US and them....who's winning the LIBOR race?

22 May 2020

Phil LloydHead of Market Structure & Regulatory Customer Engagement

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Six announcements from ARRC1 in the first two weeks of May.  Does this signal a surge of progress in the US ahead of ISDA2 protocol publication, CCP3 discounting switch and perhaps finally a path for conventions?

Below we take stock of the recent LIBOR4 developments in the States, and how discussions there are affecting the direction of travel elsewhere.

So what has ARRC been talking about?

ARRC, the US RFR5 working group, has always been more 'chatty' than the UK group (19 announcements in 2020 compared to Sterling working group's 5), though it does seem to have kicked up a gear recently.  In May so far we have had:

In truth there is not too much that is especially controversial in these announcements (although more on swaptions, the index and the conventions muddle later).  But the mood music has changed a bit.

The story so far.... 

A quick reminder of where the US is compared to UK and Europe.  Broadly the UK is the furthest progressed in the "race" to transition away from LIBOR with a well-established SONIA8 market, the US is following but with a nascent SOFR market, and the EU has stated that for the time being at least EURIBOR9 will continue (though €STR10 is well established as the successor rate to EONIA11).

But the US plays a pivotal role in the global transition....the decisions made there tend to filter out to become the international standards others follow.  However the US is also held back by the lack of liquidity in the SOFR market. In the charts below you can see:

  • SOFR Futures volumes hit a high in February of this year, stayed elevated into March, but then fell precipitously after the Fed cut rates to the zero lower bound
  • Swaps trades saw a similar surge of volume into Feb/Mar, but decline in April.  Some swaptions and XCCY trades12 have surfaced, but the volume is still predominantly basis or OIS contracts13
  • Despite recent increases in SOFR volumes, it is from a very low base and not material compared to USD market as a whole.

Transition away from USD LIBOR won't happen until there is greater SOFR liquidity, but liquidity won't come while markets continue to depend upon LIBOR.  This chicken and egg scenario might be broken by the upcoming move of discounting / PAI14 for CCPs from Fed Funds to SOFR in October, finally building a deeper SOFR market.

There is also nervousness about the perceived volatility of SOFR, at least when compared to its UK cousin SONIA.  In recent market turmoil SOFR has experienced greater volatility (as indeed LIBOR has), whereas SONIA has more closely tracked BoE base rate changes.  That said, compounded SOFR over 3M smoothes out some of those daily spikes (see comparison graphs below).

Note: after 18 Feb the 3m compounded rates based on forward curves (as realised rates not yet available for full 3m period when data cut on 18 May)  

A further knock to SOFR came recently when the COVID loans in the US were linked to USD LIBOR rather than SOFR – understandable given unfamiliarity with the SOFR benchmark and in arrears compounding methodology especially at the less sophisticated end of the market, but hardly a resounding endorsement of the future rate.

Has the US 'shifted' its view on conventions?  

Back in December last year we explained in Conventional wisdom that although UK had set the pace with compounding conventions for the first SONIA FRNs in 2019 (with use of the "Lag" day weighting), the US were leaning towards the "Backward Shift" method, subsequently borne out by the Fed’s support for and publication of the SOFR Index. The BoE are now planning a SONIA Index as well, due to be published in July.  The Index lends itself to Backward Shift (though it would be possible to construct an alternative using 5 day lag).

But now there are indications that the US loan market may be leaning towards the Lag method after all for larger loans, and simple averaging (i.e. not compounding in arrears at all) for the smaller loan market.  This may well bring us back to the original SONIA standard of compounding in arrears with a 5 day lag, with the day weighting based on the interest period not the observation period (i.e. Lag rather than Shift).

The latest ARRC statement from the FRN WG in support of the SOFR Index, and the ongoing Fed publication of an index, do rather militate against this change in direction, but are not insurmountable barriers. 

So confusing in the short term, but more important that we settle on a standard and press on with infrastructure build work to support the transition than spend more time arguing the detail and forget the big picture. 

The swaptions bunfight

Both the EU and the US have recently published the results of their consultations into voluntary compensation for swaptions settling following the discounting changes from EONIA to €STR flat (26 Jul) and Fed Funds to SOFR (16 Oct) at CCPs.  

And the results are.....mixed.

The authorities are in favour of voluntary compensation but it is not at all clear whether market participants, with potentially very different commercial drivers, will adopt the same approach.  And even where counterparties are in principle willing to agree to compensation, there are still a number of ways it could pan out.

Time is running out for agreement – the EONIA CCP switch is fast approaching.

And beyond the bunfight about compensation due to discounting switches, there is also the bigger question of liquidity in the RFR swaptions market.  It has not built yet even for SONIA, and without it there is a significant backlog of LIBOR transition activity still waiting to start. Increased focus on this market will have to be the next step. 

So where does this leave global alignment? 

It is good that ARRC is communicating about developments, and too much is better than too little.  With so many stakeholders across asset classes, client types and jurisdictions, it is always going to be a bit noisy and confusing. 

But it is critical that debates about the detail do not derail the overall timelines and objectives.  The recent market turmoil has underlined the extent to which LIBOR is based on 'expert judgement' rather than underlying transactions, and that is likely to redouble authorities' commitment to its eventual demise.

Glossary

  1. ARRC - Alternative Reference Rates Committee
  2. ISDA - International Swaps And Derivatives Association
  3. CCP - Central Counterparty
  4. LIBOR - London Interbank Offered Rate
  5. Rfr - Risk-Free Reference Rates
  6. FRN - WG Floating Rate Notes Working Group
  7. SOFR - Secured Overnight Financing Rate
  8. SONIA - Sterling Overnight Index Average
  9. EURIBOR - Euro Interbank Offered Rate
  10. €STR - Euro Short-Term Rate
  11. EONIA - Euro Overnight Index Average
  12. XCCY trades - Cross-Currency Trade
  13. OIS contracts - Over-The-Counter Trade Derivative
  14. PAI - Price Alignment Interest
Regulation
LIBOR
SONIA
US


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