FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION LIQUIDITY INSIGHTS Markets’ transition away from Libor What you need to know March 2020 IN BRIEF • Libor (the London Interbank Offered Rate), the world’s most widely used benchmark for floating rate instruments, is transitioning to more robust benchmarks by the end of December 2021. • USD Libor is being superseded by SOFR—the Secured Overnight Financing Rate. There are also planned replacements in other currencies. This transition is important to front-end investors because many liquidity strategies invest in floaters. • While this change has its challenges, SOFR-based bonds and derivatives are already available in limited but growing volumes. J.P. Morgan Global Liquidity has been buying SOFR-based floaters since 2018 and is experienced in pricing, trading and settling these securities. Libor is currently in the process of being phased out and replaced. The authorities responsible for Libor have said they cannot guarantee its publication beyond 2021. Below are some frequently asked questions that may be relevant to liquidity investors about the Libor transition and what comes next. What is Libor? Libor, the London Interbank Offered Rate, is intended to represent the rate at which banks can fund themselves on a short-term, unsecured basis in the London wholesale market. It has been the most widely used interest rate benchmark in the world.1 Libor is determined by a bank survey administered by the Intercontinental Exchange (ICE). Every business day, ICE asks a panel of about a dozen contributing banks the rate at which they can fund themselves in various tenors inside one year in five currencies: the Swiss franc (CHF), euro (EUR), pound (GBP), yen (JPY) and U.S. dollar (USD). ICE then collates the results, omits the top 25% and bottom 25% of submissions, and averages the middle to determine Libor. Why has Libor been important for liquidity investors? A floating-rate bond is an investment that pays regularly timed coupons that reset periodically with prevailing interest rates, and pays principal at maturity. If interest rates rise, coupons rise; if interest rates fall, coupons fall. Because of their low duration, floating- rate bonds are frequently purchased by many money market and ultrashort strategies. Kyongsoo Noh Portfolio Manager Currently, Libor is the most common index rate used to reset floating-rate coupons. J.P. Morgan Asset Management 1 “Frequently Asked Questions,” ARRC, SEC, https://www.sec.gov/spotlight/fixed-income-advisory-committee/arrc- faqs-041519.pdf WHAT YOU NEED TO KNOW What else is Libor used for? marketplace. The size of the Treasury repo market is approximately $1 trillion in transactions a day on average.5 Libor is used to, among other things, set the payments of the Repurchase agreements are the main financing channel for floating-rate legs of derivatives trades, as well as the interest Treasuries held on bank balance sheets. Therefore, SOFR is rates on floating-rate mortgages, bank loans and deposits. considered a good representation of the health and liquidity of the bank funding markets. Why is Libor going away? There are concerns about the robustness and sustainability of Who produces and administers SOFR? the process used to set Libor. The size of the interbank lending The New York Fed publishes SOFR on its website on a daily market is typically less than $1 billion a day.2 By contrast, the basis, at approximately 8 a.m. EST. An internal New York Fed size of the market that uses Libor resets exceeds $200 trillion.3 Oversight Committee reviews the rate production process The relatively small size of the London interbank lending from time to time.6 market, the reduced number of banks participating in the Libor-setting process and the fact that Libor is set by a survey and not transactional data have led regulators to support the When is Libor going away? development of a more robust benchmark rate. Newly originated derivatives with floating legs are planned to transition to SOFR in the fall of 2020. Non-derivative Who is in charge of the transition process away instruments are scheduled to transition to SOFR by the from Libor for USD-denominated instruments? end of 2021. However, SOFR-based derivatives and bonds are currently available in limited amounts, and volumes The Alternative Reference Rates Committee (ARRC) is are growing. Money market funds have been significant overseeing the transition. The ARRC is a group of market buyers of SOFR floating-rate securities (floaters) issued participants initially convened by the Federal Reserve (Fed), by government-sponsored enterprises (GSEs) and are one in cooperation with the U.S. Treasury Department, the U.S. of the drivers of the volume growth in that market. Commodity Futures Trading Commission and the U.S. Office of Financial Research.4 The ARRC first met in December 2014. What are the main differences between Libor and SOFR? What is replacing Libor for USD-denominated instruments? Libor determinations are for specific terms: overnight, one week, one month, two months, three months, six months In June 2017, the ARRC identified the Secured Overnight and 12 months. SOFR is an overnight rate. Also, Libor is an Financing Rate (SOFR) as the replacement for USD Libor. unsecured funding rate, while SOFR is a secured funding SOFR is the overnight rate at which repurchase agreements rate. Furthermore, Libor is based on a survey and SOFR on (repos) collateralized by Treasuries are executed in the transaction prices (Exhibit 1). EXHIBIT 1: DIFFERENCES BETWEEN SOFR AND LIBOR7 SOFR LIBOR Risk free rate (no credit risk) Bank lending rate (includes credit risk) Overnight (backward looking) Forward-looking Secured (collaterialized) Unsecured (uncollateralized) Calculated and published daily by the NY fed Calculated & published daily by ICE Benchmark Adminsitration Transaction based Based on Libor bank submissions and expert judgment Based on ~$1tn transactions per day (repo markets) Based on ~$1 bn transactions per day (3-month Libor) No term structure Term structure 2 “LIBOR/SOFR FAQ,” Federal Home Loan Bank of San Francisco, http://www.fhlbsf.com/member/libor-transition-faq.aspx 3 “Transition from LIBOR,” ARRC, Federal Reserve Bank of New York, https://www.newyorkfed.org/arrc/sofr-transition 4 “Frequently Asked Questions,” ARRC, Federal Reserve Bank of New York, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC- faq.pdf 5 “SOFR Primer: The transition away from LIBOR,” SIFMA, https://www.sifma.org/resources/research/sofr-primer/ 6 “Transition from LIBOR,” ARRC Convened by Federal Reserve Board and Federal Reserve Bank of New York, https://www.newyorkfed.org/arrc/ sofr-transition. 7 Source: SIFMA. “SOFR Primer: The transition away from LIBOR,” SIFMA, Julyhttps://www.sifma.org/resources/research/sofr-primer/ 15, 2019, 2 MARKETS’ TRANSITION AWAY FROM LIBOR WHAT YOU NEED TO KNOW If SOFR is an overnight rate, how will it set 2021 and whose underlying documents did not anticipate monthly or quarterly to pay floating-rate significant changes to the Libor fixing process. For these, coupons? the investment decision will depend on a number of factors, which may include but are not limited to: ease of making Eventually, we believe, a derivatives market will develop amendments to the underlying security documentation, from which market participants will be able to determine liquidity, premium or discount to SOFR-equivalent securities, term SOFR rates. Until that time, monthly or quarterly pay relative value and how the coupon is determined (or is coupons based on SOFR rates will likely be calculated by expected to be determined) after the transition away either compounding or averaging SOFR in arrears over from Libor. the appropriate term. New deals that have Libor resets in 2022 and beyond now Libor is an unsecured rate and SOFR is a often have fallback language that dictates how new floating secured rate. How will that affect bond spreads? payments will be calculated after the transition away from Libor. The generic elements of the fallback language are (1) Theoretically, unsecured funding rates are higher risk and a trigger event that defines the circumstances under which should be higher in yield. Therefore, all else being equal, the Libor will be replaced, (2) a replacement rate that will be spread to SOFR should be wider than the spread to Libor for used instead of Libor following the trigger event and (3) a the same issuer to get an equivalent coupon. spread adjustment, if necessary, that will account for the differences between the replacement rate and Libor.8 One What are the main challenges of the transition? of the challenges is how to value these securities when their earlier coupons paid based on Libor and their later coupons Liquidity is evolving for SOFR-based securities. SOFR bonds will pay based on SOFR. are liquid, but bid-offer spreads are currently slightly wider on SOFR-based floating-rate securities than on Libor-based bonds. We think bid-offer spreads should tighten in 2020 Are any other index rates being changed as part on a relative basis as the volume of issuance increases, of this regulatory initiative? derivatives markets develop and market participants The transition away from Libor is a global initiative. Exhibit 2 become more familiar with SOFR. outlines the alternative reference rates that have been Another challenge is determining what to do with older selected in each Libor currency: floating-rate securities