The wake-up call
The spread between 30-Year LIBOR (London Inter-bank Offered Rate) and OIS (Fed Funds) rates, known as the basis swap has been trending higher for much of the last 12 months. In March, however, this little known and even less frequently traded market sent a warning shot across the bow of every LIBOR-based investor. In one week, the basis spiked by over 10 basis points (circled below).
While most of the flow was driven by a small investor base of levered investors who were trying to exacerbate quarter-end funding stresses in short-term borrowing markets, the impact was felt across all $150 trillion notional of interest rate derivatives (IRD) contracts (including options) that reference LIBOR. The $150 trillion dollar IRD market is further eclipsed by the overall volume (and notional size) of contracts that reference LIBOR (in any form), which is estimated to be more than double. This includes everything from the floating rate loan securities to the massive currency forward market. For this piece, we focus our attention primarily on the IRD usage by institutional investors, including pensions, insurance companies and endowments & foundations, with a particular focus on liability-driven investors.
The alarm clock is buzzzzzzing
The reality of LIBOR cessation is setting in. On December 31, 2021, the Financial Conduct Authority (FCA) will no longer compel participating banks to submit LIBOR quotes in which the market depends on to set the rate. In the meantime, the industry is busy collaborating on solutions for stop-gaps, contingencies and the eventual replacement and transition to a new “reference rate”, but the clock is ticking. The Alternative Reference Rates Committee (ARRC), chaired by the Fed, has decided on a Secured Overnight Financing Rate (SOFR), based on the deeper (more frequently traded) repurchase agreement (repo) market. SOFR was published for the first time on April 4, 2018, and the CME began trading SOFR contracts (similar to Eurodollars) on May 7. Since the inauguration of these new futures contracts, volumes and open interest has begun to rise and their potential as a replacement is promising. However, SOFR has a long way to go to establish enough credibility and serve as a replacement for the vast LIBOR-based market. Due to current regulations and the balance sheet intensive nature of repo financing, a term market (maturity points beyond 1 year) does not yet exist. To eventually trade a 30 year SOFR instrument, market participants will need time to become accustomed to trading before a well-developed forward curve can grow. The transition will be slow and painful but the market will likely migrate toward SOFR over the coming years. While LIBOR has been in place for decades, by the time it is phased out in 2021 SOFR will have had less than 4 years of market experience.
So what do we do in the interim? Even if we assume that SOFR becomes the new reference rate on December 31, 2021, we don’t actually have 3 years. $150 trillion in notional contracts can’t just be adjusted in one day. And how do we handle new hedges that are meant to last through (and beyond) the transition?
“The only reason for time is so that everything doesn’t happen at once” -Albert Einstein
December 31, 2021 is not the real deadline. In anticipation of the deadline, by 2020, the market will begin to shift to a new reference rate. While no one wants to be the first to move to a new reference rate, you certainly don’t want to be the last, or within the last third for that matter. As volumes begin to migrate, the liquidity in the LIBOR-referenced market will decline. Dealers will have little incentive to enter into new contracts using a soon-to-be-obsolete reference rate. Moreover, bid/ask spreads on LIBOR-referenced products will likely be widened to reflect the uncertainty of offloading the risk, the cost associated with novating LIBOR-referenced contracts, and the costs associated with collapsing legacy contracts within the intermediary community.
“The bell tolls for thee” -John Donne
There are many active participants in the IRD markets, but the typical end-user of IRDs (LIBOR swaps) are institutional investors, including pensions, insurance companies and endowments & foundations. With respect to pensions, investors typically maintain a derivatives overlay account in which they receive a fixed swap rate and pay LIBOR to extend the interest rate duration of their assets. This allows them to better hedge the interest rate sensitivity of their long-dated liability cash flows across the yield curve. Underfunded pension plans can take advantage of this market as well without needing a significant cash dollar allocation to interest rate sensitive fixed income assets. In addition to this capital efficiency, the institutional investor community was a big beneficiary of the collapse in LIBOR swap spreads, a privately negotiated spread over Treasury yields, which tightened from 50 basis points above Treasury yields before the global financial crisis to a level of 50 basis points below Treasury yields in late 2016. Similarly, insurers and endowments & foundations also benefited from transformations in the IRD market. Innovation has promoted capital efficiency which has allowed investors to preserve higher returns and introduced new asset volatility hedging approaches in the market, including tail-risk hedging. The risk parity community also uses the embedded leverage in derivatives contracts to balance out their risk profile across asset classes.
Fast forward to today, the average corporate defined-benefit pension plan is approximately 85% funded and approaching an allocation of 45-50% to fixed income with a higher asset duration (which includes an increasing allocation to derivatives as an integral part of the hedging strategy). According to the aiCIO 2017 Liability-Driven Investment (LDI) Survey, derivatives usage by pension investors has increased 126% over the past 3 years. These investors are increasingly comfortable with the benefits of utilizing exchange-traded and exchange-cleared instruments to enhance their hedging programs. Given the integration of LIBOR-based investment products into the pension community’s investment portfolio, it is a fiduciary imperative to search for and implement an alternative to LIBOR in a timely manner.
“Time moves slowly, but passes quickly” -Alice Walker
How do we get from LIBOR to SOFR as seamlessly as possible while remaining cognizant that liquidity in LIBOR-referenced markets could evaporate over the next couple of years? What temporary alternatives are there to hedge investors’ risks against the shift?
These are some factors to consider when deciding on a temporary solution:
Let’s focus on the comparable instruments that can be used. In order to do so, we must first understand the characteristics and benefits of the LIBOR-based swap markets:
Now let’s assess the alternatives to see how they hold up:
“Time Keeps on Slippin’, Slippin’, Slippin’ into the Future” -Steve Miller Band
LDI investors have their work cut out over the next couple of years. As illustrated above, there are no easy solutions. Treasury futures provide a strong alternative given their large liquid market would allow investors to adequately offload duration exposure relative to longer-dated liabilities. However, Treasury futures contracts don’t have the flexibility to be implemented across the full curve and must be rolled quarterly, increasing the governance burden. These contracts also don’t have the desired positive convexity to match pension liabilities, creating a sub-optimal hedge. Anecdotally, some of the swaps duration exposure has shifted to the Treasury futures markets, or more broadly, the U.S. Treasury STRIPS cash markets, where transaction costs and liquidity are higher and lower than futures markets respectively. Smaller trades can still be executed in the nascent OIS or SOFR markets, but unfortunately for many other large investors the more structured OTC markets (total return swaps) are the only other realistic avenue.
The transition away from LIBOR-referencing derivatives is a monumental task and fraught with uncertainty. There is no clear path, except forward. Investors are on the clock and the best approach is to be nimble and have a fluid plan. As the Rolling Stones wrote in the lyrics:
“Hours are like diamonds, don’t let them waste
Time waits for no one, no favours has he
Time waits for no one, and he won’t wait for me”
Establishing a plan early amidst a changing market landscape will help to mitigate some of the volatility over the next two timely years.