UK funds have largely ditched LIBOR but the situation for credit funds is more complex
- UK pension funds are switching from LIBOR to Sonia or Gilts
- Euro-denominated pension schemes have been slower to switch to €STR
- EURIBOR has been revised and strengthened, but its future remains uncertain
Nothing concentrates the mind more than a deadline and the progress of interest-rate benchmark reforms is a example of this.
In 2011, it emerged that traders had colluded to manipulate the London Interbank Offered Rates (LIBOR) system of interest rate benchmarks for borrowing money in various currencies, as well as the euro equivalent, EURIBOR.
This troubled investors, but none more so than pension funds practising liability-driven investment. They used derivatives based on LIBOR to hedge against changes in interest rates, which affect the net present value (NPV) of their liabilities and their solvency ratios.
Nine years on, liability-driven UK funds have either ditched LIBOR for Gilt-based instruments, or embraced derivatives based on its replacement, known as Sonia (Sterling Over Night Index Average). They were aware that they needed to do so because the UK regulators will render LIBOR moribund at the end of 2021.
LIBOR is based on the daily estimates of banks of the rate at which they say they can borrow; the most quoted benchmarks were for one, three and six months.
EURIBOR, on the other hand, was given a new lease of life among liability-driven investors in the euro-zone liability-driven investment (LDI) markets. This was because the regulator, keen to avoid the disruption of jettisoning a benchmark, decided that a revised system, based not only on banks’ estimates but also market transactions, met its standards. Given this, it is not surprising that take-up of swaps based on €STR (pronounced ‘ester’), the euro-zone’s new benchmark rate, is still low.
Simon Bentley, head of LDI client portfolio management at BMO Global Asset Management, summarises this divergence of two lines that at one point appeared to be running in parallel. “There are very different dynamics in each market,” he says. “In the sterling market. it is pretty clear that LIBOR’s days are numbered, and come 2021 there’s a pretty good chance that it will cease to be published.”
By contrast, “in the euro-zone market there’s a very high likelihood that EURIBOR will continue to be published because it’s been reformed, the regulator has been pretty supportive of those changes, there’s a number of vested interests, and there are quite a few products where LIBOR is strongly embedded”.
Even in the UK, adoption of Sonia has not been high. Private debt funds have been slow to adopt it, for example. This is because, as a rate based on secured lending, it carries no credit risk premium, so does not reflect their true cost of funding. However, observers agree that the UK has forged ahead in moving away from the old benchmarks and pension schemes have been at the vanguard.
“In bonds and loans the transition has been slower,” says Robert Gall, head of market strategy at Insight Investment in London. “If you talk to a credit fund manager, for example, there is a lot more work to do. But among all buy-side users of interest rate products, UK pension schemes have been quickest of all to change to the new benchmark.” Pension funds have benefited from the fact that the derivatives market, aware of the need to abandon a benchmark that questioned the credibility of hedging, has led the way.
Max Verheijen, director in financial markets at Cardano, says adoption has even reached the point where “in most cases clients are doing Sonia swaps for new contracts”, rather than LIBOR. Of all the new interest rate markets, “I would say that globally the Sonia market is the most liquid”, he adds. “The key question is: is it a liquid instrument? To me, the answer to that is: yes.”
For liability-driven investors, Derek Steeden, portfolio manager in the investment solutions team at Invesco, describes Sonia as “the natural choice” for swaps which schemes intend to hold beyond 2021, because of its liquidity.
EURIBOR has, however, put up more of a fight than Sonia. The euro-zone financial industry has reformed it to the satisfaction of regulators, because so many parties have an interest in its continuation. It is entrenched in retail markets, such as Spanish mortgages. Observers suggest that switching to a new rate in the euro-zone retail financial industry would be a headache.
In the Netherlands, the regulator demands that pension schemes use EURIBOR as the discount rate to calculate the NPV of liabilities. If the regulator told funds to use €STR, pensioners would be up in arms because it is lower. This is because, in contrast to EURIBOR, €STR is both an ultra-short-term overnight rate and a rate for secured borrowing, which carries no component to allow for the extra credit risk. Having said this, experts suggest a possible solution: adopting €STR and then adding some basis points to raise the discount rate.
Because of such considerations, EURIBOR is holding its own. The EURIBOR panel of banks and the index administrator, the European Money Markets Institute, have agreed to keep EURIBOR going until 2024.
The €STR benchmark will, admittedly, reach a milestone in June 2020, when the Eurex and LCH clearing houses switch from using Euro Overnight Index Average (Eonia) to €STR when valuing swaps positions. However, as Bentley notes, “this is unlikely to have a meaningful impact on the liquidity or availability of €STR swaps”.
As to the fate of EURIBOR – for use by liability-driven investors in particular, and by the market in general – observers disagree. “Our working assumption is that the Netherlands will permanently stay with EURIBOR for its discount curve,” says Bentley. He notes the problem that switching to €STR would create a higher value of liabilities, the lack of a market as yet in €STR swaps, and the appetite of many parties to stay with the existing benchmark. However, Menno van Eijk, head of treasury at NN Investment Partners, disagrees. “There is obviously keen interest from most of the banks to get out of it because they are of course heavily exposed,” he says. “So I think the chances of EURIBOR surviving in the mid to longer-term are relatively close to zero.”
Roger Lord, head of quantitative analytics at Cardano, is in the middle, insisting on an open mind about whether the Dutch regulator will eventually switch to €STR as the basis for its discount curve. “It depends on how the two rates evolve,” he says. “If EURIBOR remains a tainted benchmark, then you will see more liquidity going into €STR.”