by Jess L.
We are thrilled to introduce Jess L. as a new contributor to RIA. Jess started her career nearly two decades ago as a market maker at Goldman Sachs, followed by a stint at Merrill Lynch. After that, she moved over to the buy-side as a Portfolio Manager at Caxton Associates before ending her career at Millennium Partners. Throughout her career, she has had the opportunity to trade a number of different asset classes, but the one nearest & dearest to her heart is the front-end of the USD rates curve. She now lives in Malibu with two children, adoring husband, and border collie – Rosie.
Follow Jess on Twitter at @MacroMorning
The fate of LIBOR is likely to precipitate one of the largest one-off structural changes to the interest rates market in our lifetimes. Regulators are growing increasingly concerned because we’re ill-prepared for what comes next. Thus, more ad lib experimentation by policymakers.
It’s a tectonic shift in a $400 trillion+ market.
On Monday, New York Fed President John Williams gave a speech entitled “LIBOR: The Clock is Ticking” to address the ultimate liquidation of a ubiquitous benchmark rate. He summed up the motive behind invoking time-bomb imagery as follows.
“Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.”
Here’s what you need to know
If nothing else, there are really just a few take-away bullet points.
The shift from LIBOR to SOFR rates is happening & has massive implications.
The fate of benchmark rates will be driven by events such as last week’s move in repo. The Fed’s decision to embark on OMOs will extend far beyond October for a number of reasons. Key among them? Protect the sanctity of the incoming LIBOR replacement.
We’re talking about $400 trillion.
What’s $400 trillion between friends?
400 trillion is such a large figure, it’s really, really difficult to conceive.
Imagine human beings began counting to 400 trillion around the time of the first discovered form of writing (about 32 centuries ago). A weary descendent today would be still counting… with 99.75% remaining.
If (in a more financial, but equally less pragmatic way) you were somehow able to cover the surface of the Earth in gold plating a meter thick, $400 trillion would get enough gold for a second copy as well – and then some.
If (while recreating a cult movie classic) you spent $400 trillion on gas, you’d have enough to drive the distance from here to Alpha Centauri – and back. About 40 times. In a Winnebago.
But perhaps that’s because we’re using the wrong yardstick, using as a basis for comparison concepts that are familiar to us in our daily lives. If we change dimensions, the idea of such a quantity becomes a little easier to picture.
If every neural synapse in the brain cost $1, $400 trillion would get you only enough for a typical NFL Quarterback. Though to be clear, in the case of the Jets, we’d be talking about Ryan Fitzpatrick – not, y’know… anybody else.
Spend a dollar programming every possible chess combination into a supercomputer? You’d only have enough for an opening of four moves (a “Fool’s Gambit” if you reach checkmate).
And if you tallied up the total notional outstanding of interest rate derivative contracts that are about to be significantly altered by coming benchmark reform… well, that’s why we’re here, you’d have about $400 trillion.
It’s a huge number, even in the scheme of other large markets outstanding. And it’s due to be transformed – one might argue – beyond a shadow of its former self.
It’s (still) all about funding markets
During last week’s repo debacle, here’s how the replacement for LIBOR did (more on the distinction between these two lines below):
Lest you think I’m cherry-picking by showing an overnight rate versus a 3-month tenor, take a look at what the “overnight” LIBOR rate did by comparison. The relative shock wave is of similar magnitude.
Now, in order to combat these types of violent moves, the Fed has embarked upon a series of Open Market Operations (OMOs) to provide funding from now until Thursday October 10th. But if you think this all ends on that date, you haven’t been paying attention.
Last week, ISDA released their final consultation on the remaining thorny issues to be hashed out regarding fallbacks – with responses due from participants no later than October 23rd.
In other words, this is an issue that is very much front & center – now.
Making LIBOR Great Again
The saga around “the end of LIBOR” aka Benchmark Reform has been ongoing for nearly a decade. Really ever since regulators determined that “asking a cabal of bank executives who could pick up a phone call from their trading desks what they’d like the daily rate to be…” underpinning the largest derivatives market in the world left open a little room for bad actors to operate. LIBOR (the “London InterBank Offered Rate”) needed to be replaced. And the replacement would need to be something that was observable & representative of conditions in money markets.
Enter SOFR – the Secured Overnight Financing Rate.
This isn’t the place to get into the minutiae around LIBOR vs SOFR, but a basic understanding is important. LIBOR is a “forecast of unsecured funding” and SOFR is an “actual measure of secured funding”. In other words, the key is that LIBOR is only a guess at where you could borrow without having to provide collateral and SOFR is where the borrowing actually gets done that’s collateralized by US Treasuries. I’ve included links at the bottom of this article & an excellent series of blog posts on the topic, here & here.
Secured vs Unsecured
You might assume that the SOFR rate (in which you provide collateral) is always lower than the LIBOR rate (in which it’s just based on a bank’s estimate of where they could get funding, based on nothing more than a promise to return it). And, of course, because this is the world we live in – you’d be wrong.
One has to be a little cynical (or at least an active trader in today’s paradoxical market) to grasp the distinction. Banks never want to admit that funding is scarce or that they’d have a tough time tapping capital markets. Bank stocks don’t tend to like that sort of admission. So, forecasts are based on an information waterfall that, as best as we can tell, is “where have things been recently?”
PM: “Wherefore art thou Libor?” 6/28/2019
On the other hand, collateralized funding is not exactly the cheap source of financing you might have thought. Banks already have plenty of what you’re trying to offload in exchange for the cash: collateral. Much of this, however, is required due to the increase in considerations around capitalization post-crisis. Increasingly, it’s due to the fact that the Treasury is aggressively ramping up debt issuance.
Why this becomes problematic is the fact we’re whirling further & further into an environment where oversupply of collateral is causing these rates to become more & more volatile – see the most recent episode for a point of reference.
To say that last week’s repo debacle was precipitated by either the KSA or by the timing of corporate taxes & bills supply is a little like saying World War I was caused by Gavrilo Princip. Yes, that’s true – but the conditions had to be right & the stage appropriately set.
It’s a bit like the grade school chemistry lesson where you drop additional solute into an already supersaturated solution:
But, this is what regulators have decided we’re going with & we’re a few details away from getting a complete picture of what LIBOR’s replacement will look like.
Back to the future, part 1
Accordingly, efforts have been made to reduce the type of noise we saw last week. Regulators were aware of the fact this could happen well in advance.
For example, what was previously “3-month LIBOR” (i.e. the trimmed mean of daily bank estimates of where they could borrow unsecured cash for 3 months) will now be a daily-compounded in arrears SOFR rate (i.e. the daily fixings over that equivalent period compounded over that same period). Instead of using just one rate that covers the entire 3-month period which is set at the START of the period, we’ll take every business day during that period & compound all the fixings together at the END of the period.
Here’s a schematic from Oliver Wyman that shows the difference:
Back to the future, part 2
In other words, we’re going from an “expectations based” benchmark to a “present realized” index. While that might not exactly violate the space-time continuum, that does cause some quirks.
Again, the reason for this consideration is to remove some of the daily “noise” around the fixings. That’s “noise” due to things like holidays, reporting periods & unexpected vaporization of liquidity. This is obvious just from a cursory glance at that historical chart of the daily fixings for the SOFR rate compared to the 3-month LIBOR rate.
However, LIBOR doesn’t just have a 3-month term. An overnight term, a 1-month term, a 6-month term & so on also exist.
Consider what events like last week’s move in repo did to LIBOR’s replacement, even after the “smoothing”. Even without looking, you can probably guess it’s not good.
Not exactly “easing”
Let’s play this out. The LIBOR fixing that was delivered on the morning of June 17th was the one which covered an “effective” period that started T+2 (June 19th) for 3-months. Therefore, that rate would pick up all the fixings from last week. That caused the “rate” from nearly 3-months ago to increase a little over 3 basis points. Previously, you wouldn’t have cared much about what happens in the 3-months following your LIBOR fixing. Now, you care quite a bit about any significant moves in SOFR underlying that might transpire over the ensuing period.
The VaR-Shock to rule them all
What’s even more important is that the shorter LIBOR rates are the ones that underpin things like Student Loan Securitizations & Commercial Mortgage-Backed Securitizations. Well, those happen to be two areas of the market precariously balanced at the moment.
Here’s what the 1mL rate & its replacement did…
Consider: the magnitude of the move works out to a little over 12.5bps – or half of what the Fed just cut rates by. That’s a pretty big difference – in the opposite direction of what the Fed’s intending to do as they “ease” policy.
Now, this past week’s episode won’t do much since LIBOR is still clinging on. It won’t even affect the proposed spread adjustment, since that will most likely use a trimmed mean or median observation of the last 5-10 years. Stay tuned: it’s one of the biggest outstanding decisions remaining.
But, it’s a good example of how policymakers have designed a replacement benchmark to take over the largest derivatives market in the world which could deviate from the original. Best summed up in the words of Job & George Bluth.
Trillion Dollar PNL Implications
In the context of a $400 trillion market it’s a lot. Especially, since you’ve just caused the entire index to shift up by 12.5bps when it should have been shifting lower as the Fed “eases” policy. For a 1-month coupon, that difference is $42bn in PNL terms for just this one episode. That episode lasted only about 3 days.
Over a longer period (a few weeks, for example), implications are north of a trillion dollars in market PNL.
Imagine if regulators enacted by decree an instantaneous drop of $1 trillion in market PNL from US equities. You’d take notice.
Furthermore, the index jumped 12.4bps on the day that the 1mL rate moved 1.5bps. A 1.5bps move for 1mL is barely a half a standard deviation move on the long-term history, going back to 1998. That 12.4bps move for SOFR? An 8+ standard deviation event.
Regulators take heed
We live in a world where risk has been increasingly calibrated to historical VaR. That’s a seismic shock that poses a serious threat to future position concentration.
Regulators have told us in no uncertain terms that this is happening. Williams’ speech on Monday is an example of their determination to enact a shift. But, the Fed knows in order to make it stick, one must have a reliable fallback instrument.
Reliable fallback instruments for a $400 trillion market don’t move 8+ standard deviations because of a regularly scheduled tax date. Even if it just so happens to compound a number of other structural issues.
So, it’s in the Fed’s best interests to lean against such moves. That’s yet another reason why we should expect OMOs are really Permanent (with a capital “P” = POMOs). They’re due to extend well beyond the October date that’s currently on the calendar.
With that, regulators are more than happy to issue one final valediction to LIBOR.
ISDA Fallback Consultation: www.isda.org/2019/09/18/september-2019-consultation-on-final-parameters/
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