In the months since the UK Financial Conduct Authority started the countdown clock for the end of Libor (the London Interbank Offered Rate), industry leaders and policymakers have devoted significant efforts toward analyzing the implications and planning potential next steps. Despite their substantial work, substantial uncertainty remains.
Though it’s not perfectly clear whether Libor will no longer be published after the end of 2021, it is clear that central bankers and regulators need to develop a robust alternative set of rates before that date to ensure that there is no market discontinuity if Libor were to stop being published.
New short-term benchmark rates
The Federal Reserve Bank of New York will begin publishing the Secured Overnight Funding Rate (SOFR), a broad Treasuries repo financing rate, in mid-2018. The Fed’s Alternative Reference Rates Committee (ARRC) announced SOFR as its preferred fallback rate. Investors in securities, loans, futures and derivatives that currently reference Libor will need to transition to SOFR-benchmarked products over time if they are concerned that Libor will become less liquid, or even stop being published. (Other regions are turning to other rates: For example, the Bank of England and several major banks endorsed SONIA, or the Sterling Overnight Index Average, as their preferred short-term rate.)
Transition to SOFR: a plan and a call to action
For most U.S. and many global investors, if Libor is the starting point, then SOFR-based benchmarks and indexes are the eventual destination. The question is how do we get from here to there in a timely manner and without breaking things? The transition needs to be undertaken with tremendous care, and PIMCO would like to help by outlining clear steps (proposed below) for stakeholders across the industry: buy-side, sell-side, exchanges, regulators, industry bodies, and more.
The transition process of Libor products will probably take at least nine to 18 months to gain momentum, and there likely still will be orphaned products. During this transition period (and for some time thereafter), Libor swaps will continue to be the most liquid product as liquidity builds in SOFR-based products.
The focus should be on ensuring that a robust market develops in SOFR-based products as quickly as possible to allow investors time to transition.
Unlike Libor, which by construction is a term market, SOFR is a spot market. The biggest impediment to this shift in market structure away from a dated/term rate to a spot/overnight rate will likely be infrastructure builds: Most custodians and systems do not have the ability to properly calculate compound term coupons from daily rates. Regulators and market utilities need to start this infrastructure alignment process as soon as possible.
The lack of a traded term market in SOFR will be less of an impediment as futures and forwards on the compound SOFR begin to trade. Exchanges and swap execution facilities will need to create products and get regulatory approvals with expedited processes. Lack of such approvals will tend to have a perverse effect of forcing new SOFR-based products to trade bilaterally, instead of cleared.
A basis market between Libor and SOFR should begin to develop, and participants should begin to migrate positions to SOFR. It is not clear if this will happen in size before SOFR is fully cleared.
Option markets will need to develop on SOFR products. This will come later, as will migration of options on Libor to SOFR.
Bond issues, bank loans and mortgages should begin to include fallback language or directly reference SOFR instead of Libor for floating-rate notes.
There will be a remaining legacy book of products which will still refer to Libor that will need to be converted, or they will be at risk if Libor were to stop. The treatment of these legacy securities is PIMCO’s largest concern.
For further PIMCO insights into the transition from Libor, please read our Viewpoint, “No Room for Error: A Misstep in Creating an Alternative to Libor Could Be Costly to Investors.”
William G. De Leon is PIMCO’s global head of portfolio risk management.