From LIBOR to SOFR: An Unexpected Journey

Transcription

1 From LIBOR to SOFR: An Unexpected Journey An update on the transition from LIBOR to the Secured Overnight Financing Rate Garret Sloan, CFA Head of Short-term Fixed Income Market Strategy Wells Fargo Securities

2 The Problem with LIBOR The interbank offered rates (collectively, LIBOR) underpin more than $350 trillion of financial products. LIBOR is a widely utilized benchmark that is no longer derived from a widely traded market. WHY? Basel III: Pushes banks away from short-term unsecured funding. Financial crisis: Banks stopped lending to each other. Manipulation: To conceal borrowing costs and bolster trading profits. The USD LIBOR Footprint ~$200 trillion in asset exposures $145T OTC Swaps, options, Forwards, cross-currency Panel Banks: Concerns about panel-bank participation beyond In July 2017, the U.K. Financial Conduct Authority announced that it will not compel banks to provide LIBOR submissions beyond Exchange Options Forwards $45T Various regulators, including members of the Fed and the CFTC, continue to encourage market participants to adopt alternative rates. $5T Loans Syndicated, CRE Residential, Consumer Bonds FRNs Securitizations $4T 1) Source: Federal Reserve Second Report of the Alternative Reference Rates Committee. From LIBOR to SOFR An Unexpected Journey 2 Wells Fargo Securities

3 LIBOR Transition Background ARRC Mandate In 2014, the Federal Reserve Board convened the Alternative Reference Rate Committee to explore alternatives for replacing USD LIBOR as a benchmark rate in the U.S. The ARRC was convened to address the following: Objectives 1 2 Identify best practices for alternative reference rates Identify best practices for contract robustness to ensure contracts are resilient to the possible cessation of USD LIBOR In March 2018, the ARRC was reconstituted to: 1, 2 Include a broader representation of the financial market and establish working groups to address regulatory, legal, tax and accounting issues Ensure successful implementation of the paced transition plan Coordinate planning across cash/derivatives products 3 4 Develop an adoption plan that identifies factors that would either facilitate or impede the adoption of the alternative reference rates Create an implementation plan with metrics of success and a timeline 1 Source: ARRC's Website 2 Source: IBOR Global Benchmark Transition Report, June ARRC Members Banks/Dealers: Exchanges: Asset Managers: Insurance: GSE/SSA: Associations: Ex Officio Members CFPB FDIC FRB New York U.S. Treasury Fed Reserve CFTC SEC FHFA OCC OFR From LIBOR to SOFR An Unexpected Journey 3 Wells Fargo Securities

4 Rates LIBOR/ SOFR Basis (bps) Goodbye USD-LIBOR, Hello SOFR Overview In June 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative for USD LIBOR o Secured: Based on trades in the triparty, cleared bilateral, and certain DVP Treasury repo markets. o Overnight: The repo rates used are overnight and reflect borrowing for one business day o Financing Rate: The rate represents secured funding costs for financial institutions pledging Treasury collateral Average SOFR has been less volatile than LIBOR Average Daily Volumes in U.S. Money Markets ($bn) 1 Historical Rates $800 $ % 60 $700 $600 $500 $400 Liquid market of approximately $750 billion in daily volume % 2.00% 1.50% $300 $200 $100 $- SOFR $197 O/N Bank Funding $79 Effect. Fed Funds $13 $0.50 $0.34 $ mo T-Bill 3-mo LIBOR 3-mo AA CP 3-mo A2/P2 CP 1.00% 0.50% 0.00% 3M LIBOR - 3M Compounded SOFR SOFR 3M LIBOR 3M Compounded SOFR Historically, SOFR has been lower and more volatile than USD LIBOR 1) Average volumes over 2017H1, with the exception of 3-month T-bills, which are preliminary estimates from available FINRA Trade Reporting and Compliance Engine (TRACE) data over August and September month volumes are based on all transactions with remaining maturities between 80 and 100 calendar days or business days. 2) CME Group. Sources: Federal Reserve Bank of New York; Financial Industry Regulatory Authority; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation; and the Board of Governors of the Federal Reserve System From LIBOR to SOFR An Unexpected Journey 4 Wells Fargo Securities

5 Paced Transition Plan Key ARRC and Other Developments ARRC Paced Transition Plan The Paced Transition Plan was established by the ARRC to build structure and liquidity in SOFR-referencing derivatives and cash products. 1 May CME launched SOFR futures with initial trading volume of over 3,000 contracts across 50 firms July - LCH began clearing SOFR swaps with EFFR PAI/discounting Fannie Mae issued first SOFR-based FRN 2019 Continue to build SOFR-linked cash and derivatives instruments Q2 - CCPs to no longer accept new swaps contracts for clearing with Effective Federal Funds Rate (EFFR) as PAI and discounting Oct. - ARRC Paced Transition Plan approved Apr. - New York Fed/OFR began publishing SOFR Oct. CME began clearing SOFR swaps using SOFR price alignment interest (PAI)/discounting Q1 - Central counterparty clearing houses (CCPs) to begin allowing a choice between clearing new or modified swap contracts in current PAI/discounting environment or SOFR for PAI/discounting EOY Endorse a forwardlooking SOFR term reference rate Today May ARRC s Interim Report and Consultation published June ARRC selected SOFR as its recommended alternative to USD LIBOR July FCA s Bailey said panel banks will not be compelled to submit to LIBOR past 2021 Mar. - ARRC s Second Report published ARRC reconstituted with expanded membership Jul. - FCA, CFTC, FRB regulator speeches highlighting need to prepare for transition ARRC issued guiding principles for fallback contract language S&P announced SOFR is an anchor money market reference rate Sept. ARRC issued consultations on fallback language for FRNs and syndicated loans which concluded Nov 8 EOY 2018 ARRC issued consultations on fallback language for bilateral loans and securitizations which conclude Feb 5 Q ARRC is seeking to produce an indicative SOFRbased term reference rate based on futures data to help promote market familiarity with the term rate Q ARRC expects to produce final recommendations for safer contract language in FRNs, business loans, and securitizations Key Complete Anticipated Completion Completed ahead of schedule 1. Source: ARRC Progress Timeline New York Fed. Oct. 30, From LIBOR to SOFR An Unexpected Journey 5 Wells Fargo Securities

6 Alternative Reference Rate SOFR USD LIBOR vs. SOFR USD LIBOR is published in seven maturities from overnight to 12-months, and incorporates a credit risk premium. SOFR is an overnight, secured rate with no credit risk premium. USD LIBOR SOFR Definition Unsecured wholesale interbank lending rate Secured overnight repo rate Maturity/Term Overnight, 1 week, 1-, 2-, 3-, 6-, and 12 months Currently only overnight Credit Premium Unsecured incorporates credit risk premiums Secured no credit risk premium Methodology 1 Trimmed mean of panel bank submission rates based on Waterfall Methodology. Volume-weighted median for the combined triparty, GCF and bi-lateral repo datasets Historical Performance Lack of transactions underpinning the rate has led to reliance on judgment and indicative pricing Typically trades close to overnight LIBOR, but with higher volatility due to wide dispersion in repo data Administrator IBA FRBNY Publication Time 11:55 am London Time Approximately 8:30 am Eastern Time the following business day Source: ARRC Fallback Consultation Webinar: Floating Rate Notes, October 2018 From LIBOR to SOFR An Unexpected Journey 6 Wells Fargo Securities

7 Alternative Reference Rate SOFR Market Adoption Notional Oustanding ($M) Market adoption has increased significantly over the past year, with over 80 global participants currently trading in SOFR SOFR futures and swap markets were launched in Wells Fargo is approved to trade SOFR futures and cleared swaps From August 2014 through December 2018, SOFR was approximately 25 basis points less than 3-month LIBOR SOFR has been higher and more volatile for a 1-2 day period over quarter end, as some repo providers are less willing to carry balances at that time. On average over a quarterly period, SOFR has been less volatile than LIBOR Open Interest ($M) 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 Source: CME SOFR Futures Traded on CME 0 5/11/18 7/11/18 9/11/18 11/11/18 5-Day Avg Volume (Contracts) Avg. Volume (Contracts) 25,000 5-Day Avg Open Interest ($M) 20,000 15,000 10,000 5, ,000 9,000 8,000 7,000 SOFR Swap Notional 6,000 5,000 4,000 3,000 2,000 1, /16/18 09/16/18 11/16/18 01/16/19 03/16/19 SOFR vs. Fed Funds SOFR vs. LIBOR SOFR vs. Fixed Source: Wells Fargo SDR From LIBOR to SOFR An Unexpected Journey 7 Wells Fargo Securities

8 The List of Early Adopters is Growing for SOFR-based Debt Issuance Notable 2018 Issuers Over $41B in SOFR-based transactions in 2018 Already more than $40B in 2019 Volume by Tenor ($B) Issuer Name Sector Total ($B) FHLB GSE 14.4 Fannie Mae GSE 11.0 Credit Suisse FBO Branch 3.9 Freddie Mac GSE 3.0 MetLife Insurance 2.0 Bank of Nova Scotia FBO Branch 1.7 Wells Fargo US Bank 1.1 EIB SSA 1.0 World Bank SSA 1.0 JPMorgan Chase US Bank 0.8 Bank of Montreal FBO Branch 0.6 Natixis FBO Branch different securities have been issued with half the volume coming at 6m tenors Issuance has been 85% bonds (led by the GSEs) and 15% CDs (led by FBO branches) African Dev. Bank SSA 0.1 Source: Bloomberg; CME Group; as of 1/3/19 Total m 9m 1yr 18m 2yr 3yr 1 From LIBOR to SOFR An Unexpected Journey 8 Wells Fargo Securities

9 SOFR Considerations Term SOFR Creation and Administration of Term SOFR Forward-looking term rates have maturities longer than one business day. The ARRC expects to create a one and three month term SOFR by the end of Term SOFR would be administered by a private entity such as ICE/IBA (not FRBNY). Term SOFR will be based upon an agreed quantitative model which utilizes market values of derivatives referencing SOFR. Models would interpolate future daily SOFR primarily using one and three month futures contracts Models make assumptions about rate movements at future FOMC meeting dates While most market participants will trade SOFR products, some commercial end users may use Term SOFR once it exists because of systems that were built for rates known in advance Important Caveats Term SOFR is not currently a viable solution to LIBOR cessation; Term SOFR does not exist today. The SOFR derivatives market will need to be highly robust to create Term SOFR, with a significantly larger volume of transactions referencing the overnight rate. Parties that use Term SOFR will need to understand how to use overnight SOFR The majority of hedges used to fix Term SOFR investments will reference overnight SOFR Term SOFR will not contain any term lending premiums / will not embed bank credit risk Term SOFR will not be based on term repo rates. It will reference future expected overnight rates From LIBOR to SOFR An Unexpected Journey 9 Wells Fargo Securities

10 Increasing Contractual Robustness Contractual fallback language was often originally intended to address the temporary unavailability of LIBOR instead of a permanent cessation As a result, fallback language in many contracts may not produce a commercially reasonable result ISDA is working on developing new fallback language for derivatives that reference the standard ISDA definitional booklet The ARRC is working on developing new fallback language for cash products In general, fallback language has three components: 1. Trigger events: Define the circumstances under which references to LIBOR in a contract will be replaced with an alternative reference rate 2. Replacement benchmark: Identify the rate, or waterfall of rates, that would replace LIBOR following a trigger event 3. Spread adjustment: An adjustment needed to the replacement rate because SOFR and other alternative reference rates ( ARRs ) are fundamentally different from LIBOR Adjustments are intended to ensure contracts continue to function as closely as possible to what was initially intended by the parties and are designed to minimize any potential transfer of value between the parties when the fallback takes effect Consistent treatment across markets upon a LIBOR cessation will reduce operational, legal and basis risk (particularly where derivatives are used to hedge interest rate risk in cash products) From LIBOR to SOFR An Unexpected Journey 10 Wells Fargo Securities

11 Increasing Contractual Robustness ISDA is conducting a series of market consultations on issues related to new fallback language for derivatives to inform decisions about adjustments: Term Adjustment: necessary because LIBOR has a term structure (ARRs do not) Spread Adjustment: necessary because LIBOR is unsecured and incorporates bank credit risk premium (ARRs do not) It is expected that the derivatives fallback rates (including both Term Adjustment and Spread Adjustment) will be available via a third party vendor (e.g., Bloomberg screens) Results of the initial ISDA Consultation published on December 20, 2018 (non USD LIBOR): Term Adjustment Compounded Setting in Arrears Rate: The Alternative Reference Rate observed over the relevant IBOR tenor and compounded daily during that period Spread Adjustment Historical Mean/Median Approach: Mean or median spot spread between the relevant IBOR and the Alternative Reference Rate calculated over a specified period (i.e., 5 or 10 years) The ARRC is also conducting market consultations related to new fallbacks for USD LIBOR cash products (securitizations, business loans, floating rate notes) ARRC fallback provisions differ in some respects from ISDA s fallback language to address differences between cash products and derivatives. Loan fallbacks include a flexible Amendment Approach option Hardwired Approach falls back first to a Forward-looking Term SOFR (but only if Term SOFR is robust enough to be endorsed by the ARRC) Second in the waterfall is Compounded SOFR Setting in Arrears Like ISDA, the ARRC fallback language for cash products includes a Spread Adjustment to the fallback rate, which may be the ISDA Spread Adjustment (unless the ARRC decides it is not suitable for cash products) From LIBOR to SOFR An Unexpected Journey 11 Wells Fargo Securities

12 SOFR Turns 1

13 Beginning Activity in SOFR, FF and Eurodollar Futures SOFR vs. Pre-Crisis O/N LIBOR vs. Pre-Crisis Fed Funds Effective 13,000 SOFR Futures ED Futures FF Futures 12,000 11,000 The growth in SOFR futures trading over the first few weeks of the contract s history was much stronger than either Fed funds or Eurodollar futures but 2018 is a different market than the mid-80s, is this a fair comparison? 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, Initial Days of Trading Source: Wells Fargo Securities, LLC, Finadium, CME From LIBOR to SOFR An Unexpected Journey 13 Wells Fargo Securities

14 What Have We Learned? SOFR Looks Volatile SOFR vs. O/N LIBOR vs. Fed Funds Effective SOFR rates have shown more daily volatility than other overnight rates... but inter-bank rates have essentially been flat, given the lack of actual trading it could be argued that SOFR acts more like an actual market rate than either O/N LIBOR or Fed Effective /2/2018 7/2/ /2/2018 1/2/2019 4/2/2019 SOFR Fed Effective O/N LIBOR Source: Wells Fargo Securities, LLC, ICE, Bloomberg, LLC From LIBOR to SOFR An Unexpected Journey 14 Wells Fargo Securities

15 but looks similar to pre-crisis inter-bank funding markets SOFR vs. Pre-Crisis O/N LIBOR vs. Pre-Crisis Fed Funds Effective The volatility in SOFR vs. is similar to the volatility in precrisis O/N LIBOR and Fed Effective markets. Periods of heavy collateral supply can still cause sharp spikes in SOFR SOFR Pre-Crisis Fed Effective O/N LIBOR Source: Wells Fargo Securities, LLC, ICE, Bloomberg, LLC From LIBOR to SOFR An Unexpected Journey 15 Wells Fargo Securities

16 SOFR and Credit Markets

17 LIBOR and T-Bill Repricing During Market Stress Events LIBOR Tries to Capture Macro Shifts in Credit Markets M LIBOR 3M Bill Historical credit events show the difference between how LIBOR responds to credit events and how governmentrelated products respond Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Source: Wells Fargo Securities, LLC, Bloomberg From LIBOR to SOFR An Unexpected Journey 17 Wells Fargo Securities

18 Coupon Coupon LIBOR vs. SOFR Floating Rate Corporate Bonds? LIBOR Tries to Capture Macro Shifts in Credit Markets Spread Widens Stated Margin Price Risk Because the underlying index moves, the coupon also moves, which allows investors to capture the additional credit risk premium during macromarket events Stated Margin LIBOR Rate SOFR/ LIBOR Rate Macro Event Source: Wells Fargo Securities, LLC, From LIBOR to SOFR An Unexpected Journey 18 Wells Fargo Securities

19 Coupon Coupon LIBOR vs. SOFR Floating Rate Corporate Bonds? SOFR Is Unlikely To Capture Credit Events Spread Widens Price Risk the SOFR index, backed by secured Treasury trades may act more like a flight-to-quality instrument, which could compress coupons as SOFR could rally during credit events. Stated Margin Stated Margin SOFR Rate SOFR Rate Macro Event Source: Wells Fargo Securities, LLC, From LIBOR to SOFR An Unexpected Journey 19 Wells Fargo Securities

20 Other Unsolved Questions

21 Other Unresolved Questions Still unclear on the mechanisms of the fallback Expected recommendations in Q2, possibly next week Fallbacks in the cash market are the bigger issue than the derivatives market. Regardless of the mechanism, certain investors are lining up to debate the appropriate levels for the fallback From LIBOR to SOFR An Unexpected Journey 21 Wells Fargo Securities

22 Other Unresolved Questions Will LIBOR actually go away? Nothing preventing LIBOR from remaining Legal and reputational risk for LIBOR panel banks is ever-present Regulatory risk of higher margins for LIBOR-based trades Risk of higher bank capital for LIBOR exposure in stress testing From LIBOR to SOFR An Unexpected Journey 22 Wells Fargo Securities

23 Other Unresolved Questions Forward looking vs. backward looking benchmark? Derivatives market is committed to compounding in arrears Cash markets do not like the uncertainty of coupon rates calculated in arrears Will require providers of SOFR products to hedge twice Once in the term market (overnight SOFR vs. duration of hedge) Again in the basis market (overnight SOFR vs. term SOFR) From LIBOR to SOFR An Unexpected Journey 23 Wells Fargo Securities

24 Other Unresolved Questions Multiple benchmarks? SBA switched to Prime instead of SOFR ICE Bank Yield Index introduced in January 2019 From LIBOR to SOFR An Unexpected Journey 24 Wells Fargo Securities

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26 From LIBOR to SOFR An Unexpected Journey 26 Wells Fargo Securities 26