Risk Managing the LIBOR Transition

Abstract

By halting the LIBOR's publication, large volumes of fixed income securities, from loans to derivatives, will fall back to an alternative fixing reference. The initial proposal of a SOFR fallback eliminated any degree of subjectivity but opened up funding risk. Overlaying a credit spread over SOFR is a remedy that goes in the right direction, but neither guarantees a robust hedge for funding risk nor prevents accidental wealth transfers.

To ensure robust funding risk hedges under all scenarios, we propose to complement the fallback rate by overlaying it with periodic exchanges of Funding Valuation Adjustment (FVA) reset amounts. Our proposal accomplishes the LIBOR indexing’s mandate of transferring banks’ funding risk to counterparties more accurately and robustly than the LIBOR itself while being objective and legally robust.

We conclude that the LIBOR transition is an excellent stimulus and opportunity to improve funding strategies and, if implemented with foresight, can make the financial system more resilient and efficient.