Libor's Uncertain Succession Triggers $350 Trillion HeadacheBy , , and
FCA’s Bailey says Libor isn’t sustainable in its current form
Benchmark replacement is part of ongoing global reform effort
U.K. regulators’ decision to abandon the Libor benchmark by the end of 2021 is sowing confusion in the market as the industry races to replace the scandal-plagued rate underpinning more than $350 trillion of financial products.
Bankers and traders for decades have built Libor -- which stands for London interbank offered rate -- into financial contracts of all types: mortgages on homes and office towers, corporate loans, student debt and tens of thousands of interest-rate derivatives contracts. Now the finance world will need to find another reference rate for new transactions. Existing contracts will need to be renegotiated. And computer systems coded to the Libor rate will need an overhaul.
“It’s going to be a feast for financial lawyers,” said Bill Blain, head of capital markets and alternative assets at brokerage Mint Partners in London. “Libor is part of the financial infrastructure that supports the swap, loan and floating-rate bond industry. Everyone now will need to check what contracts say, and it’s going to be a headache for anyone with a Libor-based contract.”
The U.K.’s Libor-replacement effort is part of an ongoing global push to reform benchmark rates discredited by manipulation and false reporting. In 2014, the Financial Stability Board set out a road map to overhaul rates including Libor and develop viable risk-free alternatives. The decision to phase it out was inevitable as it was the only way to push users to adopt a new benchmark rate, NatWest Markets strategist Blake Gwinn.
“There had never been an answer as to how you get market participants to adopt a new benchmark,” Gwinn said by phone. “It was clear at some point authorities were going to force them.”
Andrew Bailey, head of the Financial Conduct Authority, said in London on Thursday that Libor isn’t sustainable because it is often not based on actual market transactions. The benchmark is the average rate that 20 banks estimate they’d be able to borrow funds from each other in five different currencies across seven time periods, submitted by a panel of lenders every morning. Its administration was overhauled in the wake of the scandal, with Intercontinental Exchange Inc. taking over from the then-named British Bankers’ Association with the aim of making the rate more transaction-based.
As the U.K. pushes toward a transaction-based rate, efforts on the continent have faltered. The European Money Markets Institute, which administers the Euribor benchmark index, decided in May not to move to its proposed transaction-based methodology in the short term.
The Bank of England unveiled the Sterling Overnight Index Average, or Sonia, in April as a near risk-free alternative to Libor for use in sterling derivatives and other relevant financial contracts. The replacement benchmark was recommended by a swaps-industry working group led by Francois Jourdain, chief compliance officer at Barclays Investment Bank.
The BOE took over administration of Sonia in April 2016. It reflects bank and building societies’ overnight funding rates in the sterling unsecured market. The BOE is in the process of reforming the benchmark and expects to roll out the new version by April 2018.
The U.K. industry’s embrace of Sonia, and a U.S. market panel’s choice of a broad Treasuries repo rate, are “key steps” to more reliable benchmarks, The FCA’s Bailey said. He didn’t go out of his way to promote Sonia on Thursday; instead, he outlined the goals that replacement rates would need to satisfy.
“I don’t rule out that you could have another benchmark that would measure what Libor is truly supposed to measure, which is bank credit risk in the funding market,” he said. “But that would be -- and I use this term carefully -- a synthetic rate because there isn’t a funding market, so I think it would be a combination of Sonia plus a proxy bank credit rate.”
ICE Benchmark Administration, which runs Libor, could even continue to produce the benchmark with banks on the rate-setting panel after 2021 if it chose to do so, Bailey said. Under the FCA’s plan, “the benchmark would no longer be sustained through the mechanism of the FCA persuading or obliging panel banks to stay,” he said, meaning Libor’s survival “could not and would not be guaranteed.”
ICE Benchmark Administration said Bailey’s comments would “help to ensure the transition to our evolved Libor,” and that the benchmark has a “long-term sustainable future.”
“Our evolution for Libor is based on banks broad wholesale funding and minimizes the use of subjective judgment unless necessary to ensure that the rate can continue to be calculated even in the most extreme market conditions where transactions might not be available,” a spokesperson for the company said on Thursday.
Peter Chatwell, head of European rates strategy at Mizuho International PLC in London, said the FCA’s decision to drop Libor without designating its replacement will inject uncertainty into swap rates based on the benchmark.
“The market will need guidance as to what a replacement could be, and this will lead to increased volatility and, possibly, reduced liquidity in the near term,” Chatwell said.
Bailey also addressed the issue of contracts that reference Libor and are still in effect at end-2021. Their fate depends on the “preparations that users of Libor make in either switching contracts from the current basis for Libor, or in ensuring that their contracts have robust fallbacks in place that allow for a smooth transition if current Libor did cease publication,” he said.
Scott O’Malia, chief executive of the International Swaps and Derivatives Association, said the “most obvious concerns” about the transition include ensuring adequate liquidity in the new rates and agreeing on a plan for legacy contracts.
“ISDA and its members are also actively working to develop and implement fallbacks for contracts, including legacy contracts, that continue to reference Libor and other Ibors,” he said.
As to whether the FCA’s timeline for transitioning away from Libor in less than five years in is aggressive or lax, Bailey said, “you’ll get a range of reactions.”
“It doesn’t look lax from where we sit given the amount of work that needs to be done,” he said.
— With assistance by Suzi Ring, Donal Griffin, John Glover, Hayley Warren, Alex Harris, and Dan Wilchins