- The planned sunsetting of the London Interbank Offered Rate (LIBOR) at the end of this year might disrupt financial markets because of the absence of a clear successor to the reference rate, Fitch Ratings said in a report.
“Many primary markets have yet to start moving away from [U.S. dollar] LIBOR,” Fitch Ratings said, adding that “the switch en masse away from [U.S. dollar] LIBOR without a clear successor may lead to increased rate/market volatility.”
Although the Secured Overnight Financing Rate (SOFR) promoted by U.S. regulators has become “the main successor” to LIBOR in derivatives markets, four other reference rates “are vying with overnight and term SOFR to become successors in cash markets,” Fitch Ratings said.
The Federal Reserve and other regulators in recent years have encouraged financial institutions and corporate treasurers to substitute SOFR for LIBOR, the reference rate for trillions of dollars in mortgages, derivatives, business loans and other financial contracts worldwide.
The regulators have warned that adoption of benchmarks other than SOFR may pose a financial stability risk, noting that the trading volumes that underpin the alternative rates are comparatively low.
Securities and Exchange Commission Chair Gary Gensler has singled out the Bloomberg Short Term Bank Yield Index (BSBY) as an unsuitable LIBOR substitute, saying it is based on weak trading volumes among a group of banks and is vulnerable to manipulation. Regulators began considering a wind-down of LIBOR after a manipulation scandal in 2012.
With BSBY, “like with LIBOR, we’re seeing a modest market, shouldering the weight of hundreds of trillions of dollars in transactions,” Gensler recently said, adding “when a benchmark is mismatched like that, there’s a heck of an economic incentive to manipulate it.”
For more than three decades financial institutions and corporate treasurers have woven LIBOR into a full range of contracts. The widespread, time-tested use of LIBOR — along with mixed acceptance of SOFR and competition from other reference rates — has complicated efforts to ensure smooth adoption of a new benchmark.
“The slow transition from [U.S. dollar] LIBOR to potentially multiple alternative rates for new instruments may increase disruption risk for banks and certain structured finance issuers at the start of 2022,” Fitch Ratings said. “The [U.S. dollar] debt market appears destined toward a multi-rate environment.”
The Fed has told banks not to use LIBOR in financial contracts after a Dec. 31 deadline even though SOFR has yet to emerge as the dominant alternative rate in debt markets. The final fixings for most LIBOR rates — including one-week and two-month U.S. dollar LIBOR — will be made on Dec. 31, 2021, but other U.S. dollar tenors may continue until June 30, 2023.
“Uncertainty around which rate or rates may prevail may reduce market liquidity approaching the deadline as investors perhaps pause new issuance or try different rates until there is consensus,” Fitch Ratings said.
SOFR, while based on high transaction volumes, has not eclipsed LIBOR as a reference rate because it currently lacks some of LIBOR’s appealing traits. LIBOR is derived from London banks' estimates of what they would be charged when borrowing from other banks. The LIBOR rate can be forecast three, six and 12 months into the future.
SOFR is based on overnight repurchase agreements secured by Treasuries and, unlike LIBOR, does not reflect credit risk or expedite the creation of a term structure enabling corporate treasurers and financial institutions to make forward-looking rate calculations.
Some financial markets will be especially vulnerable to disruption at the end of 2021 if no clear LIBOR successor has emerged, Fitch Ratings said.
“Evolving market preferences, competing alternatives and uncertainty around the SOFR term rate means that new contracts and bond issuance that reference alternative rates may only occur in certain markets in a rushed period at, or close to, the end of this year,” it said.