Insight & Analysis

Zombie LIBOR? Y2K 2.0? Money market participants discuss new RFR prospects

Silhouettes of zombie people walking

Is LIBOR set to join ‘the living dead’ as financial firms struggle to let go? Is the transition a lot of noise about nothing? Delegates at the European Money Market Fund Forum 2019 in London last week pondered the alternatives.

For money market fund participants, the planned disappearance of LIBOR indices in favour of new Risk Free Reference Rate (RFRs) in 2021 is not a given. In fact, around 57% of delegates at the European Money Market Fund Forum 2019 – mostly fund managers – believe we have not seen the back of these much-maligned benchmark rates.

Back in September 2018, the Financial Conduct Authority and Prudential Regulation Authority wrote to CEOs of major banks and insurers that are supervised in the UK, requesting that they divulge details of preparations and actions being taken to facilitate the proposed transition from LIBOR to alternative interest rate benchmarks.

With more than US$240trn in global financial products using a LIBOR reference rate, the real purpose of that letter was to seek assurance that senior management and boards of UK institutions actually understand, and are positively responding to, the challenges of transition.

The event straw poll reveals an element of, if not disbelief that LIBOR indices are dead, then a sneaking suspicion that these rates will linger on for a long while yet. And for good reason. Although short-term interest rates will be less impacted, the problem with replacement rate sources, it was suggested, is the lack of comparable transactional volume underpinning any offer rate.

It is perhaps unhelpful, according to one speaker, that in recent weeks the Bank of England has described the scale of preparation for transition as ‘bigger than Brexit’. The hope is that, unlike Brexit, LIBOR transition will have an end date. Other participants mooted the idea of zombie LIBOR, where the rates continue to be used but are in no way representative. There may even be an ‘element of Y2K’ about the whole replacement rate process, said the speaker; we all know how that ended.

SOFR

Amidst the commotion, there is much action directed at finding a replacement. In the US, the Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Fed, has a favoured plan. It’s current front-runner is the Secured Overnight Financing Rate (SOFR). But this is a treasury collateralised product, said one speaker. It has no credit aspect nor an associated curve.

Unlike LIBOR, which is reported daily for a variety of tenors ranging from overnight to one year, SOFR is just an overnight rate. Its adoption demands that contracts and systems designed to incorporate term rates be significantly adjusted.

Financial regulators have also acknowledged that for some cash product users that currently reference term interbank funding rates, new term rates derived from liquid markets may be needed. The Fed suggests it may be possible to use term rates derived from compound or simple averages of observed SOFR rates.

Forward-looking term SOFR rates may be derived from transaction prices for SOFR futures contracts. But although it is common for market practitioners to use derivatives prices to infer forward interest rates, SOFR derivatives markets are still a work in progress. “Trading volume on SOFR derivatives markets seems likely to continue to grow,” says a hopeful Fed.

For SOFR futures, trading volume has grown “at a rapid pace” in the last year. There is “considerable headroom” for liquidity to continue to improve as markets transition away from LIBOR-based products. Nevertheless, at current levels of liquidity, the Fed admits that it is not possible to create a robust, forward-looking term rate based on intra-day SOFR futures prices.

SONIA

The Bank of England-favoured RFR, SONIA (Sterling Overnight Index Average), is based on actual transactions, reflecting a weighted average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. It’s used to value around £30trn of assets each year. Banks report their previous-day transactions to BoE by 0700. Following a ‘plausibility check’, the results are calculated and dispatched by 0900, ready for consumption on Bloomberg or Reuters by 1000.

SONIA is expected to be used everywhere LIBOR transition is not immediately possible. But, commented one speaker, without an underlying market to support the rate, its value is diminished. In fact, it was noted that there is currently no way to create a term RFR from the market. And even if there was, there is no guarantee that it would survive if banks fail to support the alternative.

ESTER

In Europe, ‘the chosen one’ is the ECB-administered ESTER (Euro Short Term Rate). It uses transaction data collected as part of daily money market reporting from the 52 largest euro area banks. It is based on around €30bn worth of unsecured money market transactions each day. Although the ECB has released “pre-ESTER” rates, ESTER proper should start publishing before October 2019, replacing EURIBOR and its one-day equivalent, EONIA (Euro Overnight Index Average).

Not perfect

In practical terms, there is a huge amount of bank work still to do to ensure transition. There will be system upgrades necessary to cope with the new risk free rates but the main issue, noted by one speaker and acknowledged by all, is the number of contracts that will need re-papering.

Indeed, there is a huge book of legacy contracts that are simply not geared to the permanent cessation of LIBOR. If problems arise, for bond holders for example, one fall-back is the last published LIBOR rate. In such a case, floating rates suddenly become fixed and the so-called zombie LIBOR rises. This may be to the advantage of some; others will no doubt take a hit.

But after all this, is there any guarantee that SOFR or SONIA futures will be any more resistant to manipulation than LIBOR? Trades and fixing for both are real but they are nonetheless managed, noted one panellist. It was accepted that there is now far stronger regulation and observation over rates, following long-term LIBOR indiscretions, however, said another speaker, there is no perfect answer and, ultimately, the market is looking for “the least worst solution”.

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