Odd Lots - This Is The Index That's Supposed To Replace LIBOR

Episode Date: June 2, 2020

Welcome to Part II 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.Troubles with LIBOR have kickstarted a massive project to transition to a new benchmark interest rate for financial markets. On the second episode of our series, we speak with Joe Abate, money market strategist at Barclays, about the proposed replacement known as the Secured Overnight Financing Rate, or SOFR. How is it different to LIBOR and what are the downsides of having an interest rate tied to actual marketplace transactions?See omnystudio.com/listener for privacy information.

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, from corporate law to constitutional law, and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars and policy experts to break down what the rulings really mean. We do this every weekday,

then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day, and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. And welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wisenthall. So, Joe, we are on part two of our Epic Libor series. Yeah, I'm very excited about this series.

I'm, you know, I always learn a lot from doing these podcasts with you. But this is one area that I know is a incredibly important to the way the financial system works. LIBOR and the transition away from it and also an area that I don't know nearly enough. So I'm very excited that we are moving on to part two of this year. Yeah. And just as a reminder, if you haven't listened to the first episode, you definitely should. But we basically spoke about everything that went wrong with LIBOR sort of pre and post financial crisis. So just as a quick reminder, there was a huge LIBOR scandal. The idea of having banks submit the reference rate for basically an unsecured loan that would be made between dealer banks was really thrown into doubt.

And Q or fast forward to where we are today. And there's a huge effort underway to try to replace LIBOR with a brand new reference rate. Right. And just, I mean, I assume everyone should have listened to the first episode, but just a reminder. reminder why we care in part is because so many financial contract, derivative loans, et cetera, are priced in some way off this singular reference rate. And so when it was sort of everyone realized that the old one had flaws in terms of how it was constructed and it was open to manipulation and so forth, there is now the effort underway to get all these contracts and debts

and everything else to price around new singular stamp. Yeah. So in this particular episode, we're going to focus on what that new reference rate is. And we have really the perfect person to talk about it, someone who's been covering the short-term dollar funding markets for years now. And I've certainly been reading his research for years. It's Joe Abbotté, Barclays analyst. Joe, thanks so much for coming on the show. Thank you.

How is the LIBOR transition going? How would you characterize where we actually are at this moment in time? I'd say that we're making progress. Within the last two years, we obviously decided on what kind of benchmark replacement rate to use. I think the challenge at this point is to get people to actually use it. We're seeing developments in futures markets, and term rates that reference this. We've seen people start to issue off of the rate itself. But, you know, this is still, relatively speaking, early days in the process. You know, we need to see volumes in particular in a number of different sectors, whether it's issuing front in terms of borrowing, whether it's in terms of hedging. we need to see that activity pick up at this point.

So I'd say early days, but hopefully optimistic. So just to back up for a second, we know that after it was sort of agreed upon that LIBOR couldn't be sustained, what are the regulatory demands and from whom were these regulatory demands made on the financial system to find and develop a new reference rate? So pretty much it was a global effort, but largely it came from out of the UK where they were regulating. The PRA was regulating the LIBOR. And, you know, obviously they had done the work, you know, in terms of identifying the deficiencies in the unsecured rate. And so, you know, they were leading the effort.

was adopted by the Federal Reserve, I think back in 2014, and the Fed effectively convened a committee called the Alternative Reference Rate Committee, which then began work to find an alternative reference rate, and then once that reference rate was decided, the alternative reference rate committee would move to kind of the adoption phase, right? So speaking to end users, if you will, to get them to start using the new rate. So it's been a, you know, to your point, it's been a multi, multi-year process begun with regulators. So the alternative reference rate that they eventually settled on, and we spoke a little bit about this in the first episode, but it's something called the secured overnight financing rate or S-O-F-R SOFER. How did they settle on that one?

And what, in your view, is the key difference between it and the predecessor, LIBOR? They essentially gave the alternative reference rate committee marching orders and told them, you know, find a replacement rate. It must be based on transparent, liquid and deep. market so that you wouldn't have a submission process, as is the case with LIBOR. And there were certain rates that you were not allowed to use, basically policy instruments, right? So you couldn't use the Fed Funds rate, for example. And, you know, after much deliberation, the alternative referenceary committee settled on the

SOFER. and the key differences that I think between Sofer and LIBOR are really threefold, right? One is that the SOFA rate is an overnight interest rate. And of course, LIBOR is a three-month rate with a forward-looking component. The second is that SOFER is a Treasury repo rate. So again, it's a secured funding rate. and LIBOR is an unsecured bank borrowing rate. And then the third element of this, which is tied to that,

is the fact that LIBOR incorporates bank credit risk, which is not present in SOFER, right? So as a Treasury repo rate, you know, essentially you're borrowing money by pledging Treasury collateral. It should be, especially on an overnight basis, should be risk-free. So again, you have a credit component, a term component that are not present in the, in, in, in, in, in, in, in, in, in, so far.

So you mentioned that the, the, the, the, the sort of benchmark rate couldn't be just a pure policy rate. So we can't just say, oh, base it on Fed funds. But isn't a system that sort of de facto, uh, if it's based on, uh, the repo prices? and repoing credit-free treasuries. Isn't it, it sounds to me like kind of a backdoor policy rate, nonetheless. I think that's correct. I think that, you know, SOFER moves in tandem with changes in the policy rate.

So when the Fed cuts rates, SOFER goes down. And generally speaking, it goes down by about the same amount. I think the difference is that the Fed's policy rate, the Fed funds rate, is based on a fairly small market. And there's only effectively one lender in that market. You know, the Fed doesn't want to tie its policy to a benchmark interest rate where it's possible in the future that, let's say the Fed decides that the Fed funds market is too small. and wants to use a different policy instrument, if all of these $100 trillion or so in terms of LIBOR exposure, if all of that was based on Fed funds,

moving to a different policy rate would be a much more complicated issue than just deciding on the communication strategy that the Fed is going to adopt. So I agree it's kind of a backdoor approach, but, again, SOFER is based on a huge violation. volume of transactions. One final point that I want to make, too, is that in an ideal world, the Fed has complete control over the Fed funds rate. In repo and in SOFER, the Fed doesn't have complete control over SOFER.

It can influence SOFER and is very effective in doing that. But, you know, sometimes SOFER moves, you know, kind of independent of Fed actions. I wanted to bring up exactly this point, which is in September of last year, we saw repo, the repo rate shoot up. And then we saw the SOFER rate basically spike along with it. And there were some people at the time who made the point that maybe you don't want a reference rate that can be that volatile. what's your takeaway from that experience? My takeaway from the experience is that, yes, that, you know, as I was saying before, you know, SOFER, Fed can influence it but can't control it, you know, on a high frequency basis day by day.

I think the volatility in the overnight SOFA rate is a little bit misleading in part because the expectation is that when people, you know, move to a a SOFER world, they're going to be using an average of daily SOFER quotes. So you're going to be looking at, you know, whether it's a three-month average, a one-month average, you're going to be taking that as a benchmark reference rate as opposed to the overnight interest rate. So that should take some of the volatility out of the overnight rate that, you know, people are concerned about. But again, you have to take an overnight interest.

interest rate and convert that into a term rate like LIBOR, which means that you're doing some averaging. The question is, am I doing averaging from a backward-looking perspective or am I doing the averaging from a forward-looking perspective? And that's a key difference between LIBOR and SOFER, right? where LIBOR is, you know, kind of what do I think the average bank funding rate is going to be over the three months? If I'm looking at SOFER, I'm basically saying, you know, at least at this point, what's the average overnight interest rate over the past three months, right? And that's a little bit different than LIBOR.

A lot of short daily news podcasts focus on just one. story. But right now, you probably need more. On Up First from NPR, we bring you three of the world's top headlines every day in under 15 minutes because no one story can capture all that's happening in this big, crazy world of ours on any given morning. Listen now to the Up First podcast from NPR. Joe, I have a quick question and then a follow-up question. The quick question is, what is the official deadline remind me for when this transition is supposed to have been completed? So the official deadline for the end of publication of LIBOR is December of 2021. Okay. So the longer question I have is explain to us the complexity. Why is it, and I,

know you were just talking a little bit about it in terms of the depth of this market and the challenge of converting an overnight rate into a term rate. Talk to us about the specific difficulties of you have all these contracts that are denominated in LIBOR, why we can't just go through all the contracts, scratch out the line, LIBOR, replace them with SOFER and the new world is here. Yeah, I mean, I wish it were that simple. It turns out. No, I'm aware it's not. Otherwise, we wouldn't even be having this conversation. But yeah, I mean, I think, First of all, there's a technological challenge, right? That in many cases, there's hundreds and thousands of different instruments or references that a single bank may have.

That refers to LIBOR. You can take the example of an oil company, for example, where it's not really using LIBOR as a borrowing rate. It's using it as a penalty rate for people who, you know, hypothetically don't make a delivery, they have to pay a charge that's equal to LIBOR plus 500. And you have to go through and find all of those references, which is a monumental task. Second element of this, I think, is that when you look at most financial market contracts, they have not been, you know, written with fallback clause. more adequate fallback clauses for a situation in which LIBOR doesn't exist. So, you know, they were kind of developed without a replacement rate in mind. And because of that, there are certain things that can happen.

So if you had, you know, some contracts where, you know, the default assumption if Lybor is not available, is the floating rate on your instrument becomes whatever the last posted LIBOR rate was, and your security becomes effectively a fixed rate security. So let's say that you've hedged yourself or you think you've hedged yourself against interest rate risk, you're now going to have an instrument where, you know, the final years of its maturity, it's fixed, and that interest rate is whatever happened to be the last posted libel rate. So if we're in a super high interest rate environment at some point, and you fixed it at whatever that rate is and rates fall,

you're going to be experiencing payment shock of some kind. So I think that that's the problem. And again, it's a big legal challenge to kind of go through and write these or rewrite these fallbacks. And that's just, that's floating rate notes. I'm not talking about mortgages or syndicated loans and things like that where, you know, in some cases, you need to have 100% approval of all the investors to agree to change the coupon on the security. It's a much, much bigger challenge than just cutting and pasting. Are there any operational risks in the meantime during this time when we're actually making the transition from LIBOR to SOFER.

For instance, a few people have been talking about the prospect of zombie LIBOR, which is this reference rate that is sort of dead, but basically still operational and haunting the market in many ways and might not be totally reflective of what's actually going on in funding markets. Is that a risk? I think it's a potential risk, although I think that regulators are, you know, realizing that that's a challenge. And so, you know, they've been kind of recommending people put in kind of what's known as pre-cessation clauses. And the pre-sensation clause would basically, you know, kind of trigger itself in the event that regulators deem that LIBOR itself is not a, representative interest rate. Once that happens, you know, the expectation is that publication of

LIBOR would cease. To your point about the zombie situation, you might have a scenario, let's say, where, you know, regulators have said the rate is no longer representative, but it's still being published. So you now have kind of a published interest rate that people can, you know, legally still use, but it's been deemed unrepresentative. And that's kind of your zombie LIBOR situation. You know, zombie LIBOR, in other cases, would require banks to kind of continue to contribute to the LIBOR panel. And I struggle to see situations in which banks would willingly contribute to an index when they don't have to. And when there's a alternative. benchmark that other people are using. So to me, I think that zombie libor risk is a low probability.

But, you know, there's probably other operational risks that we need to consider that, you know, people are working on right now. So just in terms of hitting regulatory benchmarks in demands, how realistic are they in your view in terms of making this changeover? And what? other kind of forbearance or moves might regulators be forced to make, you know, in the coming months ahead to deal with the question of whether we can actually sunset LIBOR as planned? You know, you could probably make the case that there should be a legislative approach that prevents, you know, a litany of lawsuits that could follow, you know, triggering of fallbacks and the replacement of LIBOR, we might see something along those lines in the future, right,

to kind of speed the process along and to kind of prevent it from getting gummed up. Banks are probably the furthest along in terms of the transition and making the necessary language and fallbacks and things like that. I think the non-financial sector is probably not quite as far along. in this process and, you know, that might require, you know, more education and urgency from ARC and regulators. I'm not sure how that gets done, to be honest. How much does the creation of things like SOFA futures actually help? Because I think the CME has been rolling out those contracts, and we've actually had a few

trades. Does that help with adoption? I actually think it's necessary for adoption, right? You need a derivatives market that you can rely on for two reasons. One is to develop that term forward-looking sofa rate that I mentioned earlier. The second is that you need this market to be able to hedge, right? You need to be able to know that I can convert a series of floating rate payments into fixed-rate payments if I want to or go in the other direction. You need to be able to kind of, to your point earlier, I want to hedge against changes in Fed policy, for example. So I want to be able to use an interest rate that allows me to do that. So derivatives market is absolutely crucial for adoption of SOFER. Just remember that the Eurodollar market is massive compared to the size of

the actual underlying trades that go into LIBOR. So if you think about just the size of your dollar futures, and I think it's something like two or three million contracts that get traded on a daily basis, you compare that to what really amounts to about $150 million a day in AA financial CP issuance, you get to see how the derivatives market is actually far more significant, at least in terms of size, than the actual cash market. In the case of

SOFER, it's the opposite. We have a much bigger cash market, right? Sofer volumes about a trillion dollars. And, you know, something like, I don't know, and I'm probably going to get this wrong, but a few hundred thousand contracts are trading on a daily basis in SOFER futures. So again, you know, I think the perspective here is the same, which is that the cash market, a lot of volume futures market needs to develop in order for broader adoption of SOFER. So just talking about the transition and potential problems is half-hearted transition a place where we could see some difficulty.

So for instance, if a company is borrowing at a LIBOR-based rate, but they're getting money from a SOFER-based swap, that could end up being quite a bad mismatch. I would imagine. Does that come up at all? That comes up frequently. So the issue is particularly acute for certain types of banks whose lending activity is all based off of LIBOR and their funding is also off of LIBOR if they have to start making loans off of SOFER, but their funding is kind of all off of LIBOR. There's a mismatch. You know, the big concern that people have is that, you know, you've got a lending rate that implicitly includes a bank credit component and, you know, a borrowing rate, let's say, that's based off of a risk-free rate, what happens in an environment, let's say, where there's a flight to quality and people are piling into treasuries and repo, and those rates are falling. but your borrowing is all based off of LIBOR, and that's moving in the other direction because bank credit risk is going up.

And there's no easy solution to that, to be honest. You can, again, rely on the derivatives market to kind of hedge some of that. But, you know, the concern that people have is that there's a mismatch there. And, you know, the answer to this is that there will be a market that develops and picks up volume, to kind of offset that rally risk, if you want to call it, that there'll be a cost associated with it, dealers are going to charge people for that. But again, it does add to the cost of transitioning to Sofer. Last question, Joe, because I know you have to go. But as all these issues crop up, does it make you maybe more sympathetic to the LIBOR process as it was? Like maybe there's a benefit

to having banks come up with interest rates. You know, clearly it's embedded in the financial system as well, but maybe you can make an argument even that it's counter cyclical. I'm being a little bit facetious, by the way. I suppose you could, but to be honest, I'd much rather have an interest rate that's based on transactions and transparent transactions that I can look at. I struggle because, you know, I can look at repo and I think I have a decent understanding of what, you know, are the factors that move and drive repo. I have little or no transparency into bank boring rates beyond what I can see in, you know, the commercial paper market.

And oftentimes I'm, I see movements in LIBOR of, you know, in some cases, a couple of, you know, basis points, and I have no explanation for that move. That to me makes it a difficult benchmark interest rate to use if you can't understand why it's moving on a day-by-day basis. So far, on the other hand, I can kind of get, I kind of understand why it moves up and down. I may not be able to forecast it on a daily basis with precision, but I at least kind of understand what's going on in that market. There's a lot less transparency in the markets that are underlying LIBOR. And I don't want to get into all of the details, but LIBOR is increasingly relying on level three submissions, which basically require inputs from various different markets and different

weightings attached to them. So you're getting even less transparency in the submission process as LIBOR moves further and further closer and closer to its deadline. Well, Joe, I think that's a good place to leave it. Thank you so much for coming on the show. We really appreciate it. Thank you. Thanks, Joe. That was great. I learned a lot.

I enjoyed that conversation. I know we got a little bit detailed in some parts of it, but I think that's the way to go, given that so much of the transition away from LIBOR is actually all about those technicalities, like how do you amend the contracts, which never foresaw this notion that one day we would be moving away from LIBOR? Yeah, exactly right. I mean, I do think, like, in my mind, this idea that's like, okay, well, LIBOR roughly trades in line with every other interest rate most of the time. And so far, more or less trading in line with policy rates, except for some occasional deviation.

so why can't you just swap them? And I thought Joe did a great job explaining why nothing is remotely that simple when you're talking about rewriting contracts that never had this kind of one step shift in mind. Right. And the other thing that this really puts me in mind of is that zombie LIBOR ideas. So not only do you have a shrinking pool of banks that are actually submitting their live. LIBOR estimates, as Joe mentioned, but you also have those estimates getting priced off level three assets, which I don't know, people remember, but those are the things that are the most difficult to sort of price.

Right. So there's this notion that LIBOR is getting sort of sketchier and sketchier while the entire world is still trying to get to a place where SOFER is the default rate. You know what this whole transition debate really reminds me of Tracy? Are you going to say Bitcoin? I'm really worried. No, no, no, no, no, no. Nothing like... Okay, go on. What does it remind you? You know how like every once in a while, like people we talk about some social network and like, oh, Facebook sucks.

Facebook takes our privacy and or Facebook, whatever, why can't we all just switch to something new or Twitter sucks? Why can't we switch to something new? And it never seems to happen. And the reason is like network effects of a thing that everyone coalesce around are not, there's no easy way to just sort of like, right, folks, let's all just jump at once. Because even if half the people jump, then each of the new networks is not have as valuable. They're much less valuable because for obvious reason, network effects compound. It makes sense when people are all on the same thing. So many things that we like talk about in the real world, we're like, this sucks.

Why can't we move off it? whether it's Facebook, whether it's Twitter, whether it's the struggles that we've seen of the entire world being dependent on the US dollar for trade. And of course, this essentially all come down with this problem of it's just not so easy for us all to jump at the same time onto the new thing, even if we can clearly identify the new thing is better. See, now I thought you were going to start talking about Bitcoin because, of course, network effects were at play there when it came to cryptocurrency adoption. Well, I guess there's that too, but, you know, no need to bring Bitcoin.

Okay, yes, I feel kind of bad. All right, let's leave it there before I say anything else. This has been another episode of the Odd Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallwart. And you should follow our producer on Twitter.

Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg. head of podcast, Francesca Levy, at Francesca Today. And check out all of the Bloomberg podcast on Twitter, on another handle, at podcasts. Thanks for listening.