Debates continue to run rampant during the last six months of the London Interbank Offered Rate (LIBOR) benchmark. Some think the Secured Overnight Financing Rate (SOFR) benchmark is the perfect unitary solution. Meanwhile, others believe that a multi-benchmark environment is best. As a result, uncertainty, confusion, and opinions have started to muddle the path of “Life after the LIBOR”.
What is LIBOR?
The London Inter-Bank Offered Rate, more commonly known as LIBOR (formed in 1986), provides loan issuers a benchmark rate for interest rates charged on various financial products. The benchmark is calculated by an average of the interest rate estimates at different maturities. These estimates, submitted by approximately 18 lending banks, are based on the submitting bank’s hypothetical macroeconomic and financial outlook. However, history showed the limitations and malice surrounding the use of LIBOR. The 2008 Great Financial Crisis spurred by the abuse of credit default swaps regarding the inadequately insured and poorly regulated subprime mortgage loan originations showed the limitations of LIBOR. Since banks estimated their rates based on macroeconomic outlooks, the LIBOR rate-setting banks kept increasing their interest rate projects as the global central banks tried to cut interest rates and employ a more dovish sentiment to reduce the economic repercussions from the liquidity crunch and the market dislocation. LIBOR, in essence, transmitted the Great Financial Crisis of 2008 to the global economy. Furthermore, the 2012 LIBOR manipulation investigation uncovered that banks submitted lower LIBOR estimates to indicate a more negligible risk of default, subsequentially bringing in millions of dollars. Moreover, banks have gradually started to change business practices leading to LIBOR not remaining a reliable benchmark.
So now what?
The LIBOR pitfalls highlighted that regulators should shift away from this benchmark. This is precisely the outcome. The end of 2021 concludes the ability to issue any new product tied to LIBOR with a gradual cessation through the end of 2023. This means that there needs to be a replacement, right? Well yes. The current replacement for the LIBOR is planned to be the Secured Overnight Financing Rate (SOFR). SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. SOFR includes all trades in the Broad General Collateral Rate plus bilateral Treasury repo transactions cleared through the Delivery-versus-Payment (DVP) service offered by the Fixed Income Clearing Corporation (FICC) to filter “special” transactions. However, there are two main limitations with SOFR. First, SOFR is only an overnight rate and has disconnects with longer maturities as the rate is not forward-looking. Second, it lacks a credit component and is much more exposed to volatility than LIBOR because it uses actual trades resulting in an added layer of uncertainty or risk on common trades or contracts based on risk aversion from obtaining a higher daily rate.
Source: FRED 06/30/2021
These drawbacks have led to numerous debates about a dual-benchmark regime. However, authorities remain steadfast on pushing SOFR to be the primary benchmark replacement through targeted programs such as next month’s “SOFR First” initiative designed to increase the use of SOFR in the swap market. Regardless, even though authorities continue to push to have SOFR be the monolith, markets seem to have contrary views to the type of benchmark favored for different transactions. Lenders have started to show some support to SOFR rivals, potentially paving the way for a multi-benchmark future. This opinion exaggerated by poor fallback language for the transition has also created investors to show concerns with a unitary benchmark environment. These splintered concerns and uncertainty around a LIBOR successor have significantly weighed on syndicated lending markets.
Additionally, this seismic change to the financial system can impact banks that offer revolving credit facilities as they are exposed to funding risk and may be inclined to customize their rates (banks inclined to do a credit-sensitive rate and borrowers may prefer SOFR). This dynamic supports the varying needs a borrower, a lender, and an investor have potentially displaying a multi-benchmark environment solution. In short, this is not bad, but there are concerns—one concern is that a multi-benchmark environment can fragment markets or decrease derivatives market liquidity. There are also concerns that a multi-benchmark landscape is a short-term solution to a long-term problem. Thus, there are very different opinions on the matter.
Regardless of the outcome, LIBOR will not be used past 2023, and SOFR will play an essential role in the post-LIBOR environment over the next few years. Many individuals with opinions on the matter also still believe SOFR will likely be the go-to benchmark for most transactions. However, there are still important aspects that must be done to make the transition successful. For example:
The U.S. government must continue to seek federal legislation to help tough legacy contracts transition.
Interdealer brokers must successfully shift swaps’ trading to SOFR by July 26.
Banks need to accelerate lending linked to LIBOR’s replacements.
Firms have to overhaul their internal systems to ensure they can cope with a new benchmark.
So, despite the transition quickly approaching, there is still quite a lot to do!
With this said, there still remains overarching uncertainty around the LIBOR benchmark replacement. However, borrowers, lenders, and investors must be aware of the benefits and limitations of a SOFR dominated, or multi-benchmark environment. It is also essential to understand that opinions on the path forward will vary, but what is consistent is the cessation of LIBOR by 2023.
Lenders, borrowers, and investors have varying preferences. Lenders may choose SOFR if they fear a second transition period, believe improvements will continue, and exhibit comfortability with the lack of forward-looking credit components and volatility. However, other lenders that are uncomfortable with these limitations may prefer an alternative benchmark. Meanwhile, borrowers may prefer SOFR as it is based on observable transactions and not on an estimated rate (reducing borrower asymmetric information). On the other hand, investors’ opinions may even have more variety depending on their investing preferences and risk appetites. Currently, the system and its players are in peak confusion as authorities push a “one-size-fits-all” approach despite the current system already functioning in a multi-rate environment (to a degree) between the Fed funds rate, LIBOR, OIS, etc. With that said, new credit agreements have already started to incorporate the Alternative Reference Rate Committee (ARRC)’s recommended comprehensive language, but traditional and older provisions allow the borrower/agent to determine a new rate in necessary situations for a LIBOR transition. Thus, most loan documentations have “at-the least” generic verbiage where borrowers and agents can select a new “market accepted” rate when LIBOR is not used anymore.
All-in-all, despite the rate benchmark uncertainty, investors must be aware of the potential changes and how their portfolios can become impacted either directly or indirectly. Some of the larger and more complex floating rate and credit managers have spent the last few years preparing their portfolios and back-office operations for the LIBOR transition. Furthermore, larger credit managers have also participated in the NY Fed’s Alternative Reference Rate Committee (ARRC) discussions with loan market participants to provide feedback on the current rate transition plans. Thus, the shift to SOFR or any alternative can have an impact on internal operations, but savvy credit managers remain prepared to be minimally impacted. Forward-looking, larger credit managers (with the funds to weather cost constraints) remain better equipped to deal with this transition. Therefore, investors should allocate capital to strategies where managers have considered the LIBOR transition risks, adjusted back-office operations, and actively manage portfolio allocations to weather the “crossing of the chasm”. These factors all remain pivotal for investors during this dynamic environment.