Life After Libor
The Libor reference rate is written into the contracts of approximately $370trn global transactions, including securitization like CLOs which comprise approximately $10trn of the total. After a string of scandals that made a change necessary, markets are beginning the gargantuan task of moving away from the benchmark.
The key question for each outstanding instrument is: what will the new reference be? It may be the benchmarks with existing history and depth like SOFR will become the default for many markets. But while derivative contracts are likely to receive globally standardized treatment from ISDA, securitized cash transactions are not homogenous. Consequently, holders must review the critical language found in each trust document. Then each trust will need to “decide.”
In some cases the transition from the LIBOR benchmark is contemplated in the language and may be a smooth process. In others the process may not be smooth. And in other indentures the transition may not be contemplated at all.
Moreover, different participants to the transaction may not be aligned, and the economic consequences might be significant. For example, in CLOs if the collateral in the asset side of the trust resets to one benchmark while the tranche liabilities reset to another, the equity might receive either a windfall or a catastrophe.
Securitized markets including CLOs are notoriously illiquid, further exacerbating the risks. It may be that even if parties are aligned to pursue a particular adjustment to the indenture language, the necessary votes to amend cannot be found! This result would echo some of the challenges that occurred following the 2008 crisis. Typically in structured credit transactions less than 10% of the holders can be identified easily from public sources. By contrast, almost half of holders of the debt of the Fortune 500 can be found, and public holders of the Fortune 500 equity can be found in approximately 85% of cases.
Therefore, for approximately $10trn of structured credit transactions globally (including CDO, CLO, RMBS, CMBS, and Syndicated loans), the stakes are high and the solutions appear to be difficult to implement.
It’s not only Libor:
An array of regulatory requirements that have unfolded in Europe and the US since the financial crisis have all shared a common objective: restoring confidence in the European financial and securitisation markets, through tighter controls and communication, increased transparency and information sharing across all parties.
STS, Solvency II, IFRS 9, Basel III and MiFID II are all scheduled to take effect in the next 15 months or have already been implemented. There have also been pushes in the US, through regulations like Reg AB II, investor based trade associations, (SFIG RBMS 3,0) and industry groups that call for similar communication.
And the call for increased communication is not only coming from regulators and rating agencies; it is also coming from investors, trade associations, and other market participants.
These create operational and compliance requirements globally for both buy side and sell side players, trustees, servicers brokers, and all other parties in the transaction chain. In the US, regulations like Reg AB II, investor-based trade associations, (SFIG RMBS 3.0) and industry groups are all calling for similar communication.
What type of communication:
With the forthcoming move away from Libor on top of the regulatory and investor-mandated initiatives, communication amongst all parties that is authenticated, identity-protected, and that makes use of voting, tabulation, and corporate actions tools will not only be beneficial; it will be mission-critical to fulfilling these requirements.
The process of finding all the interested parties and negotiating a switch (to a new reference in the case of Libor, or generally with respect to any amendment) could be time consuming and laborious without the communication tools DealVector has implementing, particularly through its Liborhub module. Liborhub connects into DealVector’s network of over 1000 institutions that participate in the structured credit space, consolidates market information, and provides communication and voting facilitation tools to make it easier for participants to manage their risk. DealVector can review documents for clients as well as analyze market holdings and estimate the difficulty of execution for parties that are concerned about their transactions.
The benefits of this type of market communication have already begun to accrue. There are numerous specific examples where firms were able to locate and communicate with their (previously unlocatable) end investors, secure and tabulate needed approvals, and provide corporate actions and other documentation. On DealVector, for example, managers were able to ‘Volckerise’ their CLO transactions, community banks were able to locate their TRuPS liability holders to effect recapitalizations, and the entire Student Loan ABS investor universe came together to pass maturity extensions on $18bn of issuances with 100% consents thresholds! The last involved position sizes from $25,000 to $200m or more across almost 400 investors.
Clearly, communication technology is beneficial to an orderly market, and policymakers have recognized this fact, particularly in Europe. But there is more to be done, since the basic settlement infrastructure of finance makes it very difficult for investors to coordinate.
The possibilities of an improved communication system would be exciting and likely lead to more business for everyone. The volume of new issuance, it is believed, could increase as confidence of investors improved.
Further benefits:
The potential to leverage better communications technology will have a meaningful impact on liquidity, which will lead to better mark-to-market pricing and a positive impact on risk retention capital requirements. Ultimately the goal is to maintain market confidence and retain investors when conditions change. This increase in liquidity and resultant positive impact on credit will ultimately help lower capital requirements and create a securitised market environment that is supportive of growth and recovery.
Another benefit of these technological solutions in aggregate is they will create a better market and allow for better pricing and valuation. With increased communication, and therefore transparency and liquidity, valuation services will have access to more actual trade data, allowing them to provide the highest quality prices. A better system for communicating axe sheets and quotes will support trade decision analyses, as well as end of period valuations and modelling. Intra-day and end-of-day pricing will become more robust, more accurate, have less volatility and will help meet audit requirements for additional marks.
Dave Jefferds
Co-founder, interim CEO
DealVector
Michelle Kelsy
Managing director
International Solutions Network
Published in AltCredit June 2018, Issue 38
