The financial world stands on the verge of a paradigm shift as it seeks to throw off the dominance of the London Interbank Offered Rate, or LIBOR, which has defined the lending market since at least the 1980s. As described in a recent blog post, LIBOR will soon disappear, and the entire market is on the move to find a new benchmark rate.
The UK Financial Conduct Authority (FCA) recently declared that, for the U.S. dollar, most tenors will cease to be representative or to be published starting June 30, 2023. This announcement received widespread support, including from the Alternative Reference Rate Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York to help ensure the successful transition to a new benchmark rate. With this announcement, LIBOR’s fate is sealed.
The successor rate endorsed by the ARRC is the Secured Overnight Funding Rate (SOFR), grounded on trillions of overnight repurchase agreements among the largest global financial institutions. Furthermore, derivatives market participants overwhelmingly adhered to a new protocol, which envisages substituting SOFR for LIBOR across almost all existing and new contracts. The transition away from LIBOR is truly underway now.
The Transition Away from LIBOR Is Picking Up Speed, but So Is Uncertainty
While things are moving fast indeed, market participants are eager for a forward-looking rate that will make the cost of borrowing known in advance. A main shortcoming of SOFR is that it is determined “in-arrears,” at the end of the period over which the interest rate is paid. This is a bit like finding out about the cost of a medical procedure only after it has taken place. Understandably, borrowers are hesitant to sign on to these contracts.
Perhaps the solution will come from the derivatives market. CME Group, the world’s largest financial derivatives exchange, published a term rate derived from SOFR futures contracts. There is also nascent liquidity in short-term swap contracts exchanging a floating leg based on ex-post SOFR for a fixed leg determined in advance. This fixed leg, for instance a three-month swap rate, may become the new reference for floating contracts.
So while a successor may now be on the horizon, much uncertainty remains as to how quickly the countless market participants will kneel to a potential heir to LIBOR’s throne and how possible delays may affect market dynamics.
Scenario Analysis Continues to Provide Useful Insights
For the IDB, this uncertain environment has translated into a need to look ahead and plan for a series of scenarios for how the transition away from LIBOR may unfold. In a baseline scenario, the transition would be smooth, with market participants accepting a unique replacement rate and quickly adopting it. In this scenario, the number of contracts applying the new rate would increase smoothly and the retail market would welcome the new rate and update legacy contracts without any pushback from borrowers.
This baseline scenario is summarized in this video. Although ideal, this baseline ignores a number of ongoing real challenges, which is why we also developed adverse scenarios that factor in potential delays, and in particular a limited adoption of the new rate in the loan market. Testing institutional strategies against such complex scenarios can help financial institutions improve strategic decision-making.
The actual transition process to a new reference rate will almost certainly not align completely with any one of our scenarios. We may end up seeing a future that combines elements from several of them. As we see these dynamics play out, our approach allows us to incorporate new information and updated scenarios.
Three Main Sources of Uncertainty Remain the Basis for Our Scenarios
IDB scenarios are built around three factors still driving the LIBOR transition: (i) operational design of the replacement rates; (ii) liquidity characteristics and speed of adoption of such rates; and (iii) borrower’s preferences during the transition.
The 2023 deadline set by the Financial Conduct Authority (FCA) is a strong signal for the market to start agreeing on a replacement rate for LIBOR-linked contracts. Operational design scenarios consider that, while SOFR has been formally named LIBOR’s successor, end users will remain reticent to adopt it as new benchmark rate and may change how they operate, use what could be described as a sub-optimal solution rate, or experiment with alternatives.
As to the second factor considered in our scenarios, the pressure for speedy adoption created by the FCA announcement is also jolting the market into migrating the existing derivatives portfolio to a new agreed rate and seeking more consensus and liquidity. This will increase the number of contracts in SOFR, even though some financial products are difficult to migrate to an in-arrears rate and will need to find an alternative or modify their intrinsic characteristics.
Finally, we consider that borrowers are on notice that LIBOR is coming to an end, although rates will continue to be published for a longer time than initially envisaged. It remains to be seen how the loan market will apply the new reference rate’s language and what reference rate will be used for new products. Some market participants may accept the backward-looking SOFR, while others may take the opportunity to find an alternative that better suits their business.
While there is less uncertainty now than there was just a few months ago, the transition to a new benchmark interest rate could still develop in one of several ways. Scenario analysis is helping us plan for robust results under each potential outcome.
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