Libor Replacement Grinds Forward After Virus Spotlights Flaws

(Bloomberg) -- Upheaval in funding markets over the past month has underscored the importance of shifting from Libor to a new benchmark rate -- even as the spreading coronavirus pandemic acts as a potential obstacle.

The group that’s guiding the transition to the new Secured Overnight Financing Rate -- the heir presumptive in dollar markets to the London interbank offered rate -- revealed a framework on Wednesday for moving cash products from the old to the new benchmark. The update from the Alternative Reference Rates Committee, a body convened by the Federal Reserve, came as a reminder that work on SOFR is progressing ahead of the official end-2021 deadline to phase out Libor. That’s despite doubts about whether this timeframe is feasible.

The latest bout of volatility has helped draw attention to some of the existing benchmark’s flaws. Libor remains elevated despite the Fed’s efforts to ease pressures at the heart of the financial system. The central bank’s actions have stabilized rates on secured lending, but pressures remain elsewhere.

The behavior of Libor rates over the past three weeks shows that they have “completely decoupled from everything else,” said Tom Simons, a money markets economist with Jefferies.

Libor, which is derived from a daily survey of large banks on how much they would charge to lend to one another, is responding to credit-risk catalysts such as outflows from prime money-market funds. The three-month rate for dollars took flight in the middle of March even as the Fed slashed its target for interest rates to almost zero. It hit a peak of just over 1.45% in late March and is still elevated at around 1.31%.

Libor’s shortcomings are well-documented, with the manipulation scandal that followed the 2008-2009 financial crisis sparking a movement to replace it. That said, SOFR’s drawbacks are also widely acknowledged, with critics arguing that it is useful for the benchmark lending rate to include some credit component for hedging purposes, and to have a term structure. Some smaller banks have also raised concerns with regulators about the new benchmark.

Negotiations around objections to the new rate continue, but the ARRC’s statement this week suggests the process should remain on track. The committee’s framework for calculating the basis between the Libor and SOFR rates uses a five-year history of the difference between the two. For consumer products, it’s also advising a one-year transition period to this adjustment methodology.

Work Continues

“Work around the transition away from Libor continues despite the Covid-19 disruption,” said Gennadiy Goldberg, a rates strategist with TD Securities. “With the spread adjustment methodology now finished, I think the onus falls on market development and increasing the use of SOFR in consumer products.”

Goldberg expects the U.S. Treasury to launch its inaugural SOFR-linked floating-rate notes this year to help fund ballooning deficits associated with the government’s rescue package for the U.S. economy.

Meanwhile, U.S. agency debt issuers last month provided a boost for the new benchmark, with an explosion in sales of SOFR-tied notes. Total issuance for both SOFR- and Libor-linked agency debt came in at $143.2 billion, well above the $29.2 billion monthly average seen since the beginning of 2019 through the end of February of this year. Even more notable: 98% of that total was benchmarked to SOFR, far higher than the 44% average over the same period.

Click here to read more on growing agency-debt issuance.

“Issuers, seeing what has happened, have incentive to focus on SOFR as a funding mechanism rather than Libor,” said Ian Burdette, managing director at Academy Securities.

©2020 Bloomberg L.P.