LIBOR reform – valuations and risk management

Moving to risk free rates will be operationally complex and time consuming, demanding a coordinated effort across multiple teams and departments against a tight timeframe.

After exploring the scale and challenge of change in my first and second blogs on LIBOR reform, this time I delve into more detail around around valuations and risk management.

Dimensions of choice

The type of Risk Free Rate (RFR) chosen (whether secured or unsecured) for each currency and the indicative timelines aside, the ability actually to trade such instruments depends on creating a term structure that captures the credit risk element of the counterparty and on the liquidity of the surrounding market.

Liquidity

Without liquidity, both term structure and credit spread risk become meaningless. Given all RFRs will be overnight, creating an effective RFR relies heavily on term liquidity being built into RFR swaps, as well as LIBOR-RFR basis swaps, in order to create a forward term structure.

Liquidity is also important for fall-back rates, as it helps price a forward spread onto an RFR for inclusion in a new rate.

The conundrum then becomes how to create a term structure across currencies without sufficient liquidity in the market? Historical time-series data for many (if not all) RFRs is limited. Basing a forward curve on a limited dataset may not only cause valuation discrepancies, but also fail to take into account how spreads could behave in a time of stress.

Finding answers necessitates talking a look at how well markets have embraced RFRs since they went live; in particular, those where activity now exists.

SOFR

Liquidity has progressively been gaining ground for SOFR (Secured Overnight Financing Rate – the US alternative to LIBOR). Since its debut almost six months ago, futures have launched in Chicago, swaps are being cleared in London and about half-a-dozen issuers have sold debt linked to this benchmark. LCH cleared the first exchange traded SOFR swaps on July 16th ahead of the CME in September. On the 20th of August, Credit Suisse became the first bank to issue debt linked to SOFR by selling a $100M 6-month certificate of deposit issued debt tied to SOFR.

But there is still a long way to go.
Volumes and open interest in derivatives products indicate the market is still highly illiquid. Given its infancy, SOFR has also proven more volatile than LIBOR; more susceptible to price swings tied to treasury-bill issuance and to month- and quarter-end supply variations.
What is also noticeable is that, given the impeding timelines, firms remain hesitant to commit to SOFR, most probably because of continuing uncertainty as to whether LIBOR will actually be retired beyond 2021.

SONIA

Like SOFR, since its inception SONIA volumes have shown promising activity quarter-on-quarter, although this has not coincided with a corresponding decrease in LIBOR swaps volumes. As yet, there is little evidence of a transition from sterling LIBOR to SONIA swaps; if there was, we would see flat or falling LIBOR swap volumes.
As promising as SONIA looks, volumes across tenors still have a way to go, which means SONIA may also continue to be more susceptible to larger swings than LIBOR in the near term. So why would participants make the transition sooner, rather than later?
  • First, most LIBOR-based loans and derivatives have relatively short durations, and, as previously mentioned in my previous blog on LIBOR reform, approximately 80% will expire by the time panel banks are free to abandon LIBOR at the end of 2021. Fewer should remain outstanding, providing no new trades reference LIBOR meanwhile.
  • Second, as the scale of the task becomes clear, concerns are emerging over RFRs’ impact on areas such as risk management and pricing. Making the transition from LIBOR to a new RFR requires change to an institution’s many databases (either amended or newly created) and multiple IT systems, right through to reporting solutions – and that’s not including the multiple departments with indirect exposure to LIBOR.
  • Third, LIBOR is also integral to risk management. The methodology for how curves are constructed for pricing models will filter through to margining and settlements all the way to regulatory capital and CVA. All processes around payments, settlements and calculations will need to be able to address and reconcile new flows and new rates.
All this is before you start to think how these instruments should be traded or hedged. Preparation is needed around how to apply RFRs for valuations and forecasting. This will require new forward-looking curves to be developed and compounded. And, while liquidity is low, any gaps across the term structure will still require some form of interpolation.
We’ll examine the methodologies for building a forward term structure elsewhere, but proposals to date (SOFR) have been focused on three approaches:
  1. Bootstrapping
  2. OIS transaction bases
  3. Actionable market quotes

 

While this is all early stages, it’s yet another reason why participants should start making the transition now.

What does the future hold?

For those banking on LIBOR being alive and well beyond 2021, this too will create its own issues, particularly given LIBOR and RFR-linked instruments may need to exist side-by-side while model developers consider not just one or two rate curves but rather three (RFR, LIBOR and OIS), as well as the basis in between each pair.

The above factors alone mean the transition to a new RFR will be operationally complex and time consuming. For many, that transition will require a coordinated effort across multiple teams and departments. Add to this the impending timelines and it’s no surprise that the topic of transition continues to grab market attention.
Next time in this series on LIBOR reform, I’ll focus on credit spread risk. Meanwhile, you can read my previous blogs on LIBOR reform:
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About the author

Paul Dobbs

Managing consultant

I help banks move from regulatory box ticking to producing highly optimised frameworks on workflows, processes, technology and people.