a series of posts addressing the end of Libor and her relatives, we look at how this will impact financial markets.
Markets impacted by the retirement of LIBOR.
The loss of LIBOR will impact, either directly, or indirectly, many markets. The impact on each will depend upon the behavior of regulators and derivatives exchanges, the pace of transition, the adoption success of proposed benchmarks, and the behavior of the legal and compliance.
The impact varies from significant and potentially existential, in the swaps and their use in LDI hedging strategies, to almost minor in foreign exchange. Furthermore, the proportion of transactions naturally running off over the next five years will reduce disruption, notable in the interest rate derivatives markets. In Exhibit 1 we summarize those conclusions.
Exhibit 1: Table of markets impacted and brief summary of impact
|Market||Comment||Conclusion||Things to watch|
|Swaps / OTC derivatives||Much of market linked to LIBOR, impact depends upon different players reaction / ISDA response||Might lead to switch to govt-related product until alternatives achieved||Swap spreads, and volumes, ISDA response|
|Key hedging instruments like Eurodollar contracts linked to LIBOR||Eventual decline in volumes and liquidity as approach 2022||Development of new ETD products
Volumes and open interest in post-2021 maturities
|Spot/fwd Foreign Exchange||FX very adaptable and sophisticated, likely to adopt new benchmarks quickly||Perhaps the smoothest of transitions||Legal disruptions and narrowing liquidity|
|Small, but key market used to precisely hedge longer term fx risks||Needs to adapt quickly alongside main fx fwd market||Breakdown of x-currency basis market, widening dealing spreads, poor liquidity|
|LDI hedging||Swaps and derivatives used crucially to match liabilities||Higher cost of govt-based derivatives solutions may slow growth. Early closure/replacement of swaps could accelerate tax liabilities||Growth and health of LDI industry
Response of Tax authorities
|Consumer/Bus Loans||Market risks predominantly bi-partite documentation on replacement||Uncertainty should slow activity and transaction flow.||Legal challenges on “disruption”
Growth of market as approach 2021
|Securitized market||Individual deals have different replacement documentation coverage.||Some deals will suffer rating actions or worse. Market thought to have resources and time to transition.||Rating actions, liquidity and flow|
|EURIBOR||Huge market, as important as LIBOR
Main hedging tool in EUR currency
ECB stepping in to provide momentum to reforms.
|Reforms have failed alongside LIBOR
And create similar risks to system.
Independent of LIBOR – could fail on its own.
|EMMI regulator progress,
the new ECB o/n rate
Potential collision with ECB monetary policy needs.
|Other LIBOR and ibor markets||UK, Yen and SFC markets have substantial exposure to LIBOR or local ibors which are also being reformed||UK chose SONIA to replace LIBOR
Japan chose TONAR rate, and Swiss chose SARON rate. All have same problems as US SOFR – lacking term and credit premia.
|Swiss proceeding quickly and may highlight problems for other reforms
We now explore in detail the impacts summarized above. The most important impacts are likely;
- The swaps market– with uncertainty on the LIBOR-leg of the swap, and the underlying basis for benchmark likely moving from a (higher) unsecured rate to a (likely lower) secured rate, swap revaluations could trigger wholesale closure of contracts. While unclear and dependent upon many things, including the natural habitat of hedgers like mortgage players, insurance and pensions, it’s possible that this could result in further normalizing (widening – more positive, less negative) of swap spreads, especially at the long end of the curve. Furthermore, the impact of reforms and changes in other areas, like hedge accounting rulesand the regulatory environment for banks, could confuse the impact from LIBOR reform. Until other benchmarks evolve, government-related securities are likely to continue to replace swaps as hedging instruments.
- The LIBOR-based short rate exchange-traded derivatives(e.g. Eurodollar, short sterling, Euribor) markets. They are large and liquid markets. For example, CME Eurodollar futures and options saw average daily trading volume exceeding 4 million contracts (worth $4 trillion notional), and open interest of over 50 million contracts ($50 trillion notional) in the first seven months of 2017.Given these are all based upon, and settle to, the appropriate value of LIBOR, one can expect liquidity in maturities post-2021 to dry up. Indeed, even shorter maturity Eurodollar contracts could suffer as the reform progresses. Derivatives based upon the newly proposed benchmarks, or close surrogates, are likely to cannibalize the open interest on the Eurodollar contracts, and could start as soon as early 2018 (The CME Group have already started work on exchange-traded interest rate futures and options based upon the SOFR and plan a webinar to discuss their progress on Wednesday, October 4. They are hoping to launch SOFR futures and options shortly after the Fed begins to publish rates in 2018). So far there is no evidence that either volumes or open interest in the 2022 contracts is suffering, as witnessed by Exhibit 7. There we show the 5yr averages of open interest and volume in the March 2022 Eurodollar contract (EDH2). As these metrics would naturally vary through time according to many factors including uncertainty regarding Fed rate policy, we need to compare the current open interest of 71,000 and one month average volume of 79,000 with the respective averages for an equivalent 4.5yr forward contract. We’ve used the “19thEurodollar contract ED19” as a proxy and show that open interest is about in line with the past 5yrs exposures, while recent average volumes have dropped below the 5yr average. The drop in volume could be due to recent market uncertainty (North Korea, hurricanes, and upcoming Fed meeting) but could also reflect the uncertainty regarding Libor, though unlikely. These metrics are worth watching to gauge the impact and onset of the LIBOR reform process.
- Foreign exchange (FX) markets rely on LIBOR to calculate near term forward hedging costs, which are determined by the difference between the term funding costs of the two currencies. Given the sophistication and flexibility of the market, LIBOR’s replacements are likely to be smooth and quickly adopted once they’ve arrived. One side issue is the imposition of fresh variation margin requirements on uncleared foreign exchange contracts, known as the EMIR requirements. These regulations will clearly clash with the LIBOR replacement programs, and given their demand for collateral, may influence the behavior of the secured replacement rates (e.g. SOFR in the US). Then again, this can be seen as a further move in the direction of a more collateralized system, with greater emphasis on secured benchmarks.
- For longer dated FX transactions, where the currency cash flows are fully and precisely swapped, the cross-currency basis market is involved. This is already a very narrow market, where liquidity can be challenged at times, and the move away from LIBOR adds further uncertainty to this small but crucial market.
- Liability Driven Investment (LDI) accounts are significant in markets like the USD, UK and much of Europe, and players could move quickly from swaps to bond futures and other alternatives, once they recognize LIBOR is on the way out. It’s probable that this is some way away but given the scale of that segment of the market, and the desirability of making equity-bond reallocations, the flow could be sizeable. The LDI However, “tearing up” swap transactions create other complications for clients. The valuation disadvantages of using a (lower) secured rate-based instrument are worse when one realizes liabilities are generally discounted using AA rated yields. Furthermore, the tax treatment of early realization of profit and loss on the swaps may make it more prohibitive and costlier (The tax implications of LIBOR reform is itself a huge topic, and well outside this paper. As a guide, there is an excellent “Tax Questionnaire” summary in the Market Participants Group paper, on page 454, and some discussion of how renegotiation of LIBOR-based transactions could accelerate tax recognition. Clients should consult their own tax resources for final advice.) The advantages of replacing legacy swaps with new swaps that have employ the new, more favorable ISDA margining terms may not be enough of an encouragement. As a result, we’d expect counterparties to move very slowly if at all, awaiting clear leadership from accounting and financial regulatory bodies.
- The US loan and securitization markets seem exposed to LIBOR to the tune of over $30 Trillion (according to estimates from Exhibit 1) making disruption a significant risk. This is precisely why the regulators will be keen to resolve this. We understand that about 40% of outstanding ABS is floating rate, mostly in student loans and credit cards. However total ABS issuance in recent years has been skewed to fixed rate with about 20% floating rate, as student loan and credit card issuances are on the decline. Within Student loan and credit card ABS, the exposure to Libor is 90% and 40% respectively and language addressing replacement rate index varies. Some newer deals allow for a successor rate in place of LIBOR, which would work fine while other deals are not that explicit, and some allow for the last reported LIBOR rate to be used in perpetuity, effectively converting into a fixed rate security. We have included examples of recent documentation in Appendix 1. Many loan agreements are governed by trade association- recommended facility agreements (LMA and LSTA) which allow for (i) Reference Bank Rate (the average of quotes of wholesale borrowing rates supplied by Reference Banks), (ii) the cost of funds (of the Lenders or a single weighted average rate that is applied to payments to all Lenders), or (iii) an alternative rate. Furthermore, the “market disruption” clause can govern the replacement, typically a Base or Prime bank rate. On the one hand these facility agreements help reduce the potential for chaotic outcomes. However, on the other hand, they may make the transition to alternative industry-sponsored alternatives that do not “look like” those in the facility agreements, or are costlier, much more prone to legal disagreements and lawsuits. In the securitization markets, while amending securities documents is always challenging, it’s not impossible as recent attempts to amend legal final maturities in past two years testifies. It’s thought ABS issuers should have enough time and resources to transition away from LIBOR although the lack of adequate replacement language exposes securities to a potential ratings review. Finally, it is possible that ABS and loan issuance could slow as the LIBOR issue grows in understanding, further impacting market liquidity. In CLOs, the challenge is severe. According to the LSTA, amendments in CLOs “typically require 100% vote of each class and majority of equity. So, any LIBOR amendment probably should be done in the context of a reset or a refinancing where all holders of non-refinanced classes are known. The good news, though, is that if LIBOR is discontinued after 2021, most existing CLOs may well be in wind-down mode (or post-non-call) already.
- It’s worth noting that EURIBOR suffers from the same flaws, and reforms there too have stalled, although the regulator isyet to call time on the unsecured nature of the benchmark. Securities and liabilities impacted by EURIBOR are worth at least another USD220 Trillion and will be impacted by the success or failure of the LIBOR reform process. The regulators are acting to progress their reform, hoping to either keep/transit EURIBOR to a hybrid (EURIBOR+?) or set the stage for a migration to a new benchmark, in much the same way the US and UK authorities intend. To that end, the ECB recently announced a new ECB unsecured overnight rate, which will form the basis for the transition away from the old EURIBOR. This new rate will be unsecured, and hopefully based upon transactions rather than submissions. However, there is already a private-sector-administered, unsecured o/n rate – EONIA, with a well-developed OTC derivative market and plenty of activity, and the new ECB rate will be a direct competitor to EONIA. It’s felt that its public sector (Euro system) backing, together with its transactional basis, will be enough to ensure its success and eventual cannibalization of the EONIA market. It will have greater reach than EONIA, taking into account transactions from 50+ reporting banks, some outside the interbank market. EONIA is based upon the 28 panel banks and is only interbank. Expect to see more on the ECB rate around mid-2018 and watch for the development of exchange traded derivatives based on this rate, a crucial contributor to its success.
- Other currencies affected include GBP, YEN and SFC, as discussed above. In Sterling, the BoE has stepped firmly behind the newly reformed SONIA benchmark and is optimistic that new SONIA-based derivatives will help guarantee its success, cannibalizing volumes from the existing and well established “short sterling” ETD contracts. LIBOR impacts most sterling markets, and we explore the details in our companion paper “The end of Sterling LIBOR – What you need to know”, together with the other alternative benchmarks considered and their backing.
- The Yen LIBOR reforms are progressing fast, and with JPY-LIBOR amounts over US$ 30trn of exposure, the working groups been tasked to get the replacement unsecured Tokyo Overnight Average (call) Rate, TONAR off the ground as quickly as possible. Clearly the Japanese investor makes a greater use of fully swapped foreign product than any other, and the cross-currency basis swap market is significant at around US$ 3trn back in 2012. Given the narrowness of this marker and with 40+% LIBOR related these reforms create an important risk. (See Appendix 2 for details)
- Swiss reforms are on the fastest timetable, replacing their unsecured OIS-based benchmark TOIS (not LIBOR-related) with a new secured repo-based benchmark, SARON from the end of 2017, from which participants should move to the new SARON rate, or terminate the existing contracts, as the old TOIS rate will no longer exist. SARON will form the basis for the switch away from SFC LIBOR products and faces many of the same problems the new US SOFR faces. While smaller than the other four, the SFC LIBOR market is still US$6trn, although encouragingly around 70% of contracts roll off in 5yrs. (See Appendix 2 for details)
A comment on the current differences of opinion between market participants
There already appears to be differences between market participants over issues like the 2021 date, the potential success of the preferred alternatives, and the stability of existing LIBOR regimes. This does not surprise us. It seems to us there are three types of participant within this LIBOR-replacement process.
- The regulators – who will largely follow the FCA lead and are unlikely to volunteer to take over from the FCA given the current litigative nature of the LIBOR proceedings.
- The “in-crowd” of banks and asset managers– those involved in the creation of the replacement, and who will likely dominate it once it’s formed.
- The “out-crowd” of banks – those on the periphery of the creation process, and outside the final functioning – they will be “users” not drivers.
Some banks will clearly fall into category 3) in US$ (especially EU banks) and in sterling (especially after BREXIT) 3) in Yen and SFC given the domestic nature of those two markets.
In euros, the EUR-LIBOR market is already minor – EURIBOR is king – and those EU banks are set to continue to remain firmly in 2) in whatever replaces EURIBOR.
Given that breakdown, we’d expect some of the banks in 3) to” offer to eat their hat” if LIBOR ever goes away.
Our own view, as we described above, is simply to take FCA at their word, and keep a keen eye on the developments that will take place in these major markets, while keeping our clients abreast of the important ones.