How The Transition Away From LIBOR Is Actually Going

and I guess it kind of makes sense. After all, this is the reference rate that affects you know, I can never keep track, but I think it's something like, you're into fifty trillion dollars worth of assets, so obviously it's absolutely crucial for the financial system, right, I mean, yeah, as you say, it makes sense that people have so much to say about it, given that it's been so crucial to the pricing of trillions, hundreds of trillions of

dollars worth of assets, and it's this sort of herculean task to sunset it in some way and transition to something else. So I don't know, maybe we should do like a month long live ar series. Oh god, Okay, look, we have two more episodes scheduled, including this one, so let's do those first and then we can talk about

maybe doing a month long live BRLK, we'll revisit. Okay, um, but I'm really happy to say that today for our guest, we have someone who's actually, you know, personally involved in the transition process from library to sof sofar of course, is the secured overnight financing rate. If you don't know what that is by now, then you should go back

and listen to some of our previous episodes. But it's basically the thing that's supposed to replace librards, so it's going to be really interesting to talk about the thinking behind that transition process but also how it's actually going. Great. I'm really excited about this because again, I do like a lot of our top I, like when we have discussions on anything that are actually now that are not just sort of theoretical, but deal with the sort of

nuts and bolts with how you actually do something. Yeah, this is definitely uh practice. So okay, let's bring on

our guest for the episode. It is Tom Whipp, who is chair of the Alternative Reference Rates Committee and also Vice Chairman of Institutional Securities at Morgan Stanley, Tom, thanks so much for coming on, Thanks for having me so Tom, maybe just to begin with, you can give us a sort of brief description of what the Alternative Reference Rates Committee or the a r r C actually does, When

was it started, and what's the goal. So really, the the the ARC was put together in two thousand fourteen, originally UH to begin to select an appropriate, durable alternative to librar and and then to put forward a plan to actually get off live ar and onto that new rate.

That work continued UH for several years, and at that point that group selected SOFA, which is you noticed a secured overnight financing rate, which is basically the US Treasury repo market reported over a trillion dollars a day in UH in daily activity and transactions. And that really solved for the first problem because if you go back to the history of library that the issues developed because the inner bank market itself had shrunk tremendously over over some

period of time. Additionally, the use of librar had gone up exponentially, and you think you sort of can take that from sort of you know, the mid nineteen eighties all the way up until two thousand twelve, and the scandals that emerged from that, but so much of that was based on the fact that the underlying transactions and the inner dealing market had reduced cansiderably used had gone up, and you get this uh, this uh, this concept of

the inverted pyramid, which is too few transactions supporting too many financial contracts and without transactions to create those rates, submitting paddle banks who create live or were forced to use what they call expert judgment. So when we decided on so for the first thing we tried to solve to was can we find something that has sufficient underlying transactions that would mean that these that that there would

be really no need for expert judgment. But in fact we could just rely on actual trades to create the rate. From your perspective, as you say, one of the nice things about so far is there's actual trades. There's no ambiguity, no less opportunity to manipulate the number. What in your view is the primary challenge and what is the work that you do to enable this transition from one index

to another. So, so when the art was then reconstituted after making those two in the important decision, first the selection of SOFA and second to do what we called

the pace transition plan. You'll hear you know, you've probably heard a lot about that, and you continue to hear a lot about that, which was not to have really a cliff effect, but too over the period of time that we had between I would say, two thousand and seventeen and two thousand twenty one to be in a position to have people use UH, use live or less UH and to address some of the legacy UH contracts that go beyond the end of live or one, but

also you know, reduce that exposure through new issue and

usage of SOFUR. So what we've really tried to do over that period of time UH and most recently with the with the release of our of our best practices for the remainder of the transition is to really give market participants to tools that they need to actually enable that pace transition, whether that be for legacy UH legacy challenges where they have contracts or securities that go beyond ende that we can we can have better fallbacks and when live world ends, how do you get from live

board to sofa? So you know, we put we put our fallbacks, we put out we've consulted with the market, we have provided over the course of just I would say, just even the last the last several months, you know, recommendations for things like swaptions. Uh we how do you how do you how do you price new floating rate mortgages. So the art really over the last several years has been developing and providing to the market tools to actually

make this transition as smooth as possible. So, Tom, you're a long time repo man, uh rebot man, repo guy at Morganstown. UM, could you maybe like explain the rebo connection for sofa and I guess I'd be curious to just get your take on the transition of the repo market from pre financial crisis to now as well. Certainly, so if we think about what SOFA is, it really is US Treasury Bank three pos so the tread you know, Treasury securities on repo, which which represent obviously h the

risk free rate. Uh. And even if you go prior to the financial crisis and beyond and through that particular market has always held up very well because of the

risk free nature of the collateral. So when we think about issues in the repo market broadly during the crisis, that was really you know, things that were backed by you know, less liquid assets and things like that, but the treasury repo market for many decades has been really been the underpinning and in terms of volume, uh, you know, we can look and see it again over a trillion dollars a day and traded activity from both the clearing

banks and from from the Central Clearing House DCCC. So when we really looked at that over the period, uh, it really stood out as as the best selection because our other choices, if you think about what the mandate was, would have been things like the overnight bank funding rate UH FED funds rate, And if you compare that trillion to the FED ones market or it's the overnight thing UH funding rate, or to h or two things like

commercial paper bills, the numbers really really go down. You know, you go from sort of a trillion to a hundred and fifty to below a hundred. So the choice really was to have that strong foundation which we could look back and you can you can really model us all the way back. It seemed like that was the obvious choice, and that and that experience in the report market, I

think led us to believe that over time. One of the key things we looked at way back in two thousand and fourteen was we certainly don't want to do this work again. We want to do it once, and we want to do it right. You mentioned tools, and you said giving tools to market participants so that they can deal with some of the issues that might arise, such as contracts that are pegged to liebor that are

going to extend beyond. What does that mean specifically, what what kind of tools do people have to ameliorate some of the issues that will arise from the transition. Just a simple, a simple example I would I would say

as the easiest one is UH floating rate notes. Uh. If you think about existing floating rate notes pre all these work, UH floating rate notes typically if live boar would have cease, had a fall back, had a fallback in there, you know, in the in the bond documents, that would basically say you would take the last printed lie bar and that would be your rate until final maturity.

So if you think about an investor, what a floating rate note is going to float to a three month live war and it went well beyond one at some point they would take that last fixing of libar, the last one at the end and they would live with that rate until final maturity. What the ART did because and to change those rates in most cases in the US you need a d percent consent from bondholders obviously,

as in your impossibility. So what the ART did way back was we put out better fall back language for new issue floating right notes. And you can see in the floating rate note market we've got well over six hundred six hundred billion of new issue using SOFA directly,

which is obviously the best answer. But even those that continue to use live war now have fallbacks that create a series of waterfalls that go from go from libor with a credit spread and the term spread to replicate on a look back what the differences between SOFA and librlar over reasonable period of time, and at some point now those new issues, even using Librlar will have much clearer outcomes at the end of live War, But obviously

the best case is to use SOFA. So we think about the floating rate note market and presented a real big challenge, And what the ART did was provide that fallback language so people could put their new issue out in a much safer way than they could have prior to that right, So you have to fall back language in order to enable people to get contracts done for financial securities, UM, even if libral is no longer available and you know, sort of before the new reference rate

is widely available. I'm curious, what's the I don't know, is take up the right word? What's the like adoption rate on that kind of fallback provision? Is everyone using it nowadays for the most part? Yeah, And and certainly in the floating rate note market, we would see people either either going directly to sofa, as you know, with I said over six d billions of new issue using

Sofa directly. And I would say that for the for a vast majority of that market, because there's an obvious risk that you can't undo what you've done post issue because of that consent challenge. So I think that, you know, for places where there's true economics, uh, not a lot of that, not a lot of flexibility that that market really was, you know, certainly an early adopter to these

fallbacks and to sofa itself. Are there instruments, just to be clear, other instruments out there that face a cliff nonetheless, that were issued before the fall back language uh was was offered before their ideas before people were really thinking about this, that a is going to create a real problem for um either holders or issuers of the notes. Yeah, and I think I think that the way I think, the way we think about oh this is really in terms of you know, legacy, you know, or or stock

and then flow. Right. So obviously when we look back on this, you know, the roll downs of of live or exposures when we began this work, you know, by the time we had arrived at two thousands twenty one, had everyone stopped using live or, we would have been in a much smaller exposure number. Uh. But obviously since this has taken some time, Uh, we we really think about that. But the real term we use, whether it be whether it be stock or legacy or flow and

new issue is what we call the tough legacy. And and the tough legacy are things like floating rate notes issued without good fallbacks that mature after with certain hybrids, perpetuals, and a lot of things that for the most part either have fallbacks no fallbacks whatsoever, uh they never contemplated the end of live ar or or they have fallbacks that revert to last libar or the third one where there is uh pretty pretty I would say extreme discretion by an agent or a trustee to pick the new

rate at the end of library. So those three categories

are what we call the tough legacy UH. And on the tough legacy in the US, we've been pursuing, UH, we've been pursuing a legislative path which would allow for through legislation for those tough legacy UH, securities and other contracts to embed ARC fallback language UH in place of no no fallback, in place of fallbacks that reference live ar which wouldn't exist and gives people also some ability on a on a voluntary basis if they have a lot of discretion to embed ARC fallbacks to create uh,

you know, some degree of safe harbor. So the tough legacy is the piece that we've really spent a lot of time on and again we are pursued doing a legislative path on that. But when we speak to market participants, UH, we were very very we really think people need to focus on that because whether or not that legislative path uh, you know, works out or not, people need to think

about that. It's probably when they risk prioritize that those are their single biggest risks is do you have a number for how big the tough legacy world is, like the size of this issue I don't have in front of me. Job. We could definitely get back, but it really, it really, it really deals with if you think about, you know, parts of the fixed income market again floating

rate notes that go beyond hybrids. Uh, you know that you think about the back end of a lot of a lot of trust preferreds that reference library that are well beyond one. Those are the kinds of things that you have out there. They really can't be. Uh, they

can't be. And you go much deeper into you know, into into just traditional uh you know, contracts that referenced live war for penalty rates or other things where if there's no lib ar and there's no fallback, you're gonna find yourself in, you know, in a lot of disputes

slash potential litigation. So if we just go back to um to sofa for a second and the link with the repo market, one of the criticisms of sofa as a replacement rate for a lib or has to do with this sort of dramatic rebo madness that we saw on the market back in September when we saw the

repo rate spike very quickly and very dramatically. And the criticism was that if you have a reference rate tied to a repo rate, that is that volatile something that can you know, change that quickly in a single day. But that probably wasn't a good thing for financial assets

or for the financial system. How do you respond to that, Tom, Yeah, thanks, you know, we looked at that and certainly, you know, the dynamics of the repo market we're certainly identified early days and we and we took that into consideration even even when we chose SOFA. I mean, obviously we know about war ends and near ends and you know, and how those things can you know, can create that type

of volatility. Uh. But again, when we thought about, you know, our our main goal was having enough underlying volume to make sure that we do this once and do it right. The second goal was to ensure that this was robust

and available, which it was. And I think the second piece of this is, you know, as much as we've seen these sort of uh, you know, a couple of days spikes in repo, the assumption would be that most market participants using SOFA would be using it in an average basis anyway, So when we talked about September, one of the things we put out and obviously we you know, we took a lot of incoming on that appropriately, was that the we found that the uh you know that

three month live or had moved had had actually moved more than three months sofa during that period on an average ninety day basis. So when we think about the uses of sofa, if you know, if if you're gonna use sofa and use you know, either three months three month average or you know, or a or a six month average or whatever, that these small spikes shouldn't actually

be uh that impactful. Uh. Nonetheless, I do think that you know, certainly, what we've seen in the markets recently gives us, I think and everyone a chance to really look at the data. Because if you go back to when we did this work, we all speculated on how sofa were con performed during the stress period. We speculated on how library were performed during a stress period, uh, and we and we speculate on how and how sort of other credit rates would perform during the stress period.

So with with with real data now, I think it's we're looking at it certainly at the ARC, and I think, you know, we would encourage others to take a look at how all these rates performed. Right, So so so for probably I think performed along what people would have expected as a flight to quality rate. It went down to attracted the monetary policy rate. Uh so pretty much wonderful. One. We looked at live war, which you know, was a

little bit harder to explain. So I think when we kind of put it all together and we look at the commercial paper markets, we look at live war, was live board tracking commercial paper, was commercial paper tracking live bar? What happened to money markets over that period? Uh? You know, one thing we will draw off from this obviously these challenging times, is that we do have real data to look at. So I do think that people in the market can model so for better and look at sort

of how it's performed under real life stresses. And I think, frankly, I think it does open up you know, still more questions about live or and where it comes from and where these submissions you know, what they reflect in the markets, uh, you know overall, so I think we're gonna try to do some real, real hard comparisons of this data. But but the but again that's your point the quarter end

and you're in spikes. I think are you know, get a little bit overblown in terms of their importance on an average basis, But they're important and they're real true factors in the report markets. So going forward in terms of your day to day work on this issue, what are the biggest um challenges that you still see ahead that need the most attention. So we recently released our our our sort of date specific best practices from the ARC that will take us from here, you know, through

the end of the transition. And uh, really what we did uh at sort of at the last several meets the ARC just during this even during this period, we've sort of doubled our meetings and you know, certainly we continue to see uh you know, the restatement of the deadline, so you know, uh, even in light of uh COVID nineteen, the work continues, and I think the what we've seen is that certainly the message we've gotten from the official sector even last week when Edwin's schooling water from the

st A, so there's no change in the position on compelling panel banks. We struck the deal that they would stay only end of one, and that's kind of the deal. So I think what we've what we've gotten here is a restatement of the twelve twenty one deadline, which means that it was important for the ARC, I think to

lay out, you know, some some things ahead. So in our best practices, we sort of we work our way from say June thirty when we when we we recommend these are obviously recommend the best practices that floating rate notes, residential arm securitizations should just at a minimum use ARC fallback language. We work our way to September through December,

and obviously the key dates in the future. I think one I really want to call out is when the central clearinghouses are going to switch their discounting on clear derivatives from UH from FED funds to SOFA and that's going to happen in October sixte and I think it'll answer probably some of the questions you may have had in previous UH in previous podcasts about UH the liquidity

and sulfur. So when that happens, that will actually you know, should serve to put a pump a lot of liquidity into sofur as people begin to uh, you know, swap out their discounting methodologies on clear transactions. Is the plays

a huge role here. They've got their protocol which will help deal with the legacy swaps that comes out, and the ARC is recommending that people sign that as quickly as a pot sibly can, but you know, certainly within four months of publication, and then we work our way through to things like streaming prices from dealers, and at some point when we get sort of out, you know, sort of with six months to go, really you know,

we recommend no new librar for business loans, floating rate securitizations, we clos go a little further out based on some feedback,

and then stopping new derivative traits that increase risks. So we've really tried to address this by getting the legacy UH in the best possible shape through fallbacks and protocols and other things, and then really you know, stopping new issue to some degree, we're slowing down new production, right, and really the whole idea of you know, the best way out of the holes to stop digging, which I think we can we can do today, and I think

we're just really trying to lay that out. So the ARC has really I think taken a position now to hopefully inform participants in the market on steps that they can take between now and the end of live War.

In addition to all the things that we put out in terms of tools, and we've also held ourselves were pretty high standards and meetings and uh and I have to say that even during this period, although we've been meeting virtually like everyone else we've been, we've been doubling our meetings and we continue to get product out there because we're continuing to address a deadline at twelve m. So I think it's kind of funny that you refer

to the committee as the arc, which obviously has biblical connotations. I don't know if that was sort of what you were thinking about, but do you feel a sense of responsibility when it comes to making the transition from live Board? This is clearly a new beginning in some sense um for the financial system. Tracy really comes down to that that this, this work is an opportunity for the industry to solve a problem that was that was quite obvious,

you know in two thousand and eleven and twelve. And I think the way we've tried to look at this is, you know, in acknowledging the challenges we have. We also know that we can that the market can act truly do this right with without you know, the market has an ability to correct this problem and and to put put the market on firmer on a on a firmer bit of footing. Uh. It turns out, you know, obviously the live woar is is a critical component of the infrastructure.

Uh it has it has you know, we've we've identified you know, the weaknesses of live war. We've identified what we think is a workable replacement. And certainly people in the market you know, can figure out ways to use sofa. And one of the tools we put out a while back was just how do you use sofa? How do you use to compounding? How do you do different things

to FED? Recently, now you can look go on the FED every day publishes averages of sofa that look back over periods of time, which will be a key component to the mortgage with the floody right, no mortgage market. So if you really just need to take it. In many cases we found and talking to you know, market participants, is that they just need a rate. They wanted to rate from screen and they used to be able to

look up and see three month live war. Well now you can see three month average SOFA and it's and it's on an it's you know, obviously it's administered by the New York Fed, so we have an unassailable administrator. We have a rate that's based on transaction. So you know, when we kind of get there, uh, you know from the people I've been on the Arctians the beginning and

took over his chair last year. But you know, between the people who've done it before, Brian Leach, Sandy O'Connor, who have chaired this, you know, there's been a degree of the people around this work, Uh can really see the challenges and also know that we have to get to the next place. And I think that people who are around this topic are are there's a lot of zeal around that, I would say, because it's an obvious problem and the solutions, although challenging, are there and we

can get this work done. Let's question for me, I mean one of the sort of like overriding themes of this and honestly other discussions at least that strikes out to me is just this whole idea of like inertia and network effects and how hard that is to break and how much work it is to go from one sort of de facto platform to another. And you mentioned, you know, aiming for a sort of real drop dead day and saying, uh, no more a goal of no

more library based contracts. Why is it that even at this late point, it's difficult for people to not just reach for lib or first, when you know the the alternative is now clearly available. It's it's a great point that the inertiats of the status quo around this has been, you know, one of our biggest challenges. And if you go back and you know think, uh, you know, anyone who's been in the market, you know since has seen library as a key component of of of the markets

and removing that. We talked about this, you know, years back. It's sort of the five stages of grief and how people have to go through it. But more and more we do face that and we will reach critical mass at some point. The key things I think on the

question is the derivative markets. There has been an enormous amount of reliance on the is the protocol because the IS the protocol allows people and there's been a lot of confidence that is that we'll get this work done, will deal with your legacy book in a fairly straightforward manner.

So the comfort people having a derivatives market is that the protocol will solve a lot of their problems, even if they're trading beyond the end of Really, if you think about it, at the beginning of this year, if you did a ten year swap, you were really doing two years of live or and eight years of so for so more and more, I think as people begin to understand this, But to me, one of the biggest incentives I think that will begin to get people moving

even a little bit more quickly is the capacity to operationalize all the things that we're doing, whether that be fallbacks or protocols. Just imagine we're here, you know, at the New Year's Eve in one and you've got thousands of protocols that you have to actually connect with counterparties on, and you have thousands of fallbacks that you have to recalculate and do these things. That capacity, I think will begin to be the incentive again to get people just

stop digging the whole. So more and more we're you know, we're anticipating that there will be a greater awareness as we move forward, and I think the tipping points could

be the is the protocol, the CCP conversion. As I talked about the central clearing houses switching their discounting methodology to SO for so, there's a few things coming down the pike where we think that, uh that more and more if you think about so for being, you know the way all clear product is discounted, Well, that's gonna create new hedging demand, that's going to create new activity and more and more. We think that we'll get there.

But I would say that we certainly would have hoped to have been a little further down the road here, but with the deadline in place, I think that I think our industry response to deadlines pretty well. Tom. That was a great sort of run through the work of the committee, and you really appreciate you coming on and explaining what's going on with us. Thank you so much. Yes, thank you great to Thank you so Joe. Just listening to that conversation, I mean, I don't really envy the

work that Tom is doing on that committee. It sounds like a pretty gargantuan task, to be honest, But I think your point about the network effect is really interesting and that's something that we've talked about well, in relation to a few different things now, but bitcoin being one of them. But it is. It is really interesting to see when a large group of people start to change behavior for something that's related to you know, this enormous

dollar amount of financial assets. Yeah. I thought that was really interesting, and especially like the specific deadline team mentioned and I like when he got into the details about Okay, on this day clearing houses are going to do, ex etcetera.

Because it's one thing to have another sort of platform so to speak, or index that you sort of hope will become the default standard, but then actually talk about what it takes to do the transition rather than just sort of having it out there because obviously, even if it's everyone can agree that so far or whatever, but in this case, so far is the better measure. Uh, that's not enough to get the transition over. You actually have to like put in the work and put on

all these deadlines. And I like what to talk about the language tools that use to use the transition. It's good to just hear about someone who's like very much like sort of sleeves rolled up in the work of doing this. Yeah. Absolutely, I also like the description of having like long term market participants move away from library as the sort of five stages of grief. Um, yeah, like who knew that people could be so personally tied

to an interest rate? But there we are. Well, you know, it's it's like we've all been in offices and workplaces long enough that we know that people get irrationally attached to bizarre things, certain workflows that people have dealt with

their entire careers. If he was saying, even if logically there's no good reason for it, it's like that's what they're familiar with, that's where they're the experts, and so you just have to uh, you see it all the time, and I guess I'm not surprised that uh an index or an interest rate could be one of them. Right, No one likes change. Okay, Well, I mentioned in the intro that we have two more episodes. This has been

one of them. We've got one more coming up, which will make our Librard series a total of five episodes in all, so something to look forward to. And I think I think by the time we finished this, I know you want to do that month long library series and keep it going. I'm good. I think a week is a good start. Yeah, I really think with five episodes will have covered. Um. I want to say all the bases, but I'm sure something will crop up that

we haven't covered, but the vast majority of bases. Okay, all right, Well this has been another episode of the All Thoughts podcast and another episode in our library series. I'm ms Alloway. You can follow me on Twitter at mssy Alloway and you can follow me on Twitter at the Stalwart. Follow our producer on Twitter, Laura Carlson at Laura M Carlson. Follow the Bloomberg head of podcast, Francesca Levi at Francesca Today, and check out all of our

podcast at Bloomberg under the handle at podcasts. Thanks for listening.