DerivSource LIBOR Transition Podcast Series – Episode 1 Transcript (Listen now)
Julia Schieffer:
Hello, and welcome to this DerivSource Podcast. I’m Julia Schieffer the founder and editor of DerivSource.com. As the market prepares for the transition away from the use of LIBOR to alternative benchmarks or risk-free rates (RFRs), financial institutions must closely look at their strategies for tackling legacy trades, which reference this soon to expire interbank lending rate. The trouble with legacy trades is that there is no one way to migrate these transactions to the post LIBOR era. Rather, there are several options a firm can take. And all methods will likely be taken to adjust the entire portfolio in question. Including the reliance on the ISDA IBOR Fallbacks, direct renegotiation of contracts with counterparties or even reliance on synthetic LIBOR, which is in the works in some jurisdictions.
In short, tackling this one element of the LIBOR transition is set to be laborious and a complex task for many firms. In this podcast series, we explore the complexities, challenges and opportunities firms have when looking to execute their own strategy to migrate legacy trades away from LIBOR. We will take a look at some of the market-wide, legal, operational and technological hurdles, inherent in this journey for the derivatives and cash markets. We will also look at the options and solutions that may assist a firm as it works towards the upcoming deadlines. But before we get into the details, in this episode we will take a market-wide look at the top challenges the financial industry faces with the LIBOR transition.
And to explore these challenges further and kick off this podcast series, I have with me, Adam Schneider, Partner at Oliver Wyman’s Digital and Banking Practices in the Americas, and co-chair of the Alternative Reference Rates Committee or ARRC, Operations and Infrastructure Working Group. Welcome to the podcast, Adam.
Adam Schneider:
Thank you very much. Appreciate the opportunity to speak to the audience.
Julia Schieffer:
Adam, you seem to be living and breathing the LIBOR transition these days. Both in your role at Oliver Wyman, but also as co-chair of the ARRC’s Operations and Infrastructure Working Group. Can you please share a little bit about yourself for our audience before we get started?
Adam Schneider:
I’ve been involved in the financial industry for just a few decades all over the largely New York and international banks, and insurers and asset managers primarily as a consultant, but I’ve had operational roles primarily in asset management where I was the COO at an asset management firm. I got interested in LIBOR when the end date was announced in the summer of 2017. Thinking that this would be a topic of high concern to the industry and one which really had to get started from scratch. Because no firm that I knew of was really focused on LIBOR, or focused on LIBOR transition. Really everybody was going at a standing start.
Julia Schieffer:
Let’s jump right into one of the biggest challenges that the market faces with this transition away from LIBOR, that being liquidity. Adam, can you explain a little bit more about the challenges revolving around liquidity?
Adam Schneider:
So LIBOR is about $400 trillion of cash assets and notional derivative assets. Of course, that’s mostly notional, but it all trades as one thing – you can hedge enormous amount of exposures and you can trade an enormous amount of exposures. And in fact, cross-currency swaps and cash instruments are normal because LIBOR is the sea level finance. So you could really count on it being operating the same across the markets. Inside of LIBOR is five currencies. The dollar, the pound, the Swiss Franc, the Euro, the Japanese yen. And now there will be five rates all sponsored by their national regulatory bodies. Just for an example, the dollar is SOFR and the pound is SONIA. As a result of liquidity must splinter between the various parties because it simply has to – it has to be divided by five. And in fact, we’re already beginning to see some sign of that where trading volume is migrating out of LIBOR, into SOFR or SONIA or the other currencies.
In addition, especially in the US market, there are several flavors of SOFR. SOFR starts off as a backwards looking overnight rate; if you want to construct a forward rate, that’s a different flavor with different risk characteristics. If you want to construct a term rate, that’s a different flavor with different characteristics. In the US market, there’s a mortgage related rate for consumers known as SOFR in Advance. All of these are going to split the liquidity of the underlying market into little pieces and the exact relationships between them still have to be worked out because many of these rates are not even in existence yet. So for example, how do you hedge the term rate of SOFR? Well, it doesn’t exist yet. You don’t have to hedge it, but those who use it will want to go and hedge out of that same pool of global liquidity. The net of it is less liquidity, plenty of choices and pricing and hedge effects over time. But a lot of trading products that still need to be in effect.
Julia Schieffer:
The cash lending side, can you tell us a little bit more about how the cash lending market is impacted by this?
Adam Schneider:
The cash market does vary by currency and the two biggest markets are the dollar and the pound. In both cases, LIBOR is used as the corporate lending rate; that’s largely for bank to corporate lending and the bank to corporate lending market is very simple. You might issue a five-year loan. It goes a LIBOR and every month or every three months, perhaps it resets to the then current rate. So from a bank point of view, your rate is current with the market. From a borrower point of view, your rate is current with the market.
And you may, as a borrower, want to fix it and hedge it against the hedge market. The core problem is one, what are we going to do going forward when there is no LIBOR because there is no equivalent rate that everyone knows to go use. And the new rates designed by the regulatory authorities are very different in how they behave. And two, just speaking for example, for the US market, there’s $8 trillion of loans outstanding and they will change from LIBOR when LIBOR ends. And the economics of that change are actually very different and very complicated. So if you are lending or borrowing understanding this change is critically important.
Julia Schieffer:
We’ve discussed the differences already between how this transition is progressing in the UK versus the US. Another area of complexity that affects currencies is the currency facility. What are the global and multi-currency implications of currency facilities?
Adam Schneider:
So currency facilities are very convenient because you can borrow in the currency you need more or less on demand. We think that an awful lot of these are going to become individual currency contracts rather than multicurrency facilities because truthfully the rates are not comparable. Just speaking dollar, pound, Euro, the rates work differently, have different economics and you would be hard pressed to come up with an easy translation algorithm to take dollar LIBOR or pound LIBOR into dollar SOFR, pound, SONIA and make it all into one contract.
Obviously, you could put them together, paragraph by paragraph, but it would be different economics. The spread between LIBOR and SOFR is fundamentally going to be different between LIBOR and SONIA and out-market. So we think it means a lot of opening up these contracts, a lot of new or single currency contracts. Perhaps less flexibility around which choice of currency to get. And a lot more energy around the new product side of the effort that really has to go develop.
And I just want to double down on that – the development and the marketplace has largely been in the derivative markets. Derivatives are 90% of that $400 trillion outstanding. So it’s very logical. An awful lot of the issues remaining are in the lending and cash market. And the cash market products are still being developed in the US; they largely don’t exist today. The UK is in a better shape. Some of the other countries such as Switzerland are in better shape. But there’s an awful lot of work to be done to even have the cash products exist as of right now. SOFR lending in the US for example, is minuscule right now.
Julia Schieffer:
Sticking with the US and focusing on SOFR, the US lending market is not adopting this. Why not?
Adam Schneider:
Well, it is important to note that LIBOR is ending for the other four currencies at the end of this year. That is locked down in stone. The dollar market, I think the why, is essentially the US regulators ask for time basically to allow for two or three things to occur. One, more items to simply mature off. Two, more time for loans, which have the word is fallback in it which is what happens when LIBOR is over, which have bad fallback terms to be fixed or remediated. And three, the fallback issue was of such significance shown by legislation proposed by the Federal Reserve ARRC committee for New York state, and by Jerome Paul himself, Chair of the Fed for congressional level national legislation. The combination of all of that, which is millions of contracts that have fallbacks that are very difficult to handle, limited time and essentially a fair amount of financial and operational risk has led to the US to ask for more time.
And I think that is the why, the actual conversations as to the why are not public, but it’s all around that comment. If you look at just some simple math, the US trading in SOFR, which is the new rate is about 2% of the LIBOR trading. It’s a really small number. But if you look at the same and the pound, it’s about 50% of the LIBOR number, it’s very close in terms of the total market. So, you can look at the LIBOR market UK and you can say, “Okay, that’s pretty ready. That rate was well established has been here for many years. We understand what SONIA is. People understand it from a lending and consumer point of view. They got it.” In the US we invented a new rate just a few years ago, and it’s still snowballing into existence in terms of scale of use, hence the need for an extension.
Julia Schieffer:
Absolutely, all new things have kinks that need to be ironed out. But a little bit more on this Adam, in the US market, as you mentioned, the lending market is not quite adopting it yet. What is the future forecast for this space?
Adam Schneider:
That’s a great question. And it’s really the about $5 trillion question in the lending market right now. We diverge a bit from what the ARRC would say. So what the ARRC would say is, is they will publish term SOFR. In other words, the rate of say 30 days, 60 days in advance and the market will move there, and it’ll happen sometime in the course of this year. We do not think the ARRC will be able to meet that deadline. And we wish they could. That’s not a pejorative statement, but the way the Federal Reserve wants to publish the number is based on futures trading. You need a lot of futures trading to publish the number; there’s no sign of that today. And we think therefore that it will miss its date and move that well into 2022. What that means is in a few months, we’re going to get to near the end of the year and there won’t be a term rate from the ARRC. The market is going to make very hard decision. One, it could go with the existing SOFR that exists now, which is overnight, which functions differently than current rates do. It is literally something you don’t know the rate of in advance. It’s like getting your utility bill where it may be higher or lower, you don’t know if the exact amount, which is not what the lending market wants. Or two, the market may well move to other rates that are being provided by market vendors.
There are at least four different rates coming out from various market vendors. And those rates will function more like LIBOR. There’ll be a term known in advance, and they may well become market standard. But we sit here at the beginning of March, not knowing what’s going to happen in middle December. It’s our projection, that an awful lot of institutions are going to think very hard about lending on a rate that looks a lot like LIBOR, which is any one of these other four rates versus a term SOFR rate that doesn’t exist. And we’re going to get to a very hard call about that in fourth quarter of this year.
Julia Schieffer:
And just to touch base on this a little bit more, why is this an issue and why is lending going so slowly?
Adam Schneider:
It’s going slowly for a combination of reasons. Reason one, the new rate in the US SOFR really works differently than the old rate LIBOR. So there’s a lot of reluctance simply to use it. It works differently, operationally, it works differently economically, and those differences add up. So operationally most organizations had to do some surgery to their systems and processes for SOFR to work. And that surgery actually wasn’t scheduled to be done in most cases until June of this year – the original ARRC date for issuance. So we’re here in March, wondering why something hasn’t happened yet, when most firms weren’t going to be ready until June. So that’s part of why it’s going slowly today. Part number two is much more fundamental. The economics of lending on SOFR, is wildly different than the economics of lending in LIBOR. Now, why is that? LIBOR intended to mimic our bank funding books. SOFR is an exact representation of the repo market overnight. Well, those two were not the same thing. Even today, as we said, interest rate curves is busy steeping up (it’s a headline story right now over inflation expectations) but at the same time, the fed number for SOFR is very flat because they’ve committed to keep the overnight rate very low. So the difference between those two things means that bankers who look at it economically say, “Well, we’re not in such a rush to go on that rate. And oh by the way, operationally, we have all this stuff to go build. There is no great rush there.” Eventually of course, the tech and ops will be all caught up. And then you’re going to get down to core economics. Which is, do you want to lend on that rate promised and promulgated by the Federal Reserve?
And for many bankers, the answer is no. There’s been extensive work into understanding and researching, what’s known as credit sensitive rates, CSRs. The Fed itself has held a series of workshops on what are the credit sensitive rates and what does implementation means. And we’ll see whether banks go that direction over the next few months. But we actually do project a lot of interest on both sides, both client borrowers and bank lenders in using these rates. And it’s really pretty simple. The current LIBOR has an insurance policy. The rate tracks the cost of funding, but when the bank system is stressed, it goes way up. And that’s not good for borrowers, but it’s really good for banks who are worried about borrowing really taking cash assets out of the bank. The new credit sensitive rates would perform very similarly, SOFR does not. And this was literally seen a year ago when COVID hit. SOFR crashed almost immediately to near zero from about 150 basis points, LIBOR was higher for much longer. And it’s not so much about the earnings; it’s about the reflection on cash credit. If you were a business under stress and your rate was based on SOFR, you would think, “Hey, what a good time to draw down that line of credit.” And banks are worried about illiquidity, they’re worried about essentially your run on the undrawn line type of problem. And they’re worried about how do they deal with managing under SOFR lending department. I’ll do one more further. There’s a more general version of this. If we’re moving from LIBOR to SONIA or to TONAR or to any one of the rates that exist out there that is not the same, you really have to think about how do I reinvent the product that’s just on top of the rate.
So, if LIBOR is good for the banking system, in the sense of it parallels some of the issues, a new products, same product based on SOFR, actually needs different features. So in that same case before, if I had a SOFR product that had a higher rate for undrawn lines, that had maybe extra fees for undrawn lines, that had a different floor for undrawn lines, you would find different products that actually could immunize the sting of the new rate structure, but those have to be invented. And when I say have to be invented, actually there’s a real world example, this really good example of this. So a LIBOR mortgage was very standard in the US until recently. The old LIBOR mortgage reset once a year, and had a certain premium over LIBOR. If you look at the current SOFR mortgage, it resets twice a year, and it has a higher premium over SOFR than you would have expected from LIBOR. In fact, higher than just the average difference, if reset twice a year is less risky for the banking system because it’s just more chance to be in the right math. And the higher reset over the base rate is simply to allow for the fact that SOFR behaves differently. It’s a different product. It works differently. It is not economically different in the sense of what a borrower would expect. But the product had to be changed to allow for SOFR as the underlying rate. If SOFR becomes the core lending rate, we expect that type of product reinvention to occur up and down the system.
Julia Schieffer:
And with the economics of the products changing with the transition, it seems prudent that firms should be doing some kind of deeper impact analysis on their existing contracts. Is this something that you would agree with? And do you see firms doing this already, Adam?
Adam Schneider:
So we absolutely believe that firms should be understanding the economic effects of moving to new rates. So why do we think that? Well, we’ve done the math. So we think this based on facts and expectations. There’s two halves to this analysis. Number one, there’s many trillions of assets and derivatives exposures in the market -hat happens when they change is really important.
And we have seen impacts on the order of five to 700 basis points. That’s five to 7% of principal on a net present value basis, depending on, are you borrowing lending? Is it good? Is it bad? But we’ve seen real value get created or destroyed. And it’s a complicated calculation. You need to think about your interest rate forecast. You need to think about the future of the product. You need to think about whether you can get out of the exposure, et cetera, but we’ve seen real value changes.
And we think it is not prudent to not look at what happens to your existing portfolios. Again, four currencies will change in a matter of months. Even for the fifth currency, the dollar spread is set. So we know effectively what will happen, and we can do detailed modeling of whether that’s good, bad, or indifferent. Same question applies to new products. If you go to a… One of the giant G-SIFI banks and say, “How many LIBOR products do you have?” Well, there’s a taxonomy of what a product is, but at the end of the day, it’s in the hundreds. It is not a small number. There are hundreds of LIBOR based products. If you say, “Oh, heck let’s just go reinvent the rate. Cross off LIBOR and put in SOFR.” You have a fundamentally different product with fundamentally different economics. And if you are a lender, you surely should understand that.
And if you are a borrower, well same thing. You surely should understand that. And you should be thinking very hard about whether you like the product, want to buy into the product, have a fiduciary responsibility. It gets understanding the level of investment and really need to dive into the details. Different players have different roles. The same loan, bank A lends to stationary company B might be between those two parties, might be bought up by a fund, might be part of a CLO, might go through various places in the financial system, might need to be daily valued inside of a mutual fund. Everybody has a different role and responsibility. But the one thing we know is that that existing loan is going to change. And that forward loan is going to go change. And if you have a decision or investment responsibility over that, it is absolutely in your interest to understand that before it occurs, because it will occur.
One more point to add. There’s a lot of comfort taken by the fact that the authorities have sponsored some wonderful work to translate between old and new. And in fact, with the fixing of dates this spread is now fixed between old and new. For example, the dollar and all the other currencies. Problem is, is that is based on an historical average, five-year average. And it is based on a historical average, when rates were very low and rates were pretty static. And the actual difference is very small. There is nothing to say that, that’s where the market will be when the fallbacks execute or how the new products will behave. Absolutely nothing it’s like saying, “I will wear tomorrow, the clothing I needed for yesterday’s weather.” It just doesn’t make a lot of sense.
In the case of the dollar, you’re taking a spread difference calculated over the last five years and applying it in say two and a half years from now; that is not without risk. That is in fact with a lot of risk. And we want to urge folks that we’re not opening up their portfolios to understand what they’re committing to, to think very hard about how to get that done.
Julia Schieffer:
I hope our audience and listeners will take heed of your calls for urgent action. If, of course they haven’t already. Adam, thank you for sharing your expert insight with us today. You’ve heard the first episode of our LIBOR transition series. Stay tuned for upcoming episodes in the coming weeks. And you can find further information on this topic via our show notes page. Thank you for listening. Join us next time.
