The LIBOR endgame - term rates in the spotlight

Published

May 2023

As the final transition from USD LIBOR looms, progress seem to differ between asset classes. While the derivatives market’s transition has benefited from strong leadership from the International Swaps and Derivatives Association (ISDA) and impacted exchanges, the cash market’s transition from LIBOR is moving slower due, in part, to the complexities around the broad range of trading parties and the fragmented standards in contracting.

At the end of 2020, it was estimated that over US$70 trillion of USD LIBOR exposures would remain outstanding beyond June 2023, with 90% of the exposures being in derivatives1. Despite the large amount of outstanding derivative contracts, fallback protocols and transition plans have been largely mapped out or implemented by ISDA for OTC trades and by individual central counterparty clearing houses (CCPs) for exchange-traded derivatives. The adoption of the new alternative risk-free rate (RFR) among derivatives trades also significantly improved over the year, with the ISDA-Clarus RFR Adoption Indicator rising from a monthly average of 16.4% in 2021 to 45.3% in 20222.

Meanwhile, outstanding LIBOR contracts in cash products are relatively limited, with an estimated US$2 trillion of bonds and securitisations, US$2 trillion of business loans, and US$1 trillion of consumer loans expected to be outstanding beyond June 20233. Although the exposure is relatively smaller than derivatives, remediation plans do not appear to be as straightforward for cash products.

The challenge was reflected in Asia-Pacific markets. In Hong Kong, where HK$2.1 trillion and HK$0.6 trillion of the banking industry’s assets and liabilities still referenced LIBOR in the end of December 2022, 24% of these LIBOR-linked assets and liabilities were yet to incorporate adequate fallback and other transition arrangements. This compared to just 1% out of HK$21.1 trillion of outstanding LIBOR-linked derivatives contracts4.

In Japan, 45% of the outstanding USD LIBOR asset and liabilities including loans, bonds and insurance products had not incorporated fallback provisions, compared to 33% of outstanding USD LIBOR-linked derivatives as of end-December 20215.

The delay in transitioning cash products like loans was partly due to customers wishing to assess the interest rate situation while trying to reach an agreement among many contracting parties.

Another challenge lies with the Secured Overnight Financing Rate (SOFR) being the chosen replacement rate, which unlike USD LIBOR, is an overnight transaction-based rate that is published only in the next morning. Market participants used to be able to know in advance the actual amount of interest to be paid with LIBOR’s long-established and forward-looking term structure, but trading parties lose that ability when their contracts are linked to SOFR compounded in arrears.

Some market participants have turned to SOFR Term Rates, such as ICE Term SOFR, creating a term structure based on SOFR future and swap markets. This means the reliability of the SOFR term structure depends on the depth and liquidity of the compounded SOFR-based derivatives market.

However, as more cash products are linked to a SOFR Term Rate, there is also growing interest in derivatives linked to a SOFR Term Rate. This has created some concern that volumes would diverge from the underlying compounded-in-arrear SOFR derivatives markets that are relied on to construct the SOFR Term Rate6.

Subsequently, the Alternative Reference Rates Committee (ARRC) issued a document that advised against using SOFR Term Rate for the majority of derivatives markets, except for end-user facing derivatives intended to hedge cash products referencing SOFR Term Rate.

While the ARRC believed this could protect the depth of SOFR derivatives transactions, some market participants believe the restrictions are no longer necessary with the underlying derivatives market being sufficiently liquid.

The restrictions also led to emergence of different basis risks. According to a research paper by Bank for International Settlements (BIS)7, there are at least three types of new basis risk being introduced by the transition from LIBOR to RFRs. The first type of new basis risk stems from the difference between RFR in arrears and in advance. RFR in arrears uses overnight rates prevailing during the current coupon period, whereas RFR in advance compounds past daily overnight rates.

The second type of new basis risk arises from the difference between term RFR and RFR in arrears. In contrast to the backward-looking nature of RFR in arrears, term RFR is a forward-looking rate based on RFR derivatives such as futures. The basis between term RFR and RFR is therefore related to the premium.

The third type of new basis risks stems from the difference between credit-sensitive term rates and RFR. This basis is related to the evolution of banks' term funding costs. The credit risk component of the basis is typically positive and spikes in stressed periods.

Following the increased use of Term SOFR rates in business lending which led to dealers taking on basis risks, the ARRC recently revised its recommendation by indicating it believes it acceptable for end users to enter into Term SOFR-SOFR basis swaps even when they are not hedging Term SOFR cash assets8. This offers an additional channel for dealers to shift some Term SOFR risks to other market participants. Nonetheless, the ARRC continues to recommend that interdealer trading of other Term SOFR derivatives, such as Term SOFR basis swaps, be limited, and the FSB has endorsed this recommendation.

Japan, which has successfully moved away from JPY LIBOR, which ceased on December 31, 2021, may offer some insight into a world without restrictions on the use of term rates.

Japan’s benchmark committee has recommended the fallback provision for JPY LIBOR-linked loans and bonds with a waterfall structure prioritising TORF (Tokyo Term Risk Free Rate) but contracting parties would not be precluded from using alternatives. Users are free to choose from TORF, TONA (Tokyo Overnight Average Rate) compounded in arrears and TIBOR (Tokyo Interbank Offered Rate) according to their characteristics and needs9.

The recommendation by the Cross-Industry Committee on Japanese yen Interest Rate Benchmarks resulted in a shift to TORF for many existing contracts, in particular subordinated loans. However, there are no known bonds referencing TORF as participants are still observing the liquidity of TORF swaps. At the same time, the absence of central clearing process for such swaps is limiting their widespread use. This quickly turns into a chicken-and-egg problem, which shows that even markets without restrictions can face challenges in building liquidity in the term rate.

Nonetheless, the execution of TORF swaps were seen in some customer transactions and a growing market interest in boosting their liquidity is expected to improve the quality of TORF. It is believed that an increase in outstanding cash instruments and trading of cap/floor instruments will eventually lead to greater trading volumes for TORF swaps10.

The market sentiment and regulatory approach in Japan is very different from the U.S., which is reasonable given the two markets are inherently different, such as the range of fallback options available, trading volume, risk appetite and the prevalence of electronic transactions. Despite these differences, one commonality is the solid demand for term rates in the loan market. Ultimately, it is about striking a balance between guarding the robustness of the risk-free rates and accommodating a sustainable hedging environment for term rate-linked cash products.

1Financial Stability Board. Progress Report on LIBOR and Other Benchmarks Transition Issues - December 16, 2022

2International Swaps and Derivatives Association. Transition to RFRs Review: Full Year 2022 and the Fourth Quarter of 2022 - January 23, 2023

3FSB Progress Report.

4Hong Kong Monetary Authority - Reform of Interest Rate Benchmarks

5Financial Services Agency and Bank of Japan. Key Results of the Survey on the Use of LIBOR - March 31, 2022

6Alternative Reference Rates Committee. ARRC Best Practice Recommendations Related to Scope of Use of the Term Rate

7Bank for International Settlements. Interest rate basis risks in the Libor and RFR worlds - December 5, 2022

8Alternative Reference Rates Committee. ARRC Issues Summary and Update of its Term SOFR Scope of Use Recommendations - April 21, 2023

9Banks of Japan. Bank of Japan Review. Review of JPY LIBOR Transition and Future Initiatives - May 2022

10Quick Expanding TORF Usage - a Smooth Transition from LIBOR in Japan - May 31, 2022