22 Sep Replacing LIBOR
We’ve used the London Inter-Bank Offered Rate (LIBOR) as a benchmark rate for the past 40 years. Now, we’re replacing LIBOR with the Secured Overnight Financing Rate (SOFR). Let’s look at how this change came to be. The first thing to look at is the difference between the LIBOR Deposit Rate and LIBOR Reset Rate.
LIBOR Deposit Rate
Since 1981 we’ve used LIBOR to price Interest Rate Swaps. Since LIBOR is an inter-bank rate and banks have swap dealing units, it made sense to use LIBOR rates to price swaps. As the swap market grew, liquidity in LIBOR-based products grew. LIBOR rates became the de facto curve to price interest rate swaps.
The at-market swap rate is the rate at which all future cash flow discount to a Net Present Value of zero. That rate is adjusted for the difference between the bank and the clients’ credit rating.
An Interest Rate Swap has intermediate reset dates for the floating leg. Using LIBOR deposit rates could vary from bank to bank. In 1986, the British Banker’s Association (BBA) started to calculate the LIBOR reset rate. All swaps or assets resetting on that day received the same rate.
In 2007, LIBOR Rigging came to light. The Intercontinental Exchange (ICE) replaced the BBA in 2009.
- The BBA set short term “IBOR” rates for many currencies, using a specific process
- The BBA began polling the panel banks at 11 AM London Time or 5:00 AM New York Time.
- Even when LIBOR was at its most liquid, 5:00 AM made it difficult to capture the US market.
- In 2007, the Great Credit Crisis gained momentum and market liquidity evaporated.
- The LIBOR Reset Rate and the LIBOR Deposit Rate de-coupled.
- The spread between Fed Funds and LIBOR widened.
- This prompted an investigation which brought the LIBOR rigging scandal into the light.
EURIBOR & TIBOR Rigging Scandal
- In 2011, the European Commission began investigating bank activities in Asia and Europe.
- The Commission’s investigation uncovered a 7-bank cartel.
- The cartel operated for three years, from September 2005 to May 2008.
- The seven banks were Barclays, Crédit Agricole, HSBC, JPMorgan Chase, Deutsche Bank, RBS and Société Générale.
- The European Commission fined 3 of the banks, Crédit Agricole, HSBC, and JPMorgan Chase a total of € 485 million
ISDAFix Swap Rate Manipulation
In 2012, the CFTC began investigating bank activities in ISDAFix Swap Rates.
The ISDAFix rates were the mid-market rate for swap contracts with maturities from one – 30 years. ISDAFix rates settle payments on OTC contracts such as:
- Swap Curve Steepeners & Flatteners
- Constant Maturity Swaps
- Deliverable swap futures.
The manipulation of ISDAFix rates was more costly to investors. Because ISDAFix covered long term swaps, which have a larger DV01. Swaptions had $30 trillion notional amount outstanding – all settling versus ISDAFix rates.
The Alaska Electrical Pension Fund filed suit against 13 banks. The AEPF alleged the banks manipulated ISDAFix rates. The manipulation resulted in lower payments to derivatives clients. You can read more about the ISDAFix Swap Rate Manipulation here.
Against the backdrop of the scandals discussed above, LIBOR’s reputation suffered.
- While LIBOR deposits are less liquid with an average daily volume of $500 million maturing within 6 months.
- LIBOR is still used as the benchmark for $200 trillion face value/notional amount of securities or roughly 10 times our GDP.
The Fed Funds Rate & Overnight Index Swaps (OIS)
On the road to phasing out LIBOR, we took a pitstop at the Fed Funds Rate. The logic behind using Fed Funds was that there was already an existing liquid product trading in the marketplace, the Overnight Index Swap (OIS).
- Overnight Index Swaps are liquid out to 30 years.
- The OIS contract swaps LIBOR for (an average of) the daily Effective Fed Funds Rate (EFFR)
Here’s a box and arrow diagram of an OIS:
Although Fed Funds can only trade out to 270 days, the OIS market was liquid out to 30 years. So, Fed Funds seemed to be a good alternative for Valuations. Transactions would still be priced using the LIBOR curve. But mark-to-markets would use the OIS Swap Curve.
- LIBOR rates are still used to price & trade Interest Rate Swaps.
- OIS rates are used to calculate the mark-to-market for all interest rate swaps. Mark-to-markets are used to calculate the Variation Margin which flows from the loser to the winner every trading day.
- The quoting convention for OIS is the spread between LIBOR and Fed Funds. So it was easy to change from your “transaction” curve (LIBOR) to your “mark-to-market” curve (EFFR).
- The Effective Fed Funds Rate is the weighted average of all Fed Fund transactions for the day. The net between the average daily EFFR versus the LIBOR reset rate is used to settle the OIS.
Problems Using The OIS Curve
The OIS curve was liquid, but:
- The underlying Fed Funds market is short term (maximum maturity of 27 days). Further, the term “Fed Funds” only applies to a bank’s excess reserves.
- Although we can make adjustments from LIBOR to Fed Funds by using the OIS Curve, it presumes the OIS market will remain liquid.
- Using the Effective Fed Funds Rate also presumes banks will always lend their excess reserves
- Two presumptions we couldn’t rely upon.
With most Interest Rate Swaps clearing at a Swaps Clearinghouse, the need for Overnight Index Swaps dwindled. OIS swaps were used by leveraged asset managers who used Interest Rate Swaps as synthetic bond positions.
Here’s a box and arrow of an actual bond purchase, showing both the fixed coupon on the note and a Repo agreement:
With an actual long position on a 5-year note, the fund would receive a fixed coupon for five years. The bond purchase is financed in the repo market. The repo, similar to a collateralized loan, charged an overnight interest rate.
Using an interest rate swap, gave leveraged funds the same fixed rate exposure as an actual bond position, but the floating leg was very different. The interest rate swap used 3 month LIBOR as their floating leg, not overnight rates.
It was this mismatch which created a large demand for OIS. Recall, the OIS from above:
The leveraged fund adding an OIS to RECEIVE LIBOR and PAY Effective Fed Funds Rate (overnight rate) brought their synthetic asset closer to their actual asset:
- SWAP: Received Fixed coupon & Pay LIBOR
- OIS: REC LIBOR & Pay overnight EFFR
- NET: Receive Fixed coupon & Pay overnight EFFR
The OIS found tremendous liquidity from funds creating synthetic long assets and synthetic short assets.
Post Great Credit Crisis
After the Great Credit Crisis, most swaps migrated over to Swaps clearinghouses, requiring initial margin and variation margin, much like futures contracts.
- Initial margin is a good faith deposit, giving the clearinghouse a cushion in the event of default. Variation Margin being transferred to the winner from the loser at the end of each business day.
Swaps Margin could be posted using any number of eligible securities, including Tri-party repo & Bilateral repo.
- As the limitations of OIS were discovered, industry groups such as ISDA began to see repo as a viable alternative to LIBOR.
They decided to use a volume-weighted average of all repo agreements traded on a given day. The resulting rate was called the Secured Overnight Financing Rate (SOFR). Let’s take a closer look:
Secured Overnight Financing Rate (SOFR)
SOFR is the cost of overnight funding, collateralized by U.S. Treasury securities. SOFR has the widest coverage of any Treasury repo rate available. SOFR trades on average $800 billion daily since it began publication. Tri-party, General Collateral & DVP repo volumes dwarf the volumes underlying LIBOR.
The SOFR rate is the weighted average of three repo rates:
- Tri-Party repo (TGCR)
- General Collateral Repo (BGCR)
- DVP Repo rates (DVP)
SOFR does not include:
- Securities trading on “special” (“hard-to-borrow”, DVP repo)
- Repo’s used by the Fed, where the Fed is a counterparty.
As the administrator and producer of SOFR, the FRBNY began publishing SOFR on April 3, 2018. The rates are posted daily on the FRBNY website around 8:00 AM Eastern Time.
The Tri-Party General Collateral Rate (TGCR)
- The TGCR is overnight, specific counterparty repo transactions secured by Treasury securities. The FRBNY collects the tri-party data from the Bank of New York-Mellon (BNYM).
The Broad General Collateral Rate (BGCR)
- The BGCR is a measure of overnight Treasury General Collateral repo transactions. The BGCR includes all trades used in the TGCR plus GCF Repo trades. GCF Repo data obtained from DTCC Solutions.
The Delivery-Versus-Payment Repo Market (DVP)
- The DVP repo market is security-specific. Unlike tri-party repo which identifies a basket of acceptable collateral. DVP repo where the securities are trading “special” is not included in the DVP Repo Rate used for SOFR.
The three repo rates are then volume-weighted to calculate the SOFR. Greater details on the calculation of SOFR can be found here
Other currencies will phase in similar short-term interest rates: EUR, CHF, JPY & GBP
Replacing LIBOR with SOFR
There are transition issues to address by 2021. SOFR is very different from LIBOR. LIBOR is an unsecured Inter-Bank rate. The following details the differences between SOFR and LIBOR.
Term Rate versus Overnight Rate
- SOFR is an overnight rate. To reflect a longer-term floating rate, daily SOFR rate will be calculated. (i.e. 3 month, 6 month, etc.)
Difference in Credit
- SOFR is a collateralized rate. Banks will make changes in their calculation for Credit Valuation Adjustment (CVA). The CVA should widen because the SOFR rate is lower than LIBOR.
Changes in Documentation
- Replacing LIBOR will also require a change in documentation. LIBOR will continue until 2021. By that time, all LIBOR-based products will need new Documentation. Particularly regarding a fallback plan.
IBOR Transitions in Other Countries
- Before 2008, BBA posted IBOR rates for 15 currencies. In the future, we’ll use five currencies: British Pound (GBP), Euro (EUR), Swiss Franc (CHF), Japanese Yen (JPY) & U.S. Dollar (USD). The implementation will be a challenge. But the greater challenge will be cross border confluence.
Timeline for the Transition Plan
- The Federal Reserve’s Alternative Reference Rates Committee’s (ARRC) members. Infrastructure for futures and/or OIS trading in the new rate will be in place.
- Anticipated completion: 2018 H2
- Trading begins in futures & bilateral, uncleared, Overnight Index Swaps (OIS) that reference SOFR.
- Anticipated completion: by end 2018
- SOFR FUTURES TRADING (May 2018). Volume: ~86,000; OI: ~300,000
- Trading cleared OIS: SOFR vs. the Effective Federal Funds Rate (EFFR). Price Alignment Interest (PAI) and discounting environment.
- Anticipated completion: 2019 Q1
- CCPs allow market participants a choice between clearing new* or modified* swap contracts. Using the current Price Alignment Interest (PAI) environment or uses SOFR for PAI.
- *swaps paying floating legs benchmarked to EFFR, LIBOR, and SOFR.
- Anticipated completion: 2020 Q1
- CCPs no longer accept new swap contracts with EFFR as PAI. Except to reduce outstanding risk in legacy contracts that use EFFR as PAI and discount rate. Existing contracts using EFFR as PAI continue in the same pool but would roll off over time.
- Anticipated completion: 2021 Q2
- Once liquidity has developed, a term reference rate based on SOFR
- Anticipated completion: by end of 20