“Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful.” Margaret J. Wheatley
By Elham Saeidinezhad
In 2017, after a manipulation scandal, the former FCA Chief Executive Andrew Bailey called for replacing LIBOR and had made clear that the publication of LIBOR is not guaranteed beyond 2021. A new rate created by the Fed—known as the secured overnight financing rate, or SOFR- seems to pull ahead in the race to replace LIBOR. However, finding a substitute has been a very challenging task for banks, regulators, and investors. The primary worries about the transition away from the LIBOR have been whether the replacement is going to reflect the risks from short-term lending and will be supported by a liquid market that behaves predictably. Most of these concerns are rooted in the future. However, a less examined yet more immediate result of this structural change might be the current instabilities in the market for short-term borrowing. In other words, this transition to SOFR creates daily fluctuations in market prices for derivatives such as futures that are mark-to-market and in the process affects firms’ funding and liquidity requirements. Understanding these side effects might be a key to understanding the puzzling situation that the Fed is currently facing which is the turbulence in the repo market.
This shift to the post-Libor financial market has important implications for the prices of the futures contracts and firms’ liquidity constraints. Futures are derivatives that take or hedge a position on the general level of interest rates. They are also “Mark-to-Market,” which means that, whenever the futures prices change, daily payments must be made. The collateral underlying the futures contract, as well as the futures contract itself, are both marked to market every day and requires daily cash payments. LIBOR, or London Interbank Offer Rate, is used as a reference for setting the interest rate on approximately $200 trillion of financial contracts ranging from home mortgages to corporate loans. However, about $190 trillion of the $200 trillion in financial deals linked to LIBOR are in the futures market. As a result, during this transition period, the price of these contracts swings daily, as the market perceives the future value of the alternative rate to be. In the process, these fluctuations in prices generate cash flows that affect liquidity and funding positions of a variety of firms that use futures contracts, including hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.
To sum up, the shift from LIBOR to SOFR not only is changing market structure but also generating cash flow consequences that are putting extra pressure on money market rates. While banks and exchanges are expanding a market for secondary financial products tied to the SOFR, they are using futures to hedge investors from losing money or protecting borrowers from an unexpected rise in their payments. In doing so, they make futures prices swing. These fluctuations in prices generate cash flows that affect liquidity positions of firms that invest in futures contracts. Money markets, such as the repo, secure the short-term funding that is required by these firms to meet their cash flow commitments. In the process of easing worries, banks are consistently changing the market price of the futures, generating new payment requirements, and putting pressure on the short-term funding markets. To evaluate the effects of this transition better, we might have to switch our framework from the traditional “Finance View” to “Money View.” The reason is that the former view emphasizes the role of future cash flows on current asset prices while the latter framework studies the impact of today’s cash flow requirements on the firm’s survival constraints.