(Bloomberg) – US regulators are betting on a major transformation of the multi-trillion dollar interest rate swap market, which is exactly what it takes to wean Wall Street off the London interbank supply rate for good.
In an important development in the shift from the discredited benchmark, the swap desks will switch from the Libor to the secured overnight financing rate from Monday when most interdealer deals are concluded, which effectively changes their hedging of the interest rate risk.
The move is intended to trigger a spate of activity in SOFR-linked derivatives and ensure sufficient liquidity to create a forward-looking maturity structure, a critical deadlock that has prevented various cash markets from accepting the rate. This is the first step in a renewed effort to benchmark companies ahead of the year-end deadline to abolish the Libor on new deals, and comes amid increasing competition from a number of new benchmark rate providers attempting their own slice of the landscape the Libor.
This “is a big deal,” said Thomas Pluta, global head of linear rate trading at JPMorgan Chase & Co. “We were surprised at how slow the adoption of SOFR derivatives has been up to market needs.”
More on the transition away from Libor:
With the move, the SOFR will replace the Libor as a floating leg in all linear swaps, swap spreads and curve trades in the interdealer market, where financial institutions like JPMorgan and Goldman Sachs Group Inc. hedge the interest rate risk they trade with Customers.
The best practice recommendation of the market risk advisory committee of the Commodity Futures Trading Commission has no influence on Libor SOFR basic transactions, ie companies can continue to hedge their risk using the Libor as they wish.
Still, it will, by definition, create more volume in SOFR derivatives, said Bart Sokol, a director of US interest rate swap trading at Barclays Plc. This should narrow bid-ask spreads, encourage banks to move end-users to SOFR, and ultimately ease the liquidity that the Federal Reserve-backed Alternative Reference Rates Committee announced before approving an interest rate.
“It’s a healthy way to build the market,” said Sokol.
Removing the Libor from the financial system has proven to be a monumental undertaking since global regulators announced plans to phase out the benchmark in 2017. According to the ARRC, there were over $ 220 trillion in assets tied to the dollar iteration of the interest rate as of late last year, including over $ 80 trillion in face value in over-the-counter interest rate swaps.
In particular, participants in the syndicated corporate loan markets indicated that operational constraints made it difficult to transition from the forward-looking Libor to an overnight rate such as the SOFR without a similar maturity structure.
“We’re talking about a very complex ecosystem,” said Tal Reback, a director at KKR, on July 21 in a panel discussion hosted by the ARRC. “With the interest rate, you have the option of projecting your cash flows into the future – both as a borrower for your interest expenses and as a lender – predictable.”
Monday’s Shift seeks to repeat a similar move in the UK last year, which is credited with helping to get swap counters in London to abandon the Libor.
“This is an opportunity for the industry to take joint action and provide a piece of the puzzle to deliver deadline-critical SOFR in mission-critical parts of the market,” said Tom Wipf, ARRC chairman and vice chairman of institutional securities at Morgan Stanley during the panel.
Term rate problem
Some market watchers remain cautious. It wouldn’t be the first time officials predict an increase in SOFR trade only to be disappointed.
The so-called big bang switch of the derivatives exchanges to SOFR in October to discount the cash flows for swaps and the publication of a highly anticipated legal protocol by the International Swaps and Derivatives Association to support the switch from Libor-linked contracts to SOFR provided relatively fleeting impulses.
As did ISDA’s spread adjustment – which is used to determine the fallback rates for Libor trades that mature after the benchmark expires – earlier this year.
These setbacks partly prompted the ARRC to announce in March that it would not be able to recommend a future-oriented interest rate until the middle of the year as originally planned and that it could not even guarantee it until the end of the year.
For more information on the Libor transition, subscribe to the Libor Countdown
Although officials have since increased the urgency, the announcement helped other Libor alternatives gain momentum.
Last month, the American Financial Exchange, the administrator of Ameribor, introduced interest rates based on futures contracts listed on the CBOE Futures Exchange.
And in May, the first syndicated corporate loan linked to the Bloomberg Short Term Bank Yield Index was issued, following the first swap trade and the first benchmark-linked bank bond. BSBY is managed by Bloomberg Index Services Limited, a subsidiary of Bloomberg LP, the parent company of Bloomberg News.
But the regulators have started to push back in the last few weeks and to make their preference for SOFR clear.
Earlier this month, Edwin Schooling Latter of the UK Financial Regulator said that so-called credit-sensitive interest rates are flawed because they are derived from markets where liquidity “has not been shown to be resilient to stress”.
For now, all eyes will be on when the ARRC will approve SOFR schedule rates. Wipf said last month that after the swap switch it could be a matter of days rather than weeks.
The ARRC has already selected CME Group Inc. as the recommended administrator for forward-looking SOFR, and in April the exchange began publishing maturity quotes for one-, three- and six-month maturities based on SOFR futures.
However, Monday’s move is only the first in a series of changes designed to bring the derivatives market closer to benchmark before the year-end deadline to abolish the Libor. The interdealer market conventions for cross-currency basic swaps with Swiss francs, British pounds sterling, Japanese yen and US dollar Libor will be converted to SOFR in September.
Later in the year, trading in non-linear derivatives such as swaptions will switch to the course, eventually followed by exchange derivatives.
“You want to get people to transact with SOFR before they have no choice but to do it,” said Pluta of JPMorgan. “When you’re moving a trillion-dollar denomination market, you don’t want to wait until the last minute to find out how. It’s a big market so you want to make sure the pipes work. “
–With assistance from William Shaw.
© 2021 Bloomberg LP