How The Transition Away From LIBOR Is Actually Going

enJune 04, 2020

Odd Lots

Podcast Summary

ARRC's mission: Replace LIBOR with SOFR as new benchmark rate: The ARRC, chaired by Tom Witt of Morgan Stanley, was formed in 2014 to find a replacement for LIBOR and selected SOFR as the preferred alternative due to its significant activity in the US Treasury repo market. The transition to SOFR as the new benchmark rate is ongoing.
The Alternative Reference Rates Committee (ARRC), chaired by Tom Witt of Morgan Stanley, was established in 2014 to address the need for a durable alternative to the London Interbank Offered Rate (LIBOR) and develop a plan for transition. The ARRC selected the Secured Overnight Financing Rate (SOFR) as the preferred alternative due to its significant activity and transactions in the US Treasury repo market. The goal is to replace LIBOR, which faced issues due to the decline of the interbank market, with SOFR as the new benchmark rate. The transition process is ongoing, and the ARRC continues to work towards implementing this change.
Transitioning from LIBOR to SOFR: Addressing the Inverted Pyramid Issue: SOFR, based on actual trades, is more transparent and reliable than LIBOR, which can be manipulated due to an 'inverted pyramid' issue. The primary challenge is ensuring a smooth transition for legacy contracts.
The transition from LIBOR to SOFR involves addressing the issue of an "inverted pyramid" where too few transactions support too many financial contracts. This can lead to the need for expert judgment and potential manipulation. SOFR, on the other hand, is based on actual trades, making it more transparent and reliable. The primary challenge in this transition is ensuring a smooth process for legacy contracts that extend beyond the end of LIBOR in 2021. The ARC has been providing market participants with tools to facilitate this transition, including fallbacks and recommendations for pricing new contracts. SOFR is connected to the repo market through US Treasury-backed repo, which has always been a stable and risk-free market. During the financial crisis, issues arose in the repo market due to less liquid assets. The treasury repo market has been a reliable underpinning for decades. As a repo expert, Tom can explain the repo connection for SOFR in more detail and provide insights on the evolution of the repo market from before the financial crisis to the present.
Understanding Financial Markets through Repo Market: The repo market, with its large daily trading volume, is an essential selection for grasping the intricacies of financial markets. Regulatory bodies like the ARC offer tools to help market participants navigate the transition away from LIBOR, such as fallback language for new issue floating rate notes.
During the discussion, it was emphasized that the repo market, with its trillion-dollar daily traded activity, was the best selection for understanding the financial markets due to its large volume and historical significance. This choice was made in comparison to other potential options like the overnight bank funding rate or the Fed funds rate, which had significantly lower trading volumes. Additionally, the Alternative Reference Rates Committee (ARC) was highlighted for its role in providing tools to market participants to help address issues arising from the transition away from LIBOR. One specific example given was the use of fallback language for new issue floating rate notes, which has helped mitigate potential risks for investors when LIBOR ceases to exist. This language includes a series of waterfalls that replicate the difference between SOFR and LIBOR over a reasonable period of time, providing clearer outcomes for investors. Overall, the discussion underscored the importance of having a strong foundation for understanding financial markets and the role of regulatory bodies in providing solutions to market challenges.
Legacy financial securities without adequate fallbacks pose risks: Regulators focus on embedding ARC fallback language in 'tough legacy' instruments, including floating rate notes, hybrids, and perpetuals, due to substantial exposure and risks for holders and issuers.
While the adoption of fallback provisions for financial securities in the absence of LIBOR is widespread, particularly in the floating rate note market, there are still significant amounts of "tough legacy" securities and contracts that do not have adequate fallbacks or reference LIBOR, posing risks for both holders and issuers. These "tough legacy" instruments, which include floating rate notes issued without good fallbacks, certain hybrids, and perpetuals, among others, are a major focus for regulatory efforts to embed ARC fallback language through legislation. The size of this issue is substantial, and market participants should prioritize addressing these legacy exposures, regardless of the outcome of any legislative efforts.
Transitioning from LIBOR to SOFR: Addressing Concerns over Volatility: Despite concerns over SOFR's volatility, its creators emphasize its robustness and sufficient underlying volume. Market participants are expected to use SOFR on an average basis, reducing the impact of volatility spikes. Recent market events suggest SOFR may have acted as a flight to quality rate during stress periods.
While SOFR has been identified as a potential replacement for LIBOR, concerns have been raised regarding its volatility, particularly in relation to the repo market. However, the creators of SOFR have considered these concerns and emphasized the importance of having sufficient underlying volume and robustness to ensure a successful transition. They also pointed out that most market participants are likely to use SOFR on an average basis, reducing the impact of small spikes in volatility. Recent market events have provided an opportunity to examine the performance of both SOFR and LIBOR during a stress period, and the data suggests that SOFR may have performed as expected, acting as a flight to quality rate. Overall, the transition from LIBOR to SOFR is a complex process, and it is important for market participants to carefully consider the implications of this change and the available data to make informed decisions.
Transitioning away from LIBOR: Key actions for market participants: Market participants must implement ARC fallback language, prepare for SOFR discounting, avoid new LIBOR for loans/securitizations, and understand market dynamics for a smooth LIBOR transition by end 2021.
The ongoing transition away from LIBOR is a complex process that requires careful attention to detail, particularly in the repo markets where quarter end and year end spikes are important factors. Despite the challenges presented by COVID-19, the deadline for the transition remains unchanged at the end of 2021. Moving forward, key actions for market participants include implementing ARC fallback language in floating rate notes, preparing for the switch of discounting on clear derivatives from Fed Funds to SOFR on October 16th, and avoiding new LIBOR for business loans and floating rate securitizations within six months of the transition deadline. The role of ISDA's protocol in dealing with legacy swaps is also crucial. Overall, the process of transitioning away from LIBOR necessitates a deep understanding of market dynamics and a proactive approach to implementation.
ARC addressing LIBOR transition challenges: The ARC is taking steps to help market participants transition from LIBOR to SOFR, including improving systems, providing guidance, and promoting acceptance of SOFR as a replacement.
The Alternative Reference Rates Committee (ARC) is taking steps to address the upcoming transition away from LIBOR by improving legacy systems, slowing down new production, and providing guidance on the use of SOFR as a replacement. The ARC recognizes the challenges in making this transition but believes the market has the ability to correct the problem and put the financial system on a firmer footing. The use of SOFR, which is administered by the Federal Reserve and based on transactions, is becoming more accessible and widely accepted as a viable alternative to LIBOR. The ARC, which includes industry experts who have been involved in this work for years, is committed to guiding market participants through this transition and ensuring a smooth implementation of the new rate infrastructure. The responsibility to make this transition successfully lies with the industry, but the ARC is providing the necessary tools and resources to help make it happen.
Challenges in transitioning from LIBOR to alternative rates: Market inertia and network effects surrounding LIBOR use, ISDA protocol to help with legacy contracts, operational challenges of implementing new protocols and fallbacks, upcoming central clearing house conversion to SOFR, and deadline pressure driving progress.
Despite the availability and necessity of transitioning away from LIBOR to alternative rates like SOFR, the inertia and network effects surrounding the use of LIBOR in financial markets make it a challenging task. The ISDA protocol, which has been a significant source of comfort for market participants, is expected to help in dealing with legacy contracts. However, the operational challenges of implementing new protocols and fallbacks, especially when the deadline arrives, are seen as major incentives for market participants to start the transition process. The upcoming conversion of central clearing houses to SOFR discounting and the resulting hedging demand are also anticipated to push the industry towards the use of SOFR. Although the industry has been slow in making the transition, the deadline in place is expected to drive progress.
Transitioning from LIBOR to SOFR: The shift from LIBOR to SOFR involves agreement on the new standard and practical implementation with deadlines and language tools, but may face resistance from long-term market participants' attachment to familiar workflows and expertise.
The transition from LIBOR to alternative benchmarks like SOFR is a massive undertaking that involves not only agreement on the new standard but also practical implementation with deadlines and language tools to ease the transition. The network effect of a large group of people changing behavior towards a new standard, even when it's a more logical choice, can still face resistance due to long-term market participants' attachment to familiar workflows and expertise. The LIBOR series on Odd Lots podcast will continue to cover the topic in depth with more episodes to come.
Matt Levine and Katie Greifeld launch new finance podcast 'Money Stuff': Friends Matt Levine and Katie Greifeld, known for their finance expertise, are starting a new weekly podcast 'Money Stuff' covering Wall Street finance and related topics on Apple Podcasts, Spotify, and other platforms.
Matt Levine and Katie Greifeld, friends of the Odd Lots podcast and well-known figures in the finance world, are launching a new podcast called Money Stuff. This podcast is an extension of Matt's popular finance newsletter, and it will be released every Friday. Listeners can tune in to Money Stuff on Apple Podcasts, Spotify, or any other podcast platform. The podcast will cover Wall Street finance and other related topics, making it a must-listen for anyone interested in the financial world. Matt and Katie's expertise and engaging personalities are sure to make Money Stuff an exciting and informative addition to the podcast scene.

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