Odd Lots - How The Transition Away From LIBOR Is Actually Going

Episode Date: June 4, 2020

Welcome to Part IV of the Odd Lots LIBOR series, in which Tracy Alloway and Joe Weisenthal take a look at life after LIBOR, the interest rate tied to more than $350 trillion worth of financial assets.It's one thing to talk about transitioning away from LIBOR, but it's another thing to actually do it. On the fourth episode of the series, we speak with Tom Wipf, Vice Chairman of Institutional Securities at Morgan Stanley, and the chair of the committee charged with sunsetting the rate. He takes us inside the effort to replace an interest rate that is entrenched in millions of financial contracts and tells us how it’s going.See omnystudio.com/listener for privacy information.

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And I'm Joe Eisenthal. So, Joe, I think on our last recording of our LIBOR series, I think I said that that was actually the last episode. But you know what? That was false advertising. You could just, there's never enough LIBOR is there? No. And also, it's kind of amazing. but as we continue to record these episodes, more and more people want to actually talk about LIBOR. And I guess it kind of makes sense. After all, this is the reference rate that affects, you know, I can never keep track.

I think it's something like $350 trillion worth of assets. So obviously, it's absolutely crucial for the financial system. Right. I mean, yeah, as you say, it makes sense that people have so much to say about it, given that it's been so crucial to the pricing of hundreds of trillions of dollars worth of assets. And it's this sort of Herculane task to sunset it in some way and transition to something else. So I don't know, maybe we should do like a month-long LIBOR series. Oh, God. Okay.

Look, we have two more episodes scheduled, including this one. So let's do those first. And then we can talk about maybe doing a month-long LIBOR series. Okay. I will revisit. Okay. But I'm really happy to say that today, for our guest, we have someone who's actually, you know, personally involved in the transition process from LIBOR to SOFER. Sofer, of course, is the secured overnight financing rate. If you don't know what that is by now, then you should go back and listen to some of our previous episodes, but it's basically the thing that's supposed to replace LIBOR.

So it's going to be really interesting to talk about the thinking behind that transition. process, but also how it's actually going. Great. I'm really excited about this because, again, I do like a lot of our talk, I like when we have discussions on anything that are actually not, that are not just sort of theoretical, but deal with these sort of nuts and bolts with how you actually do something. Yeah. This is definitely a practice. So, okay, let's bring on our guest for the episode. It is Tom Witt, who is chair of the Alternative Reference Rates Committee and also vice chairman of institutional securities at Morgan Stanley. Tom, thanks so much for coming on. Thanks for having me.

So Tom, maybe just to begin with, you could give us a sort of brief description of what the alternative reference rates committee or the ARRC actually does. When was it started? And what's the goal? So really the arc was put together in 2014 originally to begin to select a an appropriate, durable alternative to LIBOR, and then to put forward a plan to actually get off LIBOR and onto that new rate. That work continued for several years, and at that point, that group selected SOFER, which is you notice a secured overnight financing rate, which is basically the U.S. Treasury repo market reported over a trillion dollars a day in daily activity and transactions. And that really solved to the first problem, because if you go back to the history

of LIBOR, that the issues developed because the interbank market itself had shrunk tremendously over some period of time. Additionally, the use of LIBOR had gone up exponentially. And you sort can take that from sort of, you know, the mid-1980s all the way up until 2012 and the scandals that emerged from that. But so much of that was based on the fact that the underlying transactions in the inner deal of the market had reduced considerably. You see gone up, and you get this concept of the inverted pyramid, which is too few transactions supporting too many financial contracts. And without transactions to create those rates,

so many panel banks who create LIBOR were forced to use what they call expert judgment. So when we decided on SOFER, the first thing we tried to solve to was, can we find something that has sufficient underlying transactions that would mean that there would be really no need for expert judgments, but in fact, we could just rely on actual trades to create the rate. From your perspective, as you say, one of the nice things about SOFERS, there's actual trades, there's no ambiguity, no less opportunity to manipulate the number. What, in your view, is the primary challenge and what is the work that you do

to enable this transition from one index to another? So when the arc was then reconstituted after making those two, the important decision, first to selection of SOFER, and second, to do what we call the pace transition plan. You'll hear, you know, you've probably heard a lot about that. You'll continue to hear a lot about that, which was not to have really a cliff effect, but to over the period of time that we had between, I would say, 2017 and 2021, to be in a position to have people use LIBOR less and to address some of the legacy contracts. that go beyond the end of LIBOR 2021, but also reduce that exposure through new issue and usage of SOFER. So what we've really tried to do over that period of time, and most recently with the release of our best practices

for the remainder of the transition, is to really give market participants the tools that they need to actually enable that pace transition, whether that be for legacy challenges, where they have contracts or something, securities that go beyond into 2021, that we can have better fallbacks. So when LIBOR ends, how do you get from LIBOR to SOFERS? So, you know, we put, we put out fallbacks. We put out, we've consulted with the market. We have provided over the course of just, I would say,

just even the last, last several months, you know, recommendations for things like swapions. How do you, how do you price new floating rate mortgages? So the ARC continue, really over the last several years, has been developing and providing to the market tools to actually make this transition as smooth as possible. So, Tom, you're a long-time repo man, repo guy at Morgan Stanley. Could you maybe, like, explain the repo connection for SOFER, and I guess I'd be curious to just get your take on the transition of the repo market from pre-financial crisis to now as well. Certainly. So if we think about what SOFER is, it really is U.S. Treasury backed repo. So the Treasury securities on repo, which represent obviously the risk-free rate.

And even if you go prior to the financial crisis and beyond and through, that particular market has always held up very well because of the risk-free nature of the collateral. So when we think about issues in the repo market broadly during the crisis, that was really, you know, things that were backed by, you know, less liquid assets and things like that. But the Treasury repo market for many decades has been really been the underpinning. And in terms of volume, you know, we can look and see, again, over a trillion dollars a day in traded activity from both the clearing banks and from the central clearinghouse, DCC. So when we really looked at that over the period, it really stood out as the best selection because our other choices, if you think about what the mandate was,

would have been things like the overnight bank funding rate, the Fed funds rate. And if you compare that trillion to the Fed funds market or to the overnight bank funding rate or to things like commercial paper bills, the numbers really, really go down. You know, you go from sort of a trillion to 150 to below 100. So the choice really was to have that strong foundation, which we could look back and you can really model this all the way back. It seemed like that was the obvious choice. And that experience in the repo market, I think, led us to believe that over time, one of the key things we looked at way back in 2014 was we certainly don't want to do this work again. We want to do it once and we want to do it right. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets.

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giving tools to market participants so that they can deal with some of the issues that might arise such as contracts that are pegged to LIBOR that are going to extend beyond 2021. What does that mean specifically? What kind of tools do people have to ameliorate some of the the issues that will arise from the transition. Just a simple example, I would say is the easiest one is floating rate notes. If you think about existing floating rate notes pre all this work, floating rate notes, typically if LIBOR were to cease, had a fall back in there, you know, in the bond documents that would basically say you would take the last printed LIBOR and that would be your rate until

final maturity. So if you think about an investor who bought a floating rate note that's going to float to the three-month LIBOR and it went well beyond 2021, at some point, they would take that last fixing of LIBOR, the last one at the end of 2021, and they would live with that rate until final maturity. What the ARC did, because, and to change those rates, in most cases in the U.S., you need 100% consent from bondholders, which obviously is a near impossibility. So what the ARC did way back was we put out better fallback language for new issue floating rate notes. And you can see in the floating rate note market, we've got well over 600 billion in new issue using SOFA directly, which is obviously the best answer. But even those that continue to use LIBOR, now have fallbacks that create a series

of waterfalls that go from LIBOR with a credit spread and a term spread to replicate on a look back what the difference is between SOFER and LIBOR over a reasonable period of time. And at some point now, those new issues, even using LIBOR, will have much clearer outcomes at the end of LIBOR, but obviously the best case is to use SOFERS. So when we think about the floating rate note market, it presented a real big challenge. And what the ARC did was provide that fallback language so people could put their new issue out in a much safer way than they could have prior to that. Right.

So you have the fallback language in order to enable people to get contracts done for financial security, even if LIBOR is no longer available and, you know, sort of before the new reference rate is widely available. I'm curious, what's the, I don't know, is take up the right word? What's the, like, adoption rate on that kind of fallback provision? Is everyone using it nowadays? For the most part, yeah, and certainly in the floating rate note market, we would see people either going directly to SOFA, you know, with, like I said, over 600 billion a new issue using SOFER directly. and I would say that for a vast majority of that market, because there's an obvious risk that you can't undo what you've done post-issue because of that 100% consent challenge. So I think that, you know, for places where there's true economics, not a lot of flexibility, not a lot of flexibility, that that market really was, you know, certainly an early adopter to these fallbacks and to so for itself.

Are there instruments, just to be clear, are there instruments out there that face a cliff nonetheless that were. issued before the fallback language was offered, before their ideas, before people were really thinking about this, that is going to create a real problem for either holders or issuers of the notes? Yeah, and I think that the way, I think the way we think about all of this is really in terms of, you know, legacy, you know, or stock and then flow, right? So obviously, when we look back on this, you know, the roll downs of LIBOR exposures when we began this work, you know, by the time we had arrived at 2021, had everyone stopped using LIBOR, we would have been at a much smaller exposure number.

But obviously, since this has taken some time, we really think about that. But the real term we use, whether it be stock or legacy or flow and new issue, is what we call the tough legacy. And the tough legacy are things like floating rate nodes issued without good fallbacks that mature after 2021, certain hybrids, perpetuals. And a lot of things that, for the most part, either have fallbacks, no fallbacks whatsoever, because they never contemplated the end of LIBOR, or they have fallbacks that revert to last LIBOR. Or the third one where there is a pretty, I would say, extreme discretion by an agent or a trustee to pick the new rate at the end of LIBOR.

So those three categories are what we call the tough legacy. And on the tough legacy in the U.S., we've been pursuing a legislative path, which would allow for, through legislation, for those tough legacy securities and other contracts to embed arc fallback language in place of no fallback, in place of fallbacks that reference LIBOR, which wouldn't exist, and gives people also some ability on a voluntary basis if they have a lot of discretion to, bed arc fallbacks to create, you know, some degree of safe harbor. So the tough legacy is the piece that we've really spent a lot of time on. And again, we are pursuing a legislative path on that. But when we speak to market participants, we're very, very, we really think people need to focus on that because whether or not that legislative path, you know, works out or not, people need to think about that is probably when they risk prioritize, those are their single biggest risks. Do you have a number for how big the tough legacy world is, like the size of this issue?

I don't have it in front of me, Joe. We could definitely get back. But it really, it really deals with if you think about, you know, parts of the fixed income market, again, floating rate notes that go beyond hybrids. You know, you think about the back end of a lot of trust preferred that referenced LIBOR that are well beyond 2021. Those are the kinds of things that you have out there that really can't be a good. And you've gone. And you go much deeper into just traditional contracts that reference LIBOR for penalty rates or other things, where if there's no LIBOR and there's no fallback, you're going to find yourself in, you know, in a lot of disputes slash potential litigation. So if we just go back to SOFER for a second and the link with the repo market, one of the criticisms of SOFER as a replacement rate for LIBOR has to do with this sort of dramatic repo madness. that we saw in the market back in September, when we saw the repo rate spike very quickly and very dramatically. And the criticism was that if you have a reference rate tied to a repo rate that is that volatile, something that can, you know, change that quickly in a single day, but that probably wasn't a good thing for financial assets or for the financial system. How do you

respond to that, Tom? Yeah, thanks. You know, we looked at that and certainly, you know, the dynamics of the repo market were certainly identified early days. And we took that into consideration even when we chose SOFA. I mean, obviously we know about quarter ends and near ends and how those things can, you know, can create that type of volatility. But again, when we thought about, you know, our main goal was having enough underlying volume to make sure that we do this once and do it right. The second goal was to ensure that this was robust and available, which it was. And then I think the second piece of this is, you know, as much as we've seen these sort of, you know, a couple of days spikes in repo, the assumption would be that most market participants using SOFER would be using

it in an average basis anyway. So when we talk about September, one of the things we put out, and obviously, you know, we took a lot of incoming on that appropriately, was that the, we found that the, you know, that three-month LIBOR had moved, had actually moved more than three-month SOFER during that period. on an average 90-day basis. So when we think about the uses of SOFA, if you're going to use SOFA and use either three-month average or a six-month average or whatever,

that these small spikes shouldn't actually be that impactful. Nonetheless, I do think that certainly what we've seen in the markets recently gives us, I think, and everyone a chance to really look at the data because if you go back to when we did this work, we all speculated on how SOFA would perform, during a stress period. We speculated on how library were performed during a stress period, and we speculated on how and how sort of other credit rates would perform during the stress period. So with real data now, I think it's, we're looking at it certainly at the arc,

and I think, you know, we would encourage others to take a look at how all these rates performed, right? Sofer probably, I think, performed along what people would have expected. It's a flight to quality rate. It went down to track the monetary policy rate, pretty much one for one. We looked at LIBOR, which, you know, was a little bit harder to explain. So I think when we kind of put it all together and we look at the commercial paper markets, we look at LIBOR, was LIBOR tracking commercial paper, was commercial paper tracking LIBOR? What happened to money markets over that period?

You know, one thing we will draw from this, obviously these challenging times, is that we do have real data to look at. So I do think that people in the market can model SOFA better, can look at sort of how it's performed under real life stresses. And I think, frankly, I think it does open up, you know, still more questions about LIBOR and where it comes from and where these submissions, you know, what they reflect in the markets, you know, overall. So I think we're going to try to do some real, real hard comparisons of this data. But again, back to your point, the quarter end and your end spikes, I think, are, you know, get a little bit overblown in terms of their importance on an average basis. But they're important and they're real true factors in the repo markets.

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you know, through the end of the transition. And really what we did at sort of at the last several meetings, the ARC just during this period, even during this period, we've sort of doubled our meetings and, you know, certainly we continue to see, you know, the restatement of the deadline. So, you know, even in light of COVID-19, the work continues. And I think what we've seen is that certainly the message we've gotten from the official sector, even last week when Edwin's schooling ladder from the STA said there's no change in the position on compelling panel banks, we struck the deal that they would stay at the end of 2021.

And that's kind of the deal. So I think what we've gotten here is a restatement of the 1231 deadline, which means that it was important for the arc, I think, to lay out, you know, some things ahead. So in our best practices, we sort of, we work our way from, say, June 30 when we, when we recommend, these are obviously recommended best practices, that floating rate notes, residential arms, securitization should just, at a minimum, use arc fallback language. We work our way to September through December. And obviously, the key dates in the future, I think one I'd really want to call out is when

the central clearinghouses are going to switch their discounting on, clear derivatives from Fed funds to SOFER. And that's going to happen in October 16th. And I think it'll answer probably some of the questions you may have had in previous, in previous podcasts about the liquidity in SOFER. So when that happens, that will actually, you know, should serve to put a pump a lot of liquidity into SOFER as people begin to, you know, swap out their discounting methodologies on clear transactions.

ISDA plays a huge role here. They've got their protocol, which will help deal with, legacy swaps. That comes out and the ARC is recommending that people sign that as quickly as they possibly can, but you know, certainly within four months of publication. And then we work our way through to things like streaming prices from dealers. And at some point when we get sort of out, you know, sort of with six months to go, really, you know, we recommend no new LIBOR for business loans, floating rate securitizations, we CLOs go a little further out based on some feedback. And then stopping new derivatives trades at increased risk.

So we've really tried to address this by getting the legacy in the best possible shape through fallbacks and protocols and other things. And then really, you know, stopping new issue to some degree or slowing down new production, right? And really the whole idea of, you know, best way out of a hole is to stop digging, which I think we can we can do today. And I think we're just really trying to lay that out. So the arc has really, I think, taken a position now to hopefully inform participants in the market on steps that they can take between now and the end of live. in addition to all the things that we've put out in terms of tools. And we've also held ourselves to a pretty high standard in terms of meetings. And I have to say that even during this period, although we've been meeting virtually like everyone else,

we've been doubling our meetings and we continue to get product out there because we're continuing to address a deadline of 1231. So I think it's kind of funny that you refer to the committee as the arc, which obviously has biblical connotations. I don't know if that was sort of what you were thinking about, but do you feel a sense of responsibility when it comes to making the transition from LIBOR? This is clearly a new beginning, in some sense, for the financial system. Tracy, it really comes down to that this work is an opportunity for the industry to solve a problem that was quite obvious in 2011 and 12. And I think the way we've try to look at this is, you know, in acknowledging the challenges we have, we also know that we can, that the market can actually do this, right? Without, you know, the market has an ability

to correct this problem and to put, put the market on a firmer, on a firmer bit of footing. It turns out, you know, obviously, LIBOR is, is, is a critical component of the infrastructure. It has, it has, you know, we've identified, you know, the weaknesses of LIBOR. We've identified what we think is a workable replacement. And certainly people in the market, you know, can figure out ways to use SOFA. One of the tools we put out a while back was just, how do you use SOFER, how do you use to compounding, how do you do different things? The Fed recently, now you can go on the Fed every day publishes averages of SOFER that look back over periods of time, which will be a key component to the mortgage, the floating rate in old mortgage market. So if you really just need to take it, in many cases we found in talking to, you know, market participants is that they just need a rate.

They wanted a rate from a screen and they used to be able to look up and see three-month live work. Well, now you can see three-month average sulfur. And it's, and it's, you know, obviously it's administered by the New York Fed. So we have an unassailable administrator. We have a rate that's based on transaction. So, you know, when we kind of get there, you know, from the people, I've been on the arc since the beginning and took over his chair last year. but between the people who've done it before Brian Leach, Sandy O'Connor, who have chaired this, you know, there's been a degree of the people around this work can really see the challenges

and also know that we have to get to the next place. And I think that people who are around this topic are, there's a lot of zeal around that I would say because it's an obvious problem and the solutions, although challenging, are there and we can get this work done. last question for me. I mean, one of the sort of like overriding themes of this and honestly other discussions, or at least that strikes out to me, is just this whole idea of like inertia and network effects and how hard that is to break and how much work it is to go from one sort of de facto platform to another. And you mentioned, you know, aiming for a sort of real drop dead date and saying no more, a goal of no more LIBOR based contracts.

Why is it that even at this late point, it's difficult for people to not just reach for LIBOR first when, you know, the alternative is now clearly available? It's a great point. The inertia to the status quo around this has been, you know, one of our biggest challenges. And if you go back and, you know, think, you know, anyone who's been in the market, you know, since 1986 has seen LIBOR as a key component of the markets. And removing that, we talked about this. years back, it's sort of the five stages of brief and how people have to go through it. But more and more, we do face that. And we will reach critical mass at some point.

The key things, I think, on the question is, on the derivative markets, there has been an enormous amount of reliance on the ISDA protocol. Because the ISDA protocol allows people, and there's been a lot of confidence that ISDA will get this work done, will deal with your legacy book in a fairly straightforward manner. So the comfort people have in a derivatives market is that the protocol will solve a lot of their problems, even if they're trading beyond the end of 2021. Really, if you think about it, at the beginning of this year, if you did a 10-year swap, you were really doing two years of LIBOR and eight years of SOFA.

So more and more, I think, as people begin to understand this, but to me, one of the biggest incentives, I think, that will begin to get people moving even a little bit more quickly is the capacity to operationalize all the things that we're doing, whether that be fallbacks or protocols. Just imagine we're here at the New Year's Eve, this in 2021, and you've got thousands of protocols that you have to actually connect with counterparties on. You have thousands of fallbacks that you have to recalculate and do these things.

That capacity, I think, will begin to be the incentive, again, to get people to just stop digging the hole. So more and more, we're anticipating that there will be a greater awareness as we move forward. And I think the tipping points could be the ISDA protocol, the CCP conversion, as I talked about, the central clearinghouses, switching their discounting methodology to SOFA. So there's a few things coming down the pike where we think that more and more, if you think about SOFER being the way all cleared product is discounted,

well, that's going to create new hedging demand. It's going to create new activity. And more and more, we think that we'll get there. But I would say that we certainly would have hoped to have been a little further down the road here. But with the deadline in place, I think that our, I think our industry response to deadlines pretty well.

Tom, that was a great sort of run through the work of the committee, and we really appreciate you coming on and explaining what's going on with us. Thank you so much. Yes, thank you. That was great, Tom. Thank you. So, Joe, just listening to that conversation, I mean, I don't really envy the work that Tom is doing on that committee.

It sounds like a pretty gargantuan task, to be honest. But I think your point about the network effect is really interesting. And that's something that we've talked about, well, in relation to a few different things now, but Bitcoin being one of them. But it is really interesting to see when a large group of people start to change behavior for something that's related to, you know, this enormous dollar amount of financial assets. Yeah, I thought that was really interesting. And especially like the specific deadlines you mentioned.

And I like when he got into the details about, okay, on this day, the clearing houses are going to do X, et cetera, because it's one thing to have another sort of platform, so to speak, or index that you sort of hope will become the default standard, but then actually talk about what it takes to do the transition rather than just sort of having it out there, because obviously even if it's everyone can agree that SOFER or whatever, but in this case, over is the better measure, that's not enough to get the transition over. You actually have to like put in the work and put in all these deadlines. And I like to talk about the language tools that he used to ease the transition. It's good to just hear about someone who's like very much like sort of sleeves rolled up in the work of doing this. Yeah, absolutely. I also like the

description of having like long term market participants move away from LIBOR as the sort of five stages of grief. Yeah. Like, who knew that people could be so personally tied to an interest rate? But there we are. Well, you know, it's like we've all been in offices and workplaces long enough that we know that people get irrationally attached to bizarre things, certain workflows that people have dealt with their entire careers, as he was saying, even if logically there's no good

reason for it, it's like, that's what they're familiar with. that's where they're the experts. And so you just have to, you see it all the time. And I guess I'm not surprised that an index or an interest rate could be one of them. Right. No one likes change. Okay. Well, I mentioned in the intro that we have two more episodes. This has been one of them. We've got one more coming up, which will make our LIBOR series a total of five episodes in all. So something to look forward to. And I think, I think by the time, time we finish this. I know you want to do that month-long LIBOR series and keep it going.

I'm good. I think a week is a good start. Yeah, I really think with five episodes we'll have covered, I want to say all the bases, but I'm sure something will crop up that we haven't covered, but the vast majority of bases. Agreed. Okay. All right. Well, this has been another episode of the Oddlots podcast and another episode in our LIBOR series.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And you can follow me on Twitter at the stalwart. Follow our producer on Twitter, Laura Carlson at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.