Libor expert: don’t rely on forward RFR rates for transition

Swaps users should embrace backward-looking risk-free rates instead, says chair of UK working group

Forward-looking risk-free rates (RFRs) may not be ready before legacy instruments need to be weaned off Libor and so users should prepare to move to backward-looking benchmarks, according to the chair of an RFR working group.

Currency-specific working groups have so far selected RFRs based on overnight rates as alternatives to Libor. For swap contracts, these rates are generally based on a daily compounded overnight rate – for instance, a three-month Sonia rate.

Compounded overnight rates can only be calculated by looking backwards at the end of the period, whereas some users, such as non-financial corporations, prefer to use rates where the rate is known at the start of the period, which is how Libor works. However, it may not be possible to create such forward-looking term reference rates quickly enough, said François Jourdain, a senior executive at Barclays and chair of the working group on sterling risk-free reference rates set up by the Bank of England.

“If the largest part of the market can transition into the RFR with its current convention as using the swap market compounded in arrears, we need these first movers not to wait for the term rates. It takes time to build a benchmark – maybe in one year it will be up and running. We don’t have one year to waste, we need to start now,” Jourdain said at the Bank of England’s Markets Forum held in London on May 24.

The UK’s Financial Conduct Authority announced last year that from the end of 2021 it will give up its power to compel banks to submit quotes to the various Libor panels, prompting concerns the rates could disappear soon after that date. The FCA and the US Federal Reserve are encouraging market participants to start using RFRs in new trades, and to switch over legacy positions as soon as possible to avoid disruption.

Term fixings based on overnight rates tend to be calculated in arrears and are relatively straightforward to create, but forward-looking rates effectively require the development of an additional benchmark fixing.

A June 2017 paper from the sterling RFR working group says forward rates could be derived from each RFR’s yield curve. A three-month forward rate could be based on the fixed leg of a three-month Sonia contract using executable quotes. Alternatively, it could be based on Sonia futures order book data, which might require interpolation between futures settlement dates to determine a constant three-month maturity rate.

But, as yet, there are no concrete plans for any third-party entity to act as the calculation agent for such a rate. Jourdain said that, given the time pressure, swaps users should not wait for a forward-looking rate to emerge and instead consider using backward-looking compounded rates for a smooth transition away from Libor.

“I ask the first movers to at least prepare their structures and get ready to start embracing the RFRs in their natural habitat: compounding in arrears,” he said.

I ask the first movers to at least prepare their structures and get ready to start embracing the RFRs in their natural habitat: compounding in arrears

François Jourdain, Barclays

Forward-looking rates also have drawbacks that may delay their creation. One relates to market stability: the working group’s paper says that reliance on these rates creates fragility as “the robustness of the ultimate benchmark becomes a function of the depth of the derivatives market referencing the RFR, rather than a function of depth of overnight unsecured cash market”.

Jourdain flagged another potential snag: “There’s also a conflict-of-interest issue, because those people trading these short-dated swaps might have exposure to the same fixing. And as soon as you have the same person setting a benchmark having interest in the benchmark, we know conflicts of interest arise that have to be managed. It can be managed but it has to be managed.”

The audience at the conference was also ambivalent about forward-looking rates: a poll found attendees more or less evenly split between those who thought a forward-looking rate is a prerequisite to a successful transition away from Libor and those who did not.

Commenting on the poll results, Thomas Wipf, a Morgan Stanley executive and a member of the Alternative Reference Rate Committee, a US working group convened by the Federal Reserve, suggested that thinking on this has evolved: probably around 90% of the audience would have rooted for a forward-looking rate a year ago, he said. He added that working groups need to dig deeper to work out whether forward-looking rates “are something that’s really needed or something that’s just nice to have over time”.

Jourdain also warned market participants not to rely on synthetic Libor as a way to move from the out-of-favour benchmark.

The International Swaps and Derivatives Association is set to launch a consultation next month to work out the methodology to create a synthetic Libor, which would be inserted into legacy trades via an industry protocol and would kick in should Libor no longer be produced. The rate would be based on the RFRs, with a spread on top accounting for the bank credit spread element present in Libor.

However, the financial industry sees none of the three methodologies set to go out to consultation as perfect. Jourdain said market participants should move off Libor as soon as possible so they do not have to rely on any fallback provisions and potentially lose out in any valuation change.

“What some people hope is that they can deal with the problem by waiting until 2022, using the fallback rate and, by magic, all their exposure gets switched to the RFR,” said Jourdain.

The fallback is a parachute if you’re going paragliding… the fallback gives you survival certainty – it doesn’t give you painless certainty

François Jourdain, Barclays

“The fallback is a parachute if you’re going paragliding. And when you trigger your parachute, when you hit the ground, it hurts. So I think the fallback gives you survival certainty – it doesn’t give you painless certainty. So I’d advise avoiding triggering fallbacks and try to get exposure out the way.”

In the sterling swaps market, transition from Libor to Sonia swaps has been led by liability-driven investment funds, which tend to receive a fixed rate. But, on the other side, there has been little activity from the corporate community, which tend to pay fixed. As a result, the basis between 30-year Libor and Sonia swaps has jumped to 36.8 basis points as of May 29 – more than double the level it stood at before the FCA’s announcement last July that it would allow banks to walk away from the Libor-setting process in four years’ time.

Jourdain said that for a healthy transition the market needs a greater diversity of early adopters.

“We need to make sure that the early adopters are not only the pension fund industry. Otherwise you might have an effect on the market. We also need the other side, the people that need to pay fixed in particular and receive floating, to realise how attractive an RFR-based proposition is,” he said.

One of the hurdles to transition is a lack of liquidity in products referencing new RFRs. Morgan Stanley’s Wipf said the CME’s futures contract referencing the new secured overnight financing rate (SOFR) – the US successor to Libor – has seen good demand since its launch on May 7, but what is needed is more natural hedging demand. He said dealers can help by linking instruments such as floating rate notes, margin loans and repos to SOFR.

“It can be used for things where there’s reasonably short-dated activity, where the modelling is not going to be all that overpowering for the particular assets or liabilities we’re talking about,” said Wipf.

“That’s where there’s a virtuous circle, where there will be a need to hedge followed by some pick-up in activity and an increase in participation,” he added.

Editing by Olesya Dmitracova