Coming at the end of a decade of relentless financial market reform, interest rate derivatives markets’ transition away from Ibor benchmarks has suffered from fatigue.
A lack of enthusiasm for benchmark reform is easy to find in all corners of the rates market. But corporate treasurers have more cause than most to feel dread. As the Financial Conduct Authority’s end of 2021 exit from Libor mediation draws nearer, this section of the market faces sustained upheaval.
Onerous overhauls of accounting systems, understanding the complexities of new reference rates and grappling with the teething problems of new derivatives markets. These are all challenges and costs that are coming down the road fast at corporate treasurers. Many wish that they could just stay put with an Ibor.
“Corporates understand that Libor is flawed, but it is widely recognised and the majority of the time it works for them,” says Sarah Boyce, associate policy and technical director at the Association of Corporate Treasurers in London. “Relatively unsophisticated corporates in particular have struggled to understand why it needed to change at all.”
Libor permeates every corner of a corporate treasurer’s life. Debt instruments and derivatives but also accounting systems, corporate contracts and capital, tax and risk valuation methods.
The scale of rearrangement that corporates will have to undergo to migrate all of these systems and liabilities away from Ibors, which for many has little obvious benefit, has created inertia in the community. But December 2021 is not far away and in derivatives markets especially a lot needs to be done to smooth the unavoidable path to transition.
Interest rate derivatives give firms cashflow certainty when managing their liabilities. So unless their debt stacks reference an Ibor alternative, entering into any Sofr (Secured Overnight Financing Rate — the US’s favoured replacement rate) or Sonia (Sterling Overnight Index Average — the UK’s) derivative contract will create a mismatch.
Europe remains behind the pack, having decided on its replacement rate much later than the US and UK.
Glacial pace
While floating rate bond markets have been absorbing issuance of debt that references the risk-free replacements, loan markets have been moving at a glacial pace. That inertia has carried across to derivatives markets too.
“A lot corporates will not transition until they have all their products available,” says Shaun Kennedy, group treasurer at Associated British Ports (ABP) in London. “Most will get a loan and then hedge it in the swaps market so unless the loan is on a risk-free rate they won’t put on the equivalent swap trade.
“That has held a lot of treasurers back because they want to see those new markets there before they enter into them.”
ABP is an outlier among corporates. It has taken a bold stance on the transition and begun rearranging its debt and derivatives to reference Sonia.
Kennedy’s team has partly managed the derivatives piece by using swaps to manage the basis between Sonia and Libor. Market participants see this mechanism as one of the best ways for corporates to start gaining exposure to new reference rates.
But across the regions introducing risk-free rates, the markets for these products are still often under-developed and expensive to enter into. At this stage in the transition most such trades would be test runs, which make them a hard cost to justify.
“Corporates are happy to try using the benchmark but will ultimately have to hedge that basis between Sofr and Libor because internal reconciliation between the two has to be made,” says Subadra Rajappa, head of US rates strategy at Société Générale in New York.
“So they have to engage in a basis swap to realign their cashflows but there is not much liquidity in the basis swaps that they would use to hedge out the internal risks. So their reticence to use Sofr is understandable.”
Even those treasurers who see value in getting ahead of the curve face a challenge in arguing the case for such derivatives trades to other senior figures in their company. Banks and other financial institutions that operate at the coalface of capital markets may face their own challenges in transitioning away from Libor. But the significance of the migration can be easily drilled into desks across the firm.
In a company that brews beer, makes cars or produces pharmaceuticals, the cost of putting on a basis swap trade can be hard to argue for.
“Taking out basis swaps that will cost money doesn’t necessarily get you brownie points in the board room,” says Boyce. “Another challenge is the need to explain the impact of these changes clearly and simply to board members who may not be finance specialists.
“Some corporates do transact basis swaps and are very active but there are probably only about 12 of them. So yes, some companies are trading basis. That is great. But it is such a small corner of the market, and not indicative of the wider corporate world.”
Meet the new reference rate
The problem of understanding can go even deeper. Ibor benchmarks work for many corporate treasurers. They have used it for many decades and understand how it reacts to moves in market conditions. Sofr and Sonia behave in their own ways, which will take time to understand. Their billing as risk-free rates can also seem misleading. On September 16, Sofr showed that it can be volatile too.
Many corporates were alarmed when volatility hit the US repo markets. Transactions there are data points used to calculate Sofr. The wild price swings were poorly understood, and not just by corporate treasurers. That and the US Federal Reserve’s emergency intervention to backstop the market, cast doubt on Sofr.
“There had been an assumption that the benchmark would transition to a more robust and less volatile rate, however September’s volatility in the US repo market and the resultant Fed actions has shown that may not be the case,” says Boyce. “There is also a degree of nervousness among the older generation that something which works fine when rates are at 1%-2% might show a very different profile when they are at 7%-8%.”
There is still time to build understanding of the new rates and what triggers volatility in them though. While events such as September’s are concerning for the unfamiliar, there are still attractions to referencing a risk-fee rate.
“There have been a lot of conversations about what happened in the US,” says François Jarrosson, director, hedging and derivatives, global advisory at Rothschild & Co in London. “But it is important to remember that although you have bouts of volatility in the repo market, on a three month rolling period Sofr is still less volatile than Libor is. So as a treasurer you are still having a more stable cost of funding using Sofr rather than Libor.”
The repo volatility may even prove a positive in the long run. September’s unexpected market movements suddenly created a real need to hedge. Since then, liquidity has rapidly built in Sofr derivatives. Open interest in CME Group’s Sofr futures grew by 51% in the month following the repo volatility. CME’s CCP cleared a record $6.3bn of Sofr swaps in September.
‘Build liquidity and they will come’
Companies may still be shy of putting on actual trades, especially in the wake of such volatility. But if momentum keeps building in those derivatives, the repo panic may have delivered a boost in building well-traded markets.
The general principle of creating new markets is ‘build liquidity and they will come’. For corporate treasurers, making the jump from Ibors will be made much easier with the certainty that mature alternative-rate markets could give.
“Volatility in the overnight repo rate led to volatility in the Sofr rate and a need from participants to hedge that rate volatility,” says Sean Tully, senior managing director, global head of financial and OTC products at CME Group in Chicago.
“We saw enormous growth in September, with more than 8.5m Sofr futures contracts traded to date. Some 300 participants have traded the futures since launch, and on September 17, a record 153,000 contracts were traded in a single day. Through the month of October, there are nearly 140 large open interest holders, with $1.9tr of open interest.
“That has very significantly grown and the open interest shows these are real end users, not just prop trading firms (which close their positions at the end of the day).”
In the UK, ABP’s Kennedy has also noticed an improvement in the swaps markets that he has used to manage his company’s move away from Libor. Liquidity has built and pricing improved, an encouraging sign for the next round of corporate treasurers entering such trades.
“When we began transitioning our swaps we used one hedging bank for our Libor/Sonia basis swap, which was useful,” says Kennedy. “But some banks were not seeing a lot of liquidity in the Sonia market mainly because it was not something they traded. It was expensive for them to price that basis. By using banks that were more active in the market we could remove a lot of pain from that basis.
“In June we went to do more and the market was very different. Most of the banks were pricing Sonia swaps and Sonia/Libor basis swaps consistently and a lot tighter.” GC
