LIBOR’s Decades-Long Dominance of Rates Is Over

Is the market headed to a world with multiple reference rates?

The time has come for John Williams to put away the LIBOR countdown clock.

The Federal Reserve Bank of New York’s president for more than two years has been counting the days until Friday, when most versions of the London Interbank Offered Rate—with the notable exception of three-month U.S. dollar LIBOR—will be published for the last time. It’s the beginning of the end of its decades-long reign as the pre-eminent tool of the financial system, more than a decade after bank manipulation was first alleged.

For regulators, it’s celebration time. For U.S. traders, the outlook remains muddy, as the painful slog of integrating replacements for LIBOR goes on.

“Once the calendar turns, the big question will be liquidity in LIBOR markets, cash, and derivatives,” said Priya Misra, global head of interest-rate strategy at TD Securities. Those markets also include swaps and loans. “There is no doubt that liquidity in LIBOR-linked contracts will be worse than in 2021, but not clear if it will be problematic early on.”

The surviving LIBORs have expiration dates in June 2023 and are continuing mainly to avert trouble for contracts that reference them. U.S. regulators have strongly discouraged new contracts tied to the old benchmarks.

While yen, euro, Swiss franc, and British pound investors will have straightforward replacements, U.S. markets remain a contest in which the Secured Overnight Financing Rate (SOFR) is favored. Calculated under the auspices of the New York Fed, it’s based on repurchase agreements for Treasury securities.

Derivatives exchange operator CME Group Inc.—whose eurodollar futures and options referencing three-month dollar LIBOR remain its biggest product—has designated its much newer SOFR futures in the conversion mechanism for eurodollar contracts if and when the LIBOR rate ceases to exist.

Beginning in January, anyone trading a LIBOR derivative with a bank will need to document whether it’s hedging a legacy contract or qualifies as a risk-reduction, which TD’s Misra said could introduce friction and gum up trading.

That’s particularly true for syndicated loans, where in November SOFR lending was 53 percent of LIBOR lending for investment-grade and 17 percent for leveraged, according to a progress report by the Federal Reserve-backed Alternative Reference Rates Committee (ARRC).

Resistance to SOFR reflects lender interest in a rate that, like LIBOR, embeds credit risk, for a better match with their cost of funds. So while 2022 may bring greater adoption of SOFR and fewer LIBOR-based transactions, inroads are possible for a slew of lesser-known rates.

“We continue to believe the market is headed to a multiple reference-rate world where SOFR is the initially dominant derivatives rate but where credit-sensitive rates co-exist,” Bank of America U.S. interest-rate strategists led by Mark Cabana, wrote in a note. “The future USD benchmark world is still a work in progress.”

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