With the underlying markets no longer active enough to sustain the benchmark, Libor is set to be discontinued. The FCA has given a hard stop of 2021, but market participants are split as to whether an appropriate alternative can be agreed upon. Lynn Strongin Dodds reports.
The fate of London Inter-Bank Offered Rate (LIBOR) has been hanging in the balance for some time but a concrete deadline for its demise has been elusive. This changed in the summer when Andrew Bailey, CEO of the Financial Conduct Authority (FCA) officially called time and set the clock to a 2021 stop. Whether the industry can agree upon a suitable substitute within the given timeframe is open to question.
In a speech in July Bailey argued that the market for unsecured wholesale term lending to banks is no longer busy enough for Libor—the rate at which banks will lend to each other—to be based on transactions. He said “The absence of active underlying markets raises a serious question about the sustainability of the Libor benchmarks that are based upon these markets. If an active market does not exist, how can even the best run benchmark measure it?”
In other words, without transactions, setting benchmarks become more reliant on banks’ “expert judgement”, which according to Bailey creates an “inherently greater vulnerability to manipulation”.
“The market agrees that if we were to design the benchmark again from scratch, Libor would not be the main reference rate,” says Nick Chatters, fixed income investment manager at Kames Capital. “But with so much of the market already using the fix, it’s not easy to wean off it. The market needs a regulatory push. The FCA and Bank of England (BOE) do not see Libor as a desirable reference rate, and Andrew Bailey’s comments are the next step in this process.”
Is a 2021 wind down possible?
Many industry participants though are not convinced, and share the views espoused by Rick Chan, executive vice president and portfolio manager and Jerome Schneider of PIMCO. They wrote, “We at PIMCO do not think Libor will simply disappear after 2021. Given the sheer volume of derivatives contracts and debt currently tied to Libor, removing it from the landscape will be a complex exercise and is unlikely to happen by 2021. What we’re watching is how Libor may evolve over the next few years.”
The authors believe that Libor will continue after 2021 even without FCA support, “possibly through oversight by a new regulatory body or by member banks. We do, however, expect trading of derivatives keyed off other benchmarks, such as overnight index swap (OIS) rates and the federal funds rate in the U.S., will continue to increase.”
Finding a replacement was never going to be easy. This is because Libor, which debuted in 1984, has become a cornerstone of the loan and derivative markets, with over $350 trillion of contracts referencing the rate, according to figures from independent financial risk management consultancy JCRA. It underpins financial instruments ranging from home mortgages to student loans and OTC derivatives contracts.
The benchmark fell from grace due to a series of well-documented rigging and reporting scandals in the post financial crisis era, and regulators have been looking for a stand-in ever since. In 2014, the Financial Stability Board (FSB) set out a road map to overhaul rates including Libor and develop viable risk-free alternatives. In the meantime, the ICE Benchmark Administration, the London unit of Atlanta-based InterContinental Exchange (ICE), was created to take over the Libor administration reins from the British Bankers Association (which was merged into UK Finance in July this year).
Market conditions have also not been kind to Libor. A combination of long-term record low interest rates, an abundance of quantitative easing, central bank funding mechanisms and more stringent regulation have taken their toll, according to Rob Ford, a founding partner of TwentyFour Asset Management, a boutique of Vontobel Asset Management, “The significantly higher capital charges, the advent of the bail-in regime, and banks with credit ratings that are multiple notches below where they were 10 years ago, has meant that banks have simply stopped borrowing from one another,” he adds.
Alternative rates include SONIA, BTRFR, SOFR
The Financial Stability Board’s Official Sector Steering Group and the International Swaps and Derivatives Association (ISDA) have been busy working to identify potential risk-free rates and develop the mechanism to implement such fallbacks into existing and future contracts.
One of the first to come forward is the BOE Risk Free Rate Working Group. Its preferred option is the reformed Sterling Overnight Index Average (SONIA)—a reference rate based on actual transactions in the overnight unsecured loan and deposit market. In the US, the Federal Reserve Bank of New York-sponsored Alternative Reference Rate Committee (ARRC) has plumped for a Broad Treasuries Repo Financing Rate (BTRFR), which works by reflecting how much it costs to borrow cash secured against US government debt.
The Federal Reserve is theoretically publishing the new index rates in the first half of 2018. It will however run in parallel with Libor for several years, in order to help determine a fair compensating credit spread between the two benchmarks for those financial assets that will need to change their reference interest rate to the new index.
The benefits of SONIA and BTFRF are that they are anchored in significantly more active markets than term Libor and neither involves expert judgement. They are based instead on transaction data collected by central banks.
The ARRC’s working group has also selected the Secured Overnight Funding Rate (SOFR) as its preferred near risk-free interest rate benchmark for use in certain new U.S. dollar derivatives and other financial contracts. The SOFR has yet to be published but is to be based on the cost of overnight loans that use U.S. government debt as collateral, with an average daily volume of $660 billion, according to Brian Phelan, Director of JCRA in New York.
He notes that the Federal Reserve Bank of New York in cooperation with the Office of Financial Research is targeting the same timeframe as the BTFRF—the first half of 2018.
“We all want a risk free, or near risk free, rate as an alternative to Libor,” says David Clark, Chairman of the WMBA. “Libor captures credit risk premia as well as reflecting interest rate movements along the yield curve. The problem with SONIA and other solutions that are being worked on in the US, for example, is that they need a term structure for several types of user. Ideally, a benchmark should be transaction-based and liquid across most maturities, as well as having integrity, and I believe that we will see a number of initiatives in the near future.”
Ford also notes that while the swaps market may have already agreed to use the reformed SONIA benchmark as its new risk-free rate, it is still unclear as to how they will affect the changeover. “Many contracts will need a term rate to replace standards such as three or six month Libor,” he adds. “I understand what the FCA is doing to make a reliable index, but they have not given us any idea of the terms,” he says. “There are questions in terms of how that will be achieved, and whether a new basis between SONIA and the relevant term would need to be created.”
While the BTRFR has seemed to gain wide acceptance because it reflects the Treasury market, there are issues around the SOFR. “It will purely be an overnight rate, which may cause more issues for many end-users, particularly smaller derivative end-users and borrowers,” says Phelan. “For example, as a borrower looking to manage cash flow within your business, it can be valuable to understand what your interest expense for the quarter will be at the beginning rather than at the end of the quarter.”
Legacy portfolios present grandfathering challenges
A challenge common to all new benchmarks will be how to handle the legacy portfolios of derivatives that reference Libor. As Ivan Harkins, Director at JCRA, and head of the Structuring and Advisory team notes, the change of reference risk-free rate and discontinuation of Libor could result in a material amendment to legacy swaps, which may prevent the grandfathering that many market participants have relied upon.
ISDA has been looking at the best ways to implement the fallback mechanism once all the alternative benchmark rates have been selected. There are currently four working groups—three are focusing on the requirements for the dollar/Libor, sterling/Libor, and yen/Libor, while the fourth zeroes in on the same issues for the Australian dollar, Hong Kong dollar, and Singapore dollar.
“There will be protocols in place in terms of the best way to deal with the discontinuation of Libor,” says Harkins. “We are already seeing ISDA’s working groups formulating fall-backs protocols in the event that Libor is permanently unavailable and will likely select the relevant benchmark risk-free rate for each currency, with the addition of a spread to incorporate residual term and bank credit premia.”
In the longer term, market participants see the creation of liquid futures markets for the new benchmarks as one way to allay some concerns. Currently, much of the current derivatives trading is facilitated by the large and liquid pool of short sterling futures contracts, according to Chatters. “For the market to adopt a new reference rate such as SONIA, there needs to be a successful SONIA futures market established, something which is currently being consulted on by the BoE working group,” he adds.