July 16, 2018

Commodities Futures Trading Commission “Market Risk Advisory Committee Meeting”

Key Topics & Takeaways

  • From LIBOR to SOFR: CFTC Chairman Giancarlo noted the importance of anticipating and thoroughly preparing for the discontinuation of the London Interbank Offered Rate (LIBOR) and the transition to the Secured Overnight Financing Rate (SOFR) and other risk-free rates.
  • ARRC Efforts: Sandra O’Connor (JP Morgan Chase & Co.) provided an overview of the Alternative Reference Rate Committee’s (ARRC’s) efforts to date, including identification of an alternative risk-free rate, and development of an implementation plan that can support the voluntary adoption of the new rate for use in derivatives – including the creation of robust contract language.
  • Launching SOFR: Representatives from CME and LCH discussed the launch of SOFR futures and plans regarding derivatives based on SOFR.
  • Public Feedback: Scott O’Malia (ISDA) discussed the Association’s recently released public consultation on benchmark fallbacks, explaining that it is seeking public input on ways to ensure legacy derivatives contracts continue to function as intended, and stressed the importance of market feedback in this process as this will help to inform decision-making moving forward.
  • LIBOR Reform Subcommittee: MRAC members voted to form a LIBOR Reform Subcommittee.  The MRAC then stated it would be soliciting participation, which will be open to both MRAC members and non-members.

Opening Statements & Introduction

Chairman J. Christopher Giancarlo

In his opening statement, CFTC Chairman Giancarlo noted the importance of anticipating and thoroughly preparing for the discontinuation of LIBOR and the transition to SOFR and other risk-free rates (RFRs).  Giancarlo explained that LIBOR is not sustainable because it is susceptible to manipulation and is not representative of market activity.  Giancarlo also emphasized that there is no way to remedy the issues with LIBOR and that market participants must prepare accordingly by developing alternative reference rates.  In addition to recognizing the commitment of the CFTC, the ARRC, and the Federal Reserve to working with market participants to prepare for the transition away from LIBOR, Giancarlo recognized ISDA’s work in preparing for the impact such changes will have on the functioning of derivatives contracts.

Commissioner Rostin Behnam (MRAC Sponsor)

In his opening statement, CFTC Commissioner Behnam, sponsor of the MRAC, explained that his goal in selecting committee members was to ensure they had the necessary experience and qualities to address a “full spectrum” of market risk issues.  Behnam noted that the committee is tasked with developing strategies to identify and reduce systemic risk and to promote safety, transparency, and efficiency within the market.  Behnam also emphasized the need for reform by citing the issues that has discredited LIBOR.  Additionally, Behnam noted that LIBOR has an extensive presence in the American economy and directly impacts not only on financial institutions, but also on a variety of common financial matters including home mortgages and student loans.

Commissioner Brian D. Quintenz

In his opening statement, CFTC Commissioner Quintenz noted that LIBOR reform has broadly impacted the derivatives markets.  Quintenz expressed support of the development of alternative RFRs, highlighting the ARRC’s work in developing SOFR and emphasizing the importance of trustworthy global financial benchmarks in market stability.  Quintenz also noted that the May launch of SOFR futures constituted a productive step toward preparing derivatives markets for the reform.  Quintenz cautioned that a transition to RFRs will pose challenges for derivatives markets and encouraged firms to consider the implementation plans and contractual language they must develop.  Lastly, Quintenz noted his concern regarding proposed amendments to the European Union Benchmarks Regulation, which he cautioned could result in cross-border regulatory overreach, though this was not a focus for this meeting.

MRAC Discussion Regarding Committee Priorities and Agenda

Members of the MRAC next discussed priorities for the Committee moving forward.  Considerations included: (1) benchmark reform; (2) central counterparty (CCP) risk (e.g., governance, loss absorbency, and overall risk structure); (3) Leverage Ratio related issues; (4) pre- and post-trade transparency in the derivatives markets; and (5) technology issues (e.g., operational risk stemming from artificial intelligence, and automated trading).  Commissioner Behnam noted that decisions on MRAC priorities would be informed by members’ suggestions during the day’s panels.

Panel 1 – Overview of LIBOR Reform

Facilitator

  • Thomas Wipf, Vice Chairman of Institutional Securities, Morgan Stanley

Panelists

  • David Bowman, Advisor, Federal Reserve Board of Governors
  • Sandra O’Connor, Chair of the ARRC; Chief Regulatory Affairs Officer, JP Morgan Chase & Co.
  • Mauricio Melara, Associate Director, Office of International Affairs, CFTC 

The first panel provided an overview of issues surrounding LIBOR and the move towards benchmark reform.  Panelists discussed the role of interest rate benchmarks, the need for LIBOR reform, and the status of official and private sector initiatives via the Financial Stability Board and ARRC.

Wipf began by giving a background on interest rate benchmarks and developments to date.  He commented that reference rates are critical to efficient markets because they help enable trading standardized contracts, which increases liquidity and provides for transparent and independent pricing of interest rates that are referenced in many different financial products across the globe.  Wipf stated that the issue with LIBOR is that the submission process today lacks underlying data, which is problematic because when a panel bank cannot source transaction-based information, it is expected to submit LIBOR based on “expert judgment submission.”  He continued that market participants are working to find a solution to this issue and are moving forward by working with the ARRC.  Wipf commented that one of the key remaining issues is how to deal with the $200 trillion based LIBOR contracts, and that the challenges in addressing this issue exist in two buckets: (1) documentation; and (2) spread methodology.

Bowman stated that the official sector, particularly the Financial Conduct Authority (FCA) as the benchmark regulator, has encouraged banks to remain on LIBOR panels as reforms are put in place through 2021.  Bowman further commented that although the official sector has strengthened LIBOR governance, LIBOR remains unstable and may be forced to stop publication.  Further, he stated that there are an estimated $200 trillion in outstanding contracts that reference USD LIBOR and potentially $270 trillion or more that represent all the LIBOR currency together.  He then commented that of the $200 trillion in contracts referencing USD LIBOR, approximately $190 trillion are in derivatives contracts covered by inadequate fallback language in the ISDA documentation.  Finally, Bowman noted that the ARRC is seeking to recommend safer contract language to help mitigate financial stability risks.

O’Connor began by discussing the inception of the ARRC and its mandate.  She remarked that the Committee’s mandate was to first identify an alternative RFR, and then to develop an implementation plan that can support the voluntary adoption of the new rate for use in derivatives – including the creation of robust contract language.  O’Connor next explained the criteria the ARRC used to find an alternative RFR, including whether the rate is: (1) consistent; (2) transaction-based; (3) resilient; and (4) fit for purpose.  She stated that the ARRC could not find an existing rate, so it created SOFR – a repo-based benchmark.  Moreover, she stated that there exist broader swaths of the market that transact and create data to support this benchmark, which makes it more durable, including securities lenders other types of investors.  O’Connor stated that the ARRC then began working on the next challenge – how to build liquidity.  O’Connor pointed to the launch of SOFR futures by CME on May 7th of this year as a key step towards that goal.  She noted that the next step is to continue developing the cleared swaps market.  O’Connor remarked that ARRC 2.0 was created with a new and broader membership base inclusive of participants from a broader cross-section of the industry, including trade associations.  She remarked that the goal is to deliver an honest and paced implementation plan, and to work on the development of a term curve, to which cash products may need access.  Finally, she emphasized the need to develop more robust fallback language.

Melara began by commenting that IOSCO produced the principles for financial benchmarks, which have become a guiding document for administrators and regulators as they think about financial benchmark reform.  He remarked that there will be a need for market participants who haven’t considered these issues to understand them well and plan accordingly.  Melara stated his belief that the time is apt for IOSCO to contribute to this effort and that in the future the international regulatory cooperation with the OSSG will be necessary to put a good foot forward and deliver on these efforts.

Q&A

Frank Hayden (Calpine Corporation) asked, from a cash market perspective on legacy contracts, how much systemic risk exists.  Hayden also asked about potential contractual language that would permit bilateral agreement on rates if there is a need for fallback.  O’Connor responded first by noting that the derivatives market is the largest market component and currently has weak fallback language, creating a large stability risk.  O’Connor emphasized the importance of ISDA’s work to develop fallback language by noting the impracticality of bilateral negotiation due to the vastness of the market and the differences across products, among other concerns.  O’Connor further emphasized the importance of achieving a level of consistency in contractual language.  Bowman added that an important aspect of developing applicable fallback language now is the opportunity to avoid what might otherwise be a recurring issue.

Mathias Graulich (Eurex Clearing) asked about the rate differential between LIBOR and SOFR, and the extent to which LIBOR and SOFR are correlated.  Bowman responded by stating that the correlation would depend on economic conditions, and that because SOFR is an overnight rate and LIBOR is a three-month rate, ISDA’s consultation will contemplate appropriate spread adjustments in developing fallback language.  Graulich also asked how the development of SOFR will reflect or manage spikes in repo markets that usually occur at month ends and quarter ends.  Bowman responded by stating that while SOFR may be relatively more volatile on a day-by-day basis, its compound average is historically smoother than that of LIBOR.  Bowman expressed his expectation that most financial contracts will refer to some type of compound average, as the SOFR compound average doesn’t generally show swings at month ends, quarter ends, or year ends.

Jim Shanahan (CoBank) asked if there is a way for regulators to extend the allowable transition period for the many contracts that will be outstanding beyond the 2021 deadline.  Bowman responded by noting FCA statements on the topic and recognized that ARRC will need to continue contemplating the difficult issue of how to handle legacy contracts. Bowman noted that a current goal is to stop putting out new contracts containing language that will expire.

Jonathan Raiff (Nomura) asked, considering that there is still much liquidity in the EuroDollar curve, what would be an impetus to change to SOFR.  O’Connor responded by noting that the high possibility of LIBOR ending in 2021, which incentivizes a switch to SOFR as it could serve as a basis for pricing EuroDollar contracts.  O’Connor also noted that a key objective of ARRC is to get corporate treasurers, financial houses, and members of government to begin tying new issuances and loans to SOFR because doing so will increase demand for SOFR, in turn supporting liquidity.

O’Connor was asked how the ARRC 2.0 is approaching market outreach and how the group can get education moving from theoretical to practical, and from practical to actionable.  She responded that many market participants are currently considering issues, and more are becoming aware.  Further, O’Connor stated that the ARRC has engaged not only financial market participants, but also trade associations who can engage their memberships so that the ARRC can begin educating and potentially providing recommendations on how their firms could become more prepared.  CFTC Chairman Giancarlo then remarked that the Commission will continue to use the MRAC for education and outreach on benchmark transition across all types of market participants.

Panel 2 – Latest Developments with LIBOR, SOFR, and SOFR Derivatives

Panelists

  • Emma Vick, Director, ICE Benchmark Administration (IBA)
  • Scott Rofey, Managing Director, Goldman Sachs
  • Agha Mirza, Managing Director and Global Head of Interest Rate Products, CME Group
  • Phil Whitehurst, Executive Director, Product, LCH 

Vick began the panel by explaining that LIBOR is very different today than it was in 2008, and that the IBA continues to work to attain benchmark integrity for LIBOR and to improve it.  Vick explained that IBA has implemented a waterfall methodology to provide some standardization to the process.  Vick further noted that the IBA is engaging in a market survey to find out what currency tenor pairs may be important to market participants past 2021, and whether there is interest in working to find a path forward.  Vick acknowledged that LIBOR faces an uncertain path, but expressed the belief that that LIBOR and SOFR can exist together and serve different customer needs.

Mirza underscored that SOFR’s introduction will be highly constructive for the marketplace and went on to provide thoughts on how the SOFR futures market will continue to grow.  Since the launch of SOFR futures in May 2018, Mirza detailed that over 70,000 contracts have been traded amongst a highly diverse participant base, including banks, asset managers, hedge funds, and proprietary trading firms.  According to Mirza, SOFR’s behavior is financially distinct from LIBOR and Fed Funds, and is complementary to Euro and Fed Funds futures.  He pointed out that key market participants are seeking to provide liquidity in SOFR futures, and that CME plans to launch cleared SOFR swaps in September 2018.

Rofey focused on three main topics during his presentation: (1) fundamental differences between SOFR and LIBOR; (2) SOFR-based swaps; and (3) the LIBOR transition from a risk-management perspective.  He stressed that SOFR’s robust transaction volume separates it from LIBOR.  He also explained that term structure will be an important aspect moving forward, and yield curves reaching 30 years will be a key aspect of SOFR’s success.  With respect to transition planning, Rofey stressed that reasons to transact in SOFR must be organic, clarity on benchmark fallbacks will be necessary, and planning and ARRC efforts will be key.

Whitehurst began by highlighting that gaps in trading volumes between SOFR and LIBOR need to be bridged and that the ARRC’s recommended transition planning works towards this end.  He went on to note that LCH intends to clear SOFR swaps starting July 16, 2018, in support of the ARRC goals. 

Q&A

Jonathan Raiff (Nomura) queried whether there were concerns about counterparties renegotiating CSAs.  Rofey explained that CSAs are bilaterally negotiated, and that broker-dealers may have thousands across the landscape.

Stephen Berger (Citadel) asked whether there would be ability to portfolio-margin across SOFR-based derivatives and futures.  Mirza explained that, subject to regulatory approval and market demand, there would be plans to allow for portfolio-margining across SOFR futures and swaps.

Isaac Chang (AQR Capital Management, LLC) asked what might be needed to unlock liquidity in SOFR derivatives, and whether regulatory action is necessary.  Rofey explained that there will likely be organic and external market motivations driving liquidity. 

Panel 3 – Effect of LIBOR Reform on the Derivatives Markets

Panelists

  • Scott O’Malia, Chief Executive Officer, ISDA
  • William De Leon, Managing Director and Global Head of Portfolio Risk, PIMCO
  • Subadra Rajappa, Managing Director, Head US Rates Strategy, Société Générale
  • Charles Schwartz, Head of Derivatives, AXA US
  • Robert Mangrelli, Director, Global Real Estate Hedging and Capital Markets Team, Chatham Financial 

O’Malia began the panel discussion by providing an overview of recent industry benchmark initiatives.  He went on to describe recent publications and efforts, including an “IBOR Roadmap” paper (the Roadmap), industry survey, and summary report.  O’Malia explained that the Roadmap was published to bring familiarity to market participants regarding benchmark reform initiatives around the globe and show the importance of these efforts.  Regarding the industry survey, O’Malia highlighted that 154 institutions spanning 20 countries were asked what they were doing to prepare for LIBOR transition to RFRs.

The survey results were collated and published in mid-June 2018, and O’Malia provided a brief summary of the findings.  He noted that there was a high level of awareness amongst respondents regarding transition issues and the work of RFR working groups in the various jurisdictions, though for a small percentage of respondents the survey was their “first touch” on the topic.  O’Malia further stated that the survey showed that 75 percent of respondents indicated they were beginning international discussions on transition strategy, and 78 percent said they intended to trade RFR products.  O’Malia explained, however, that the industry is still very much in the educational stage and that market participants are looking for a clear and coordinated regulatory message from the RFR working groups.  O’Malia then noted that the survey results showed that market participants are focused on issues including: the concentration of term rates; the development of credit premiums; tax and accounting treatments; and cash and derivatives market linkages.

O’Malia next focused his discussion on ISDA’s recently released public consultation on benchmark fallbacks.  He explained that the consultation seeks public input on possible options and adjustments to ensure legacy derivatives contracts continue to function as intended.  He stressed the importance of market feedback in this process, as this will inform decision-making moving forward, including on protocol development.

A presentation describing ISDA’s benchmark reform initiatives may be found here.

De Leon next discussed some of the issues surrounding transition planning.  He noted that the transition from LIBOR to SOFR is more complex than previous industry-wide transitions, as it cannot be executed as a “big bang.”  Thus, he explained, the transition timing may differ across the industry.  He further highlighted that while a protocol may be beneficial for derivatives products, it would not necessarily apply to products that don’t have the same standardized documentation.  De Leon also noted that spread adjustments will be required, given differences between LIBOR and SOFR.  De Leon expressed that it is imperative for market participants to review contract fallback language to avoid problems later down the road.

Mangrelli next focused discussions on end-user concerns regarding LIBOR transition. He explained that for end-users, key concerns include value transfer and minimizing basis risk.  Mangrelli stated that cash-products-hedging could face timing differences that create the possibility of increased basis risk and value transfer.

Rajappa stated that, from the perspective of a global bank, a key concern is the treatment of legacy contracts, explaining that it is essential for any solutions to be economically viable and that they should minimize value transfer risks.  Rajappa further expressed concern about the basis risk stemming from cash and derivatives used as hedges, as well as consistency between currencies.

Schwartz noted that he is supportive of SOFR and the ARRC’s mission but expressed concerns should market participants move too quickly in the transition given potential impacts on longer-date contracts.  He expressed that an appropriate transition timing balance should be struck, with this in mind.

Q&A 

Dennis McLaughlin (LCH Group) queried whether compression algorithms in a liquid SOFR market could help mitigate issues facing legacy contracts, effectively replacing new portfolios.  De Leon noted that while compression could be a useful tool, market participants would still need to trade out of legacy contracts and into new contracts.

Lisa Shemie (Cboe Global Markets) sought insight on how difficult protocol adoption would be, considering potential difficulties in end-user adoption and global differences.  O’Malia explained that this is a huge issue, and that the industry and official sector will need to work together.

Marnie Rosenberg (JP Morgan) asked who is developing the objective criteria for determining the permanent discontinuation of IBORs.  O’Malia explained that feedback on this issue is being sought, though currently cessation is either implemented by the administrator or its regulator.

MRAC New Business – Establishment of LIBOR Reform Subcommittee

Following the panel sessions, MRAC members voted unanimously to form a LIBOR Reform Subcommittee.  The MRAC then stated it would be soliciting participation, which will be open to both MRAC members and non-members.

For more information on this event, please click here.