The future of LIBOR: Reviewing suggested changes and impact on portfolios

The future of LIBOR: Reviewing suggested changes and impact on portfolios

By Armel Romeo Kouassi, Head of Balance Sheet Management and Asset Liability Management, Northern Trust

Can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?

I am fascinated by the business of banking which involves the identification, measurements and management of risk. One of the most important risk-management functions in abank is Asset Liability Management. I am currently heading Asset Liability Management Modelling at Northern Trust with responsibility in measuring and modelling the banks IRR. One aspect of my function which I like the most is specifically empowering the organization to make educated decisions that minimize risk while optimizing return within the evolving regulatory environment and changing market environment.

What is the current situation with US SOFR?

Replacing the world’s “most important number” is a huge endeavour, a massive amount of fixed income products are priced off LIBOR.  Roughly $10 trillion worth of loans are priced based on the LIBOR. And then trillions more in derivatives. Market participants have taken concrete steps to transition from LIBOR to the transaction-based alternative. I expect LIBOR and SOFR to likely co-exist for some time. SOFR is not widely used yet due to some limitations: while LIBOR rates are available in seven different maturities, ranging from overnight loans to those lasting one year, SOFR is so far an overnight rate only.

What has been the affect/outcome of outstanding financial transactions being indexed to current libor?

Several trillions of transactions and derivatives are indexed on LIBOR. LIBOR or the world’s most “important number” was created in 1986 by the British Bankers’ Association to measure and track the interest rates banks pay when they borrow from each other. LIBOR is the primary benchmark for short-term interest rates around the world. LIBOR underlies several hundred trillion in securities across the globe. LIBOR phase-out will have significant impact on outstanding fixed income securities, loans, mortgages and investments with floating rates.
Lack of transactional data underlying LIBOR, lack of transparency, reduced credibility of the rate-setting process,scandals, and the reticence of member banks to continue making LIBOR submissions force the transition but it will be a long ride for months to come.  More to come at the conference.

What are the challenges for public record and investors?

The transition from LIBOR to SOFR will significantly affect floating-rate investments. In the future adjustable rates coupon will likely be SOFR. There are a few key differences between LIBOR and SOFR that could be a challenge for investors:
✓Liquidity in the SOFR swaps market is still relatively low and the SOFR cash market has not developed yet.
✓LIBOR rates are unsecured, tend to be higher than secured rates (SOFR), to reflect counterparty risk. SOFR is secured, implies no credit or spread risk.
✓SOFR is a market rate based on actual transactions, not banks estimations.
✓SOFR is produced by the Federal Reserve, which implies transparency and some measure of impartiality and credibility.
✓SOFR is only a short maturity overnight rate with low yield. LIBOR captured term risk by offering reference rates at different maturities on the yield curve
✓SOFR has been so far more volatile than overnight LIBOR since the Fed introduced it, largely due to Treasury issuance and Fed policy.

How have consumer loans been affected?

It is too soon in the process. Although LIBOR will be replaced by a transaction-based benchmark for variable-rate products, the demise of LIBOR could present transitional challenges to many consumer loans. There is north of 10 trillion loans indexed on LIBOR. For variables rates borrowers (mortgages, credit cards, student loans, corporate business loans, commercial mortgages and variable-rate bonds)lenders will typically inform borrowers of the transition ahead of time but for many existing floating-rate loans, there is no concrete language in the prospectuses that lays out a plan if a given reference rate no longer exists.

What has been impact on borrowers and investors?

It is too early to tell how borrowers and investors are impacted. SOFR is still new. As stated earlier for many existing floating-rate investments, there is no concrete language in the prospectuses that lays out a plan if a given reference rate no longer exists.  Most recent floating rate investments are still referencing LIBOR and included language about the transition from LIBOR with some flexibility on the rates to be used

Challenges in issuing notes in a market with two reference rates: Issuance of floating notes with SOFR, could make seasoned floaters tied to LIBOR less desirable and potentially experience a loss of liquidity. Given the challenges of the transition, LIBOR may likely exist alongside SOFR for a period. We should prepare for a potential extended period of co-habitation of LIBOR and SOFR. Preparedness is key to deal with this uncertainty. Investors and banks should be deliberate in planning.