New year resolutions – Transition planning and implementation

New year resolutions – Transition planning and implementation

Mark Cabana, head of US rates strategy at Bank of America, discusses key developments in benchmark reform, and the strategic, operational and technological challenges involved in the Libor transition

What does the outcome of October’s central counterparty (CCP) discounting switches tell us about the outlook for secured overnight financing rate (SOFR) liquidity?

Mark Cabana, Bank of America
Mark Cabana, Bank of America

Mark Cabana: The switches have generally been positive for SOFR liquidity. We’ve seen a continued increase in open interest in SOFR futures and continued activity in the SOFR swaps market. That’s an encouraging trend. The discounting change seems to primarily have given a boost to SOFR derivatives liquidity. However, I’m sceptical that liquidity will convince participants to use SOFR more broadly. To take it to the next stage you need to see more widespread marketed options for SOFR and lending products. It is hoped the market will move more in that direction in 2021, but banks are reluctant to use SOFR because of inherent characteristics such as it being an overnight index, not having a term structure and lacking a dynamic credit-sensitive component. 


What efforts are currently under way to apply SOFR discounting in bilateral markets? 

Mark Cabana: The market wants to have uniformity over discounting practices. My sense is that the process will go forward; however, discounting is not enough. The only real hedgers for discount risk are the dealers, not the end-users or clients. So having discounting in cleared or uncleared products may not be enough to convince the market it needs to embrace SOFR more widely. 


What do you see as the main pros and cons of signing the International Swaps and Derivatives Association’s (Isda’s) fallback language protocols?

Mark Cabana: The approach is very reasonable and provides uniformity across contracts so there are more pros than cons in having a market standard. Some participants may be worried that the fallback in the underlying instrument they are trying to hedge does not match with the suggested fallback but, by and large, the market wants uniformity and Isda’s language provides that in a sensible way. 


“Libor will be going and you need to take that very seriously. You need to understand what your exposures are, whether or how you are willing to adjust them and the fallback language you will use”
Mark Cabana, head of US rates strategy, Bank of America

Does the ongoing debate over ‘tough legacy’ contracts mean a multitrack timeline for Libor’s cessation is inevitable?

Mark Cabana: Yes, it is inevitable – it is very likely we will see key tenors in USD Libor running on a different timeline to other instruments. Since ICE Benchmark Administration’s announcement, clients have welcomed the change but tend to think an even longer extension may be necessary. The multitrack timeline is necessary, but raises questions about what the official sector was doing and how it was guided previously. It’s a big change in direction for the official sector and challenges the credibility of the guidance. They had one very clear function and were saying that, no matter what, the deadline would be the end of 2021, but then changed course very abruptly. It leads you to question how certain you can be about other announcements and why the process has been inconsistent.


How is transition faring in non-linear instruments such as swaptions? What additional hurdles do these markets face? 

Mark Cabana: The non-linear space is doing its part but the linear space is more advanced. The swaptions market has additional room to keep growing its product offerings and having the market more fully embrace SOFR for new instruments. But there lies the challenge because, until you have a more liquid futures market, until you have more products that need hedging, developments in the swaptions market will be limited by the tepid embrace we have seen for SOFR in other markets. 


What would you recommend as new year resolutions for those lagging in transition planning and implementation? 

Mark Cabana: Libor will be going and you need to take that very seriously. You need to understand what your exposures are, whether or how you are willing to adjust them and the fallback language you will use. You also need to keep track of the evolving guidance from the official sector. Will Libor die by mid-2023 or won’t it? Keep an eye on what is happening with the so-called legislative solutions and ‘synthetic Libor’ developments. There are still big questions to unfold, which makes planning very difficult. 

The official sector also needs to make some resolutions. It needs to make some firm decisions and offer concrete guidance. It must decide when Libor will die and make clear why. Tell us the extent to which participants should believe in a legislative solution or a synthetic Libor adjustment. How hard is the official sector going to fight for them and at what point should participants abandon hope for those things? 

The whole process has been shrouded in hypothetical scenarios. Libor may go away, but it may not. We may get a legislative solution or we may not. Synthetic Libor in the UK may be applicable for other currencies or it may not. Start providing some hard guidance, instead of continuing to live in a hypothetical world. Even if the market doesn’t like the decisions that are made, it will at least respect them. They’ve already moved the goalposts once, and they’ve moved the goalposts after saying they wouldn’t be moved. What bothers those in the market is that there is still so much that is unknown. It would help if we could narrow the range of outcomes and plan around something that is more definitive. 

We all know Libor will eventually die, but the risk-free rates may not be the ones the market chooses. Regulators can’t force it. So what will the market look like if you have a multiple-benchmark world including credit-sensitive indexes? The market has not embraced SOFR for various reasons. The market wants something like Libor, but without subjective judgement, and the sense is that the market tends to get what it wants. The official sector can’t continue to lead with hypotheticals. A multiple US dollar benchmark world may hamper liquidity but it will likely lead to better outcomes for the market.


Libor Risk – Quarterly report Q4 2020
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