The Future Without Libor, Part I: Transition Framework for Derivatives

Many investors wonder what will happen in their portfolios following the retirement of Libor as the predominant floating-rate benchmark index. The derivative industry, including investment managers, is preparing for the transition, though uncertainties remain.

Many investors wonder what will happen in their portfolios following the retirement of Libor as the predominant floating-rate benchmark index. The derivative industry, including investment managers, is preparing for the transition, though uncertainties remain.

(Background: Libor, short for London Interbank Offered Rate, is a widely used benchmark for floating-rate and short-term investments. The index is administered by ICE Benchmark Administration (IBA) and provides an indication of the average rate at which panel banks can obtain unsecured funding. After problems with Libor arose during and after the global financial crisis, the U.K. Financial Conduct Authority (FCA), which regulates the IBA, announced in July 2017 that it would eventually stop sustaining Libor. Since then, market participants and policymakers have started work on transition plans and developed or identified alternative rates.)

In the derivatives market, ISDA (the International Swaps and Derivatives Association) solicited feedback from the market via public consultation on a transition approach for non-U.S.-dollar (USD) currencies. With the results of the consultation published in late 2018, ISDA expects to produce a complete methodology this summer for the Libor spread adjustment along with supplemental consultation for USD-denominated derivatives. The approach ISDA is developing would allow for derivatives to fall back to alternative rates, such as SOFR (the Secured Overnight Financing Rate, published by the Federal Reserve Bank of New York). We believe if derivative markets adopt alternative “risk-free rates,” it will help smooth the way for other markets and other currencies.

Transition methodology for derivative contracts

As described in our last update, in 2018 ISDA solicited feedback from global financial entities on an optimal, realistic approach for derivative contracts that reference certain non-USD interbank rates to handle a discontinuation in Libor. Based on the feedback, ISDA plans to utilize a backward-looking, compounded-in-arrears approach for determining a construct of the alternative risk-free overnight rate covering a specific term (time period). To adjust for Libor’s credit component, a static spread adjustment would be applied to the compounded risk-free rate, which would be informed by the historical realized difference between the rates.

This summer, we expect ISDA to publish the exact calculation methodology for the static spread adjustment. Although the FCA has stated it will compel panel banks to support Libor until the end of 2021, it is possible Libor will continue to be published beyond that date, and if so, the ISDA spread calculation will incorporate the realized differentials until a formal announcement of discontinuation at a later date.

SOFR-indexed futures and swaps

The derivative infrastructure that was put in place during 2018 to support market liquidity for SOFR in the U.S. has supported increased trading in futures and overnight index swaps referencing SOFR. Futures contracts offered by the Chicago Mercantile Exchange (CME) on compounded SOFR rates exceeded 100,000 contracts in open interest, with similar volumes continuing this year. At this time, liquidity in swaps linked to alternative reference rates remains fairly limited, but is gradually increasing.

Although activity has been less robust in derivatives linked to SOFR relative to derivatives linked to Libor, future growth in trading liquidity should inform longer-horizon market expectations for SOFR. We expect that liquidity could increase in 2020 after central counterparties (CCPs) switch to discounting of all USD-cleared swap cash flows with the SOFR rate, as outlined in the ARRC transition plan. (ARRC is the Alternative Reference Rates Committee at the New York Fed.)

Necessary precondition

In our view, SOFR derivative liquidity is a necessary precondition to an expanded use of SOFR in other markets and products. Derivative markets provide both a view into market expectations for the level of SOFR rates in the future and a mechanism for hedging SOFR-related risks. At PIMCO, we will continue to monitor derivative market developments in SOFR as a key indicator of the trajectory of the transition process.

Read our companion blog post on how short-term markets are transitioning away from Libor.


The Author

Jerome M. Schneider

Portfolio Manager

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The "risk-free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

A derivative, such as a futures contract, forward contract, option or swap, is a security whose price is dependent upon or derived from one or more underlying assets; the derivative itself is merely a contract between two or more parties.