SOFR Takes Over

Greg Geffen:

Hello and thank you for joining us for the fifth installment in our Leaving LIBOR series. I'm Greg Geffen, head of JP Morgan's North America corporate interest rate derivatives business, and the host of today's podcast. Joining me today are a number of my colleagues who have been thought leaders in this arena.  I'm joined by Patricia Devine, head of corporate banking in North America for JP Morgan. Ben Kinney, JP Morgan's global co-head of interest rate sales. And Tom Pluta, JP Morgan's global head of linear rates and co-head of North America rates trading.

Greg Geffen:

As we sit here in mid-March, we're only a bit more than a year away from the end of US dollar LIBOR. Today we'll reflect on the progress made so far. We will discuss how markets are adjusting to SOFR as the new benchmark. And where clients should be focused in the time ahead of LIBOR cessation. We have a lot to cover in the next 20 minutes, so let's jump right in. Tom, my first questions for you. A lot happened at the end of 2021. Can you give us a quick reminder of the key events and where we find ourselves today?

Tom Pluta:

Sure. Thanks, Greg. Um, December 31st was a big milestone date in the LIBOR transition. It was the cessation date for four of the five LIBOR markets. So sterling, yen, Swiss, and euro LIBOR are no more. Um, and the vast majority of any outstanding contracts in those markets now fix to the designated fallbacks. In the case of sterling and yen, uh, for the portion of, uh, contracts that are considered tough legacy. For a one-year period through the end of this year, they will fix to a synthetic LIBOR, uh, which is calculated and- and published by a benchmark administration.

Tom Pluta:

So it gives an extra year, for those markets to restructure and unwind the more complex trades that’s one of the fallbacks or agree on an appropriate fallback. Moving over to US dollar LIBOR, uh, as you mentioned, the cessation date is not until June 30th of 2023. So another 15 months. But as of December 31st, the clear regulatory guidance is for no new LIBOR contracts or dealing. So this means that any LIBOR trading that is done now is for risk reduction purposes only.

Tom Pluta:

So for example, in the derivatives markets conversion of LIBOR portfolios to SOFR, unwinding trades, compressing portfolios of trades, or hedging LIBOR or fixing risks are all permitted use cases in this risk reduction, um, concept. Uh, so as a result, um, there's been a really rack- rapid shift off of LIBOR and onto SOFR across both cash and derivative markets in late 2021 and it continued in early 2022.

Greg Geffen:

Maybe, Tom, a second question for you. In our last podcast, you talked about the success of the SOFR First initiatives, uh, which came about late last year. Has SOFR liquidity continued to build across all derivative products?

Tom Pluta:

Yeah, so there were three SOFR First dates orchestrated in the OTC markets between July and November of last year for interest rate swaps, cross currency swaps in developed markets, and then swaps in caps and floors. And these were a big success. So essentially, at each of these dates, the interbank markets, the dealers shifted the vast majority of their volumes from LIBOR to SOFR. And then customer volumes followed soon after that. Now, in 2022, we have between 90 and 100%, almost all of new business, in these flow OTC markets across products now on SOFR with very little LIBOR trading. And most of that, again, being for the risk reduction purposes that I described.

Tom Pluta:

The one market that is an exception, and something we very much expected, is the exchange traded futures and options market. So essentially euro dollar markets, this market has been a laggard as the market structure is different. The main market maker, the main market makers aren't the bank dealers and it's also an anonymous market. So, those volumes have been a little slower to shift, but even so, um, the SOFR volumes are steadily climbing and we just recently hit, SOFR having 50% of the market share in the interest rate futures contract.

Tom Pluta:

So that's progressing and that'll keep steadily moving ahead. So, not all worried about that. I guess outside of that, one other area would be, cross currency swaps, where it's US dollar against an emerging market currency. Those are kind of transitioning at a little bit of a slower pace. And it's idiosyncratic by market. But overall, I'm very happy with how quickly the derivatives markets have shifted to SOFR.

Greg Geffen:

Ben, maybe turning to you, how have markets taken, from your perspective, to having no new LIBOR dealing in 2022? Interested to understand, what's been the feedback from clients, where do you feel like we've struggled or seen issues, just kind of a broader perspective?

Ben Kinney:

Sure, and I think, that segues nicely from what Tom was speaking to. the SOFR First initiatives last year really helped quite a bit. The biggest pockets of our market really had significant momentum going into 2022. And most of our clients were fairly well set up. That doesn't mean that there weren't areas that we were, we thought would struggle to transition, and you know, I think we've all been pleasantly surprised by how those pockets of the market have transitioned.

Ben Kinney:

You know as Tom said the guidance for after January 1st is that clients, if they're trading in LIBOR based instruments, need to be doing so to reduce risk, and not adding risk. And by and large, we think that's been the case. We are not on a transaction by transaction basis, confirming with clients at this stage that those trades are risk reducing. We all understand the spirit of the rules and the direction of travel.

Ben Kinney:

We've had significant, client conversations with the vast majority of our clients around how we're approaching this, and everybody, as I said, thought it was a thoughtful approach and has been aiming to act in the spirit of the guidance. The places where there have been friction in the markets have been pockets of the vol market, uh, you know, particularly the upper left of the vol grid has been a little bit slower to transition.

Ben Kinney:

And when I say slow, it's just there have been, that part of the market's, you know, seized up a bit or was seized up a bit for the beginning of the year when the rates were moving quite a bit. And, that was a challenge. And then pockets of the exotic derivative market, particularly light exotics, have been a little bit slower to transition as well. But on the whole, I think clients have been, acting in the spirit of what the guidance is around risk reduction and have very quickly transitioned, parts of their book, their portfolios early this year, that hadn't transitioned prior to the start of the year.

Ben Kinney:

One, I think, kind of interesting stat was last week, for the first time, the notional, of SOFR swaps that was traded in the market was higher than that of LIBOR based swaps. We have done significant risk reducing trades in LIBOR swaps over the course of the first couple months of the year, so that was artificially boosting LIBOR based, derivative notionals. Well, last week, like I said, so the notional trade in SOFR swaps or SOFR derivatives was higher than that of LIBOR based derivatives. And I think it's a sign that the transitions is really taking at this stage.

Greg Geffen:

Explain to me a little bit more on that topic too, Ben. You mentioned a number of clients have already moved portfolios. But if I have a client with a lot more portfolios that hasn't yet been addressed, how should I think about that ahead of cessation next year? You know, particularly bouncing the protocol versus restructure the portfolio proactively ahead of that.

Ben Kinney:

I think a lot depends upon how actively you anticipate turning your portfolio over. As we move forward in time, we're going to find that LIBOR-based derivatives become significantly less liquid than silver-based derivatives. So, if you have a portfolio, that you anticipate turning over, in the coming two, three years, then I would suggest moving this portfolio to silver sooner than later. I think that time in which s- LIBOR-based derivatives, are eclipsed in liquidity profile by silver-based derivatives is actually coming relatively quickly, particularly in linear derivatives. In nonlinear space, it will take a little bit longer, but I would say that if you have a portfolio that you anticipate moving- you know, turning over, you should try to keep it as liquid as possible. The transaction cost for, those transitions is quiet, quite minimal.

Ben Kinney:

We've seen very large portfolios already transitioned, although I wouldn't say that it's not on a wholesale basis at this stage. We're seeing corporates, look at the transition. And I think, the kind of the message here is you don't wanna be the last one to the party, to transition your portfolio. Now, if you don't anticipate your portfolio turning over at all and it's gonna be a static portfolio, uh, and you signed the protocol, and this is one of the key messages we've been sending out for quite some time is you really do wanna have- adhere to the fallback protocol, then maybe you don't feel the urgency to transition. But I think that... Again, depending upon the nature of your book, you should be looking to transition sooner than later so that you're not the last one sitting, holding bunch of LIBOR derivatives.

Greg Geffen:

So Trish, maybe, maybe turning to you, let's talk a little bit about the loan market. So in the last installment of this podcast late last year, we walked about how the SOFR loan market was starting to develop, but that there were a number of other, rates at the time that a- also were contending for- to be a piece of that market. How have things developed over the past few months and where do you see things going from here?

Trish:

Thanks, Greg. So, you're right. There was some speculation, I guess, late last year. But I would say that the transition to SOFR, has really kicked off, well in the loan market since the beginning of the year. Some of that being because, you know, the new or refinanced US dollar loans, cannot use LIBOR, right? So to give you a sense, 95% of the volume year-to-date, has referenced SOFR, and that's based on the global leverage finance markets. And that's info that our JP Morgan Global Credit Research has published. But I would say there is a similar trend in the investment grade market as well.

Trish:

To take that one step further, we see the CME Term SOFR as really the preferred convention globally for these US dollar loans. And as many folks are aware, those are quoted in one month, three, six, and 12 month tenors. I would say what's an evolving market practice is the credit spread adjustment. And that's been an item, that is factored into, borrowers, and, thinking about timing and determining, whether they remediate, or ultimately refinance their LIBOR deals to SOFR.

Trish:

But a couple things on that. One the spot spreads for both the one month and the three month between LIBOR and SOFR are significantly below the five-year historical averages, right? So as borrowers have been evaluating what to do, those spreads have moved. And then the other data point I would reference is, of those same number of deals in the market that I referenced earlier, which were the- two-thirds or so have referenced some CSA. Only a third, right, would not have CSA. And many of those may have just included it in the spread. So it's evolving but definitely, an important focal point for, for borrowers.

Greg Geffen:

Tom, along the same lines, so with the market shifting, you know, very heavily to term SOFR, how have we seen this market evolve in the derivative space?

Tom Pluta :

Term SOFR derivatives have very specific permitted use cases as recommended by the ARRC and in accordance to the terms of the CME licensing agreement. Specifically, term SOFR derivatives can only be used to hedge a corresponding term SOFR cash product or portfolio cash product. So the biggest users that we've seen are loan hedgers that are paying fixed and receiving term SOFR. We did do the first term SOFR swap last summer and have done many of these since. We're a market leader in this space. We provide, great liquidity in this product. So if you have interest in doing that kind of hedge, please talk to us.

Greg Geffen:

Trish, maybe a similar question to what I asked Ben in a derivative context, but in a loan context. If I'm a client with a, a legacy LIBOR deal, how and when should I think about remediating these contracts?

Trish:

So look, I think every borrower needs to think about it in the context of their own objectives. Obviously, with the cessation just a little bit over a year away, we would argue definitely don't wait 'til the end. Any modification amendments, to your agreements can take a while, and you don't wanna be caught too close to that. Having said that, there are other reasons to think about potentially, renewing, amending, et cetera. And I think we would recommend clients review the language. If they have, you know vintage fallback language, they may have terms that again, given what we discussed as it relates to the LIBOR, SOFR curves, could be more advantageous in redoing today and not referencing some of the CSA, language that they could have in their existing agreement.

Trish:

So we would recommend they stay very coordinated with their financial institutions, obviously, J.P. Morgan included in that, and watch the market. And particularly stay focused on the evolving conditions 'cause, in many cases, the market that you know today is at least more defined than the one you don't in the future.

Greg Geffen:

So Ben, it's, it's interesting because all of this is happening alongside, what may be a substantial move in interest rates, both in the US and globally. So as we think about that, how should clients be looking at the transition from LIBOR to SOFR in the context of a rising rate environment?

Ben Kinney:

So, yeah. It's been a very active start to the year in the rates market, to say the least and you've seen quite a bit of rate volatility delivered. I think the good news is that SOFR has behaved exactly as we thought it would. It tracks a trillion-dollar retail market and as rates have moved around, it really has behaved exactly as we would have anticipated as we'd modeled it out. So it's suggested it's a very, very robust rate, and I think we should be pleased by what we've seen at least in the beginning stages of the transition to what appears to be a new rate regime.

Greg Geffen:

Trish, anything you would add to that? In terms of the impact to clients around transition as it relates to a rising rate environment?

Trish:

Well, I just think, again, keeping watch of those curves, right? Because at certain points in time, it may be more or less favorable to the borrowers. As of right now, for three and six month tenors, having a CSA of 15 or 25 or even flat 10 is still favorable to the borrower. So, I think that's, something for them to consider.

Greg Geffen:

So, Tom, since our last podcast, the Sherman bill has passed through congress, what benefits do you see this bringing to the marketplace?

Tom Pluta:

Sure.

Tom Pluta:

So, the house and the senate, have just passed the Federal Libor legislation, with strong bi-partisan support. This is really great news for the market, essentially this legislation covers the tough legacy portion of the dollar Libor market that's not covered by robust fallbacks. Most of these are bonds and securitizations, and while it's just about one percent of the total Libor market, it still adds up to about two trillion dollars in contracts, and essentially it allows for these contracts to fix too, so for plus credit spread, and it avoids the need for lenders to, choose a replacement rate, and the time-consuming negotiations that would be involved with that, and even potentially disputes with clients or litigation.

Tom Pluta :

The legislation provides a safe harbor essentially from litigation if SOFR, is chosen. Other benefits I guess I would highlight, is, that it gives this certain outcome, in these cases, so people know what happens to their contracts, post June of 2023, and then finally it really gives fairness and equality because everyone's receiving the same rate, you're not gonna have picking and choosing of different rates in different situations.

Tom Pluta :

So, again, really good news and a big step forward for the Libor transition.

Greg Geffen:

So, we've covered a lotta ground in a short period of time. There's no doubt a ton of information for everyone to be thinking about. I would ask each of you as a closing of the podcast, can you just give one key takeaway, that our clients should be thinking about? Trish, maybe we'll start with you.

Trish:

Okay. So, start early, rather than waiting till the end. Those were some of the lessons learned from the non-USD remediation that happened last year. And I would say, really review and understand the dynamics of your credit facilities, and particularly the fallback language. So, clients can be nimble and move if and when they desire.

Greg Geffen:

Great, uh, Ben.

Ben Kinney:

I guess I'll reiterate maybe a little bit what I said earlier and then, follow on with what Trish commented on. We spent the last many years prepping for this transition and building models and understanding rate performance or building out rates. We’re not at the moment where actually, you wanna be considering action with your portfolio. And, to Trish's point, don't wait. I would say for derivatives portfolios, again, understanding the nature of your book and understanding the nature of your portfolio and how you anticipate it evolving over the coming years.

Ben Kinney:

I would begin the transition process, if you haven't already, to make sure that your portfolio is moved to SOFR so that you're not stuck in a liquid position that you can't unwind, or the cost to unwind that is much higher than you anticipate. So, as I said, like, we're now at the point where I think action makes sense for derivatives portfolios and putting my sales hat on for a sec, at J.P. Morgan we're very well positioned to help in the transition.

Ben Kinney:

We've spent on systems over the last few years. Our teams can help model and transition portfolios in a fairly expedient way. So, don't hesitate to reach out to your J.P. Morgan sales rep if you've got something you wanna talk about.

Greg Geffen:

Tom, last but not least.

Tom Pluta:

I would emphasize that there's no uncertainty left in the LIBOR transition. The dates have been set, the fallbacks are in place, products are available and liquid. Cash markets have already transitioned, and derivatives markets, are as liquid or more liquid than that in the rapidly dwindling LIBOR derivatives market. The other point I would make, it's kind of on the back of what Ben said.

Tom Pluta:

I think, with derivatives, most clients are gonna reach a point where they just don't wanna manage an existing legacy portfolio of LIBOR derivatives alongside a growing portfolio of SOFR derivatives. And, in fact, many clients have passed that point already. So, think about when you wanna convert the portfolio from LIBOR to SOFR, and just move forward while things are liquid in both markets.

Greg Geffen:

Trish, Ben, Tom, a big thanks to all of you for taking the time to share your views on the broader landscape. Also, a very big thank you to all of our listeners. We hope you take a lot away from today's podcast, and say the overarching goal here is that we want all of our clients to feel well informed and prepared for the transition away from LIBOR. And I'd echo Ben's comments, in that we'd encourage all of you to connect with your J.P. Morgan coverage teams to make sure you understand the impact on your organization. With that, thank you all again for joining us, and we'll see you next time.

Disclaimer

This podcast is intended for institutional clients only and the views expressed in this podcast may not necessarily reflect the views of J.P. Morgan Chase & Co, and its affiliates, together J.P. Morgan, and do not constitute research or recommendation advice or an offer or a solicitation to buy or sell any security or financial instrument. Referenced products and services in this podcast may not be suitable for you, and may not be available in all jurisdictions. J.P. Morgan may make markets and trade as principal in securities and other asset classes and financial products that may have been discussed. For additional disclaimers and regulatory disclosures, please visit www.jpmorgan.com/disclosures.