Libor exposures set to continue into 2022 as shift to risk-free rates proves slow for investors

While a vast majority of interdealer contracts have moved to Sofr, this movement has not made its way to end users, warns Bloomberg’s Bullock

by | November 2, 2021 | bobsguide

While market liquidity keeps building up for Sofr-referenced contracts, a majority of market participants will still hold Libor-based exposures at Libor’s cessation, as the shift towards alternative risk-free rates is proving slow to filter through to end users.

A survey conducted by Bloomberg and the Professional Risk Managers’ International Association (PRIMA) found that 72 percent of firms will “definitely” or “probably” hold Libor-based derivatives at the start of the new year. Most firms (80 percent) do however have a transition plan.

“The clear message from both the US and the UK official sectors has been that it’s better to not have any Libor exposure after the end of the year, than to have Libor exposure and rely on fallbacks,” Ben Bullock, interest rate derivatives product manager at Bloomberg, told bobsguide.

“Actively re-papering your portfolio into alternative reference rates is deemed by the official sector to be the preferable course of mitigating Libor-based risk.”

December 31 2021 will mark the end of sterling, yen and Swiss franc Libor as representative rates. Following cessation, a synthetic Libor rate for certain sterling and yen tenors will continue to be published in 2022. In the US, official guidance states there should be no new Libor trading after December 31, but USD Libor will continue to be published until June 2023.

To help avoid cliff-edge effects and draw down Libor exposures, regulators have been actively urging market participants to transition to risk free rates (RFRs). To move derivatives markets, the CFTC has pushed a “Sofr/RFR first” initiative, based on the UK’s Sonia first approach.

Interdealer linear swaps and cross-currency swaps using USD, sterling, yen and franc have already transitioned to using Sofr. On November 8, non-linear derivatives will also transition to Sofr.

“These convention changes occurred smoothly and engendered a sustained shift from USD Libor to Sofr in interdealer markets,” said Nathaniel Wuerffel, senior vice-president of the NY Federal Reserve, in remarks given at an ISDA conference last week.

“We estimate around 80 percent or more of interdealer linear swaps risk is now linked to Sofr, a notable shift in a market that was previously almost entirely USD Libor-based. By some measures, the switch from USD Libor to Sofr in interdealer cross-currency swaps has been even more successful.”

However, while Sofr liquidity and use is heading in the right direction, Bullock said this movement has not made its way to end users, who are still relying on Libor.

“There’s an important distinction between the interbank dealer-to-dealer market and the dealer-to-client market,” he said.

“The Sofr first initiative certainly saw quite a significant increase in linear dealer-to-dealer, interbank market flows. However, there’s certainly more work to be done when it comes to the dealer-to-customer, with a significant portion of customer flows still being USD Libor-based.”

Cash and loan market

The cash and lending market has been slower to transition away from Libor, given the fact that Sofr is an overnight rate. But with the formal recommendation of term Sofr by the ARRC, Wuerffel said the market is now making steady progress.

“The ARRC’s recommendation of Sofr term rate is a key transition tool for the loan markets, where moving from USD Libor to an overnight rate has been difficult and a forward-looking term rate can help overcome those challenges.”

“In cash markets, we are seeing progress in the transition from USD Libor as well. In floating-rate notes and consumer lending products, USD Libor use has significantly declined and Sofr is well established.”

More work still needs to be done however, in transitioning legacy contracts within this market, said Bullock.

“The type of fallback language [in those markets] can range from having no fallback language at all, in one end of the extreme, to the other end where those loans and bonds might have ARRC-endorsed fallback language.”

He added that the responsibility of mitigating Libor risk included all parties but that corporates cannot simply wait for their banks or other counterparties to make the first move.

“Corporates might expect their counterparties to reach out to them to talk about their Libor exposure. However, the decision processes are still owned by corporates themselves and they need to take steps to mitigate that exposure.”

Bullock sentiments were echoed in Wuerffel’s advice to the sector.

“The responsibility lies with you to act now to make this transition successful. Be ready for the end of Libor. Proactively slow new use of USD Libor so you can safely meet the year-end supervisory deadline.”

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