As the COVID-19 pandemic exposes global risk markets, it may also threaten plans to transition the world away from LIBOR benchmarks.

Regulators want to transition to new risk-free rates (RFRs) before the end of 2021, when LIBOR contributors will be free to stop supporting the rate. We now see this timeline likely extended, partly because resources are being diverted to COVID-19, and partly because the industry is realising how little it knows about the behaviour of these RFRs.

Potential Delays

As concerns over the economic impact of the pandemic escalate, banks around the world have shifted resources to contingency planning. We have seen foreign travel curbed and hundreds of bank employees mandated to work from home.

The Bank of England and Financial Conduct Authority have warned that the pandemic could alter some interim LIBOR transition milestones but, despite the disruption, the end of 2021 target remains in play. Regulators are also still requesting that participants in the U.K. cease issuance of cash products linked to LIBOR by the end of September 2020.

Another key date is October 2020, when the Bank of England will introduce haircuts for LIBOR linked collateral in its own operations. About 10% of the Bank’s £300bn monetary framework is linked to LIBOR. These loans will incur a 10% haircut in October 2020, rising to 40% in June 2021 and a full 100% by the end of 2021, making LIBOR instruments ineligible for liquidity operations.

On a similar timetable, clearing houses that handle USD interest rate swaps will switch the rate used for discounting future cashflows and calculating the value of cash collateral from Fed Funds to the Secured Overnight Financing Rate (SOFR).

Market participants have become notably vocal in recent weeks, calling for flexibility on the LIBOR transition, especially since individuals cannot even go to their offices to discuss these issues face to face. We would not rule out the potential that the timeline is adjusted outwards.

Rate Volatility

Emergency rate cuts, unprecedented stimulus, and a rush to USD have all served as a blunt reminder that market participants are in unknown waters when it comes to the behaviour of the potential LIBOR successors, such as the U.S.’s SOFR, the U.K.’s Sterling Overnight Index Average (SONIA), and Europe’s Euro Short-Term Rate (€STR).

As concerns over the economic impact of COVID-19 run through financial markets, a significant demand for USD has shaken funding markets, dislocating interest rate benchmarks. These extreme dislocations in U.S. short term funding markets have exposed cracks in core interest rate benchmarks (both old and new), raising concerns over whether LIBOR or its RFR successors are appropriate measures for lending markets.

USD LIBOR rates are normally in synch with its same tenured unsecured commercial paper from banks, but this relationship started to break in mid-March as nervous investors bought up the short-term commercial paper, even at overnight tenors. On March 17th, overnight USD LIBOR fixed at 0.26%, SOFR at 0.54%, and overnight commercial paper was trading at 1.18% (reaching 1.81% two days later).

This dislocation confirmed previously held fears that loans based on repo transactions collateralised by U.S. treasuries (SOFR) would not move in-line with banks’ unsecured funding (commercial paper) in a stress scenario. Banks worry the asset-liability imbalance could see distortions in times of financial distress, such as now.

Chart 1: US Rate Dislocation 2020

Source: Bloomberg

The extent of COVID-19 related financial pain is yet to be fully understood, as is how global regulators will digest the significant and noteworthy moves in various interest rate benchmarks. Discussions are certainly being had about whether the transition away from LIBOR will be delayed and whether the previously thought RFRs are the right solution. In any case, we encourage those with legacy LIBOR linked loans and derivatives to stay abreast of the developing transition. Please do not hesitate to reach out to your Validus contact with any questions or concerns.

Author: Richard Hall