More carrot, less stick in US Libor transition

Risk USA: US regulators take softer approach than UK counterparts

US Treasury
“We’re not in a situation where we’re looking to tell anyone to do anything” – Treasury Department’s Phelan

US regulators are not looking for ways to compel market participants to shift away from US dollar Libor and into the secured overnight financing rate (SOFR), despite the limited amount of trade linked to the new interest rate benchmark. 

Peter Phelan, deputy assistant secretary for capital markets at the US Treasury, is a government member of the Alternative Reference Rates Committee tasked with bringing SOFR into use. Phelan said it was not Treasury’s place to crack the whip. 

“We’re not in a situation where we’re looking to tell anyone to do anything,” he said. “I think it’s clear, given the composition of the ARRC, where we sit as an ex officio member, that it’s a private sector solution that we’re very supportive of, and the industry is doing a really good job of making the transition.”

Phelan was speaking at the Risk USA conference in New York today (November 8). 

Others agreed. Matthew McCormick, a research economist at the Treasury’s Office of Financial Research, said it wasn’t certain that regulators could force the market even if they wanted to. 

“We’ve not sought to use any regulatory tools and it’s unclear that there are those tools available to force adoption – we have freedom of contract in this country,” said McCormick. “You might be sued if a contract is not the right fit, but that’s a civil law issue, not a government issue.”  

That tone was in contrast to signals emanating from the UK, where the Financial Conduct Authority – the regulator that oversees Libor – has been busy prodding the firms it regulates to move on. 

The FCA and the Prudential Regulation Authority recently wrote a letter to the chief executives of the major banks and insurers they regulate asking what action they have taken to move away from Libor. Some in the industry believe the letter – which also instructed banks to quantify their Libor exposures – could be a precursor to the imposition of so-called Pillar 2 capital charges, those levied by a domestic supervisor to cover risks ignored by international capital standards.

Andrew Bailey, head of the FCA, has also said the agency could kill off Libor, if necessary. 

Roy Choudhury, a partner in financial services advisory at EY, commented: “I think the regulators are looking for the industry to prepare for the scenario where Libor is discontinued.” 

In the US, the move to wean the market off Libor relies on getting increased volume in contracts using the new rate. Issuance of floating rate notes from institutions such as the World Bank and Fannie Mae using SOFR has seen outsized interest from investors; swaps linked to the new rate, however, have been limited. 

According to data from the International Swaps and Derivatives Association, year-to-date traded notional of SOFR is just $3.7 billion, while US dollar Libor towers over it at $96 trillion. 

But the shift could be hastened by regulatory intervention.

“By 2021, if the adoption rate is slow, regulators can actually set some deadlines for at least the entities that they regulate to adopt the new benchmark,” said Subadra Rajappa, head of US rates strategy at Societe Generale. 

“We have moved so fast through the paced transition plan and we’re ahead of schedule, so there hasn’t been a need for a stick,” said Blake Gwinn, a rates strategist at NatWest Markets. “But if you did approach that potential cutoff date and there hasn’t been any adoption, then that’s really when you start considering whether there’s an approach that is necessary.”

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