The LIBOR transition hatches a “chicken or egg” conundrum
The market wants to see robust, well-defined alternative markets before they jump in - but if everyone is waiting, how can these markets develop?
After a year of extreme uncertainty, the particulars of the LIBOR transition seem to be solidifying, at least on the surface. The last 6 months have brought a flurry of ARRC recommendations, the implementation of the ISDA protocol, and the announcement of definitive cessation dates. Yet recent LIBOR Transition Round Tables conducted by Potomac Point Group and Spinnaker Consulting Group revealed that there is still a strong undercurrent of uncertainty.
Key areas of uncertainty:
SOFR conventions and behaviors – what happens in a rate shock?
Potential for Term SOFR – how soon / will it come?
Credit sensitive rates – who will be the winners?
As this year’s deadline to cease new USD LIBOR lending approaches, this uncertainty creates a “chicken or the egg” paradox that has real consequences. Our Round Table participants want to see robust, well-defined alternative markets before they jump in – but if everyone is in wait-and-see mode, how can those markets develop?
In the best-case scenario this uncertainty merely perpetuates LIBOR lending and slows the adoption of alternative rates in the short term. In the worst case, organizations get stuck in “analysis paralysis” that threatens their successful transition and risks trying regulators’ patience.
Where do we see the Impacts?
SOFR liquidity is building, but YTD is only 4.3% of LIBOR’s volume
SOFR is clearly the leading replacement rate for most USD LIBOR transactions. As the ARRC recently reported, SOFR futures trading volume is up ~50% over the last 3 months. This is impressive growth, but it needs to be put in context.
For the week ending May 7, 2021, LIBOR Interest Rate Derivative notional trading was ~$1.2T
This is approximately equal to the SOFR IRD notional trading for the entire year to date
Supply and demand for alternative rate products is building slowly
Our Round Table participants echoed what we hear in the industry press and even in some ARRC briefings. Borrowers say they are not being offered SOFR products, and Lenders say their customers are not asking for them. LIBOR deals are still happening today because LIBOR is familiar and well understood. Many firms are relying on Relationship Managers to present alternatives to their customers, but with interest rates at historic lows and lending at record volumes, the focus is just getting the deal done. And alarmingly, these newly originated deals don’t always have fallback language.
“People still want to get business done and they understand LIBOR, they will stick with what they know for as long as they can,” - Sara Taylor, Executive Consultant for Teraverde Management Advisors LLC
Some lenders and issuers are waiting for Term SOFR
We heard clearly in our Round Tables that Term SOFR is needed, and some are hesitant to move until it is available. Operationally it is an easier switch. For cash products it is more understandable because it resembles the prevailing LIBOR rate structure. But more than that, Term SOFR would inspire confidence as an indicator of market maturity.
The good news is that the ARRC is visibly warming to the idea of a SOFR Term structure (see recently published “indicators,” and Term SOFR administrator announcement). The ARRC says they anticipate making a recommendation “relatively soon.” But two of their indicators are growth in SOFR derivatives volumes and cash product offerings. As noted, these are growing slowly, so without specific targets the timing is still (you guessed it) uncertain.
Regional banks and smaller financial institutions are still looking for credit sensitive rates
Many institutions who fear that a risk-free rate could cause misalignment with their cost of funds are waiting for credit sensitive rate options. We observe some momentum behind alternatives such as AFX’s Ameribor, Bloomberg’s BSBY, ICE’s BYI and Markit’s SOFR credit spread. But if the details around SOFR are unclear, there is even more uncertainty around these emerging credit sensitive rates.
One of our Round Table participants likened the decision to “Beta vs. VHS.” Smaller organizations without the resources to transition more than once can’t afford to bet on the wrong horse.
What can we do now?
Fundamentally we need to build liquidity, clarify new rate conventions, and build up performance history to instill confidence in the new markets. This will take time, but financial firms must resist the temptation to sit back and wait. As a former boss used to counsel, “don’t let perfect be the enemy of good.” The best we can all do is keep moving where we can and be ready to adapt as clarity comes.
Keep moving forward in areas of relative certainty, recognizing that we won’t have perfect information. Take small steps – e.g., small pilot transactions – where you need more information to move fully forward
Engage with peer networks to collaborate over challenges and solutions, and to stay informed
Advocate for clarity, action and an appropriate array of rate options from the ARRC, Congress, regulators, and other rate providers
Execute iteratively – adopt (and budget for) continuous monitoring, planning and execution cycles as things evolve
Contact us with questions and join the conversation at our favorite LIBOR Transition LinkedIn group.
Martha-Rosalind (“MR”) Stainton