US Dollar LIBOR Takes a Different Path as the Cessation Date Approaches

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The last few months have seen the pace of change accelerate in the business loan market’s transition away from LIBOR. Several alternatives to the replacement benchmark rate recommended by the Alternative Reference Rates Committee (ARRC), the Secured Overnight Financing Rate (SOFR), gained momentum in the first part of 2021. As corporations, banks, and other interest rate users are preparing for the first wave of final publications at the end of this year, attention has shifted to the transition of US Dollar (“USD”) LIBOR as it starts to follow a different path.

GBP, EUR, CHF, and the large JPY LIBOR markets are primarily moving actively and through fallback to overnight rates. In contrast, the use of the SOFR as a replacement for USD LIBOR appears to be far less comprehensive and certain.  Recent market developments with the issuance of bonds referencing “term” interest rates such as the Bloomberg Short-Term Bank Yield Index (“BSBY”), and the endorsement of the CME Group’s term SOFR rate by US Regulators, closely followed by the expected launch of BSBY futures, are all raising questions over the key assumptions underpinning LIBOR programmes.

The scale and nature of the US Dollar interest rate market were always going to present a different set of challenges to regulators and market participants. The delay to the cessation date for major tenors until the end of June 2023,18 months after GBP, JPY, EUR, and CHF was widely regarded as a sensible step when it was announced with just over 12 months until the first announced cessation dates. However, this delay has encouraged those with longer-term exposure to USD LIBOR to consider their options and review the implications for their systems, processes, and funding strategies. 

One of the biggest criticisms of the transition from LIBORs has been the switch to overnight rates. These are computed over equivalent terms of LIBORs, one month, three months, etc., using compounding to achieve a similar periodic rate. Such an approach has led to a wide range of challenges: from options traders who consider the fundamentals of the interest rate to have changed; to corporate treasurers who lose certainty and time to prepare interest payments in advance. System re-design has been a requirement to address this specific aspect of the transition across sectors. Some well-established products such as trade finance, and Sharia-compliant lending, both of which depend on the certainty of interest payments in advance of a contractual period, have also raised challenges over the loss of the conventional term rate structure. 

More recently, the pressure on using overnight rates to replace LIBOR has emerged from banks concerned with the cost of managing interest rate risk and associated funding. Term rates have faced continued criticism from the official sector. But while maligned, the system of LIBOR rates, with its inherent weakness of subjective term interest cost predictions between submitting banks, did offer bank lending businesses with inherent risk management. LIBORs increased in time of stress, which, if captured in loan interest income with clients, would insulate the lender from increased borrowing costs. Using overnight rates decouples the cost of funding from income and has led some firms to question the use of compounded SOFR in arrears, leading to potential increased borrowing costs to the real economy as banks reserve for this mismatch. 

What does this mean for the LIBOR transition programmes in major financial institutions? How will it affect their clients? With increasing certainly, the transition of USD will follow a different and varied path from that taken by GBP and other currencies. With the publication of the term SOFR and the recent exercises by some firms to test the market demand for term index-linked bonds, preparations are underway to offer an alternative to overnight rates.

As demand from banks’ clients grows for alternative approaches to interest calculations, developments of products and the associated risk management will need to at least be properly evaluated. Competitive advantages may emerge for those banks willing to respond to client demand. But this is not a straightforward problem to solve, as many larger clients seek hedging and other trading book products to manage their risks. This will force larger commercial banks to establish cross-business line initiatives to ensure that a term product in the banking book can be funded and risk-managed effectively through price formation and market observation. 

Banks, regulators, and the markets have yet to decide when and how term rates will deliver the transition from USD LIBOR. This creates challenges for programme managers and those setting strategies to prepare for the change, but with less than two years to go, there is time for planning and implementation of new solutions for clients. One thing is clear, the transition from LIBOR is far from complete and must adapt to demand from firms concerned with managing their exposure to interest rates. 

If you have any questions on how the LIBOR transition will impact your business or are looking for skilled specialists to help navigate the transition, get in touch with Phil Marsden at phil.marsden@voxfp.com or visit www.voxfp.com to learn more.

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