Libor phase out: are markets ready?
The 51-year-old benchmark for short-term interest rates around the world will be retired at the end of 2021 but financial firms are reluctant to embrace its heirs
Libor, short for the London Interbank Offered Rate, is an interest rate based on quotes from banks on how much it would cost to borrow money from each other.
It’s the main benchmark for short-term interest rates around the world, governing debt and contracts worth more than $300trn (€277trn, £232trn), from complex derivatives to mortgages, consumer loans and credit cards.
The 51-year-old rate will be phased out at the end of 2021, putting an end to what has been called the world's most important number.
Despite the looming demise of the scandal-plagued interest rate, market participants have been slow to move to a new rate, complaining that its replacements lacks many of the attributes that made Libor successful.
What does Libor mean?
Libor is a benchmark for short-term rates, ranging from overnight to one year, across many different currencies.
It dates back to 1969, when a Greek banker arranged a syndicated loan linked to the reported funding costs of banks.
However, it wasn't formalised until the British Bankers' Association (BBA) began overseeing the collection and governance of this data nearly two decades later.
The initial $80m loan, for the Shah of Iran, opened up cross-border financial markets and sowed the seeds for London to flourish as a global financial centre.
Birth of a global benchmark
Within a few years, Libor evolved from a measure used to price individual loans to a much broader benchmark for deals worth hundreds of billions of dollars a year.
The market for loans became more complex as demand surged and grew to include instruments such as interest rate swaps, foreign currency options and forward rate agreements.
Meanwhile, banks started borrowing more of their own funding from credit markets.
Eventually, the BBA, backed by the Bank of England, took control of Libor in 1986 with the aim of boosting efficiency, transparency and governance by formalising the process of collecting interbank rates.
Why is Libor being phased out?
During the financial crisis of 2008 it became clear that the rate was easy to manipulate, because banks were asked to report a hypothetical rate at which they could borrow, not the rate they actually used.
Many financial firms rigged Libor to bolster returns and hide financial weaknesses, while borrowers ended up overpaying for rates.
After regulators in the US, UK and other countries stepped in, four banks – Barclays, UBS, RBS, and Rabobank – ended up paying combined settlements upwards of $3.5bn.
As a result, oversight of Libor switched to the UK’s top regulator, the Financial Conduct Authority (FCA).
In 2017, the FCA announced the benchmark will be phased out by 2021 in favour of risk-proof replacements.
Alternative risk-free rates have been set up for the different currencies that reference Libor to ensure any teething problems could be dealt with during the transition period.
These are Secured Overnight Financing Rate (SOFR) for USD, Sterling Overnight Index Average (SONIA) for sterling, Euro Short-Term Rate (ESTER) for the euro, Swiss Average Rate Overnight (SARON) for the Swiss franc, Tokyo Overnight Average Rate (TONA) for the yen. All of these are already being published.
Government-sponsored enterprises such as Fannie Mae and Freddie Mac in the US have announced that they would discontinue acceptable adjustable-rate mortgages based on Libor by the end of 2020. This is a huge step towards weaning markets off Libor-linked products.
One key advantage of these new rates is that they are harder to manipulate, because they are based on real transactions, unlike Libor.
However, being backward-looking rates they are more suited to derivatives markets than cash markets, which rely on forward-looking rates. This raises concerns that the new benchmarks may not suitable for all transactions covered by Libor.
Impact of Libor phase out
As a result, the transition from Libor to its successors has met some speed bumps.
One concern is that SOFR is quoted at a lower rate than Libor due to how it is derived. This means a straight transition from Libor to SOFR would result in a lower interest rate.
Libor was based on unsecured transactions and therefore included a bank funding risk. So, to ensure compatibility, an adjustment spread will be required on SOFR.
Another problem lies in the preparation of written contracts for the transition.
Any new contract that extends past the retirement of Libor should use another benchmark or have fall-back language if Libor ceases to exist.
However, legacy contracts tied to Libor without fall-back language that extend past 2021 will be more complicated to deal with.
Financial firms have the option of amending these contracts now to reduce litigation. But this is proving costly and could be even rejected by borrowers who disagree with the new terms.
There are also huge costs linked to the overhaul of banks’ systems and training staff to operate under the new benchmarks.
Unsurprisingly, the adoption of the new benchmarks has been slow, which is turning into a headache for regulators as the market is running out of time.
Financial regulators around the globe have warned banks of the need for faster action.
Federal Reserve Bank of New York President John Williams said last week that the move away from Libor was “the biggest challenge” facing the financial system.
“While some institutions are making good progress, others are sticking their metaphorical heads in the sand, hoping the issue will go away,” he said.
Japanese regulators have warned that banks should accelerate their preparation for the end of Libor to avoid damage to the financial sector and the wider economy.
Should investors worry?
Libor has been central to the global financial system for decades, so it was expected that replacing it would involve numerous challenges and risks.
While its retirement has been referred to as the financial market equivalent of Y2K – the tech scare that assumed the world’s computers would shut down as 1999 turned to 2000 – the transition is meant to be gradual and measured.
Morgan Stanley analysts have pointed out that the biggest risk is that Libor will end prematurely, either because the number of panel banks falls below the required minimum or because regulators trigger an early end.
While this is unlikely – given that panel banks and regulators have a vested interest in a smooth transition – it could disrupt the financial system if adequate fall-back clauses aren't already in place.
For legacy contracts, the discontinuation of Libor raises the possibility of major, disruptive value transfers because Libor’s replacements are unlikely to be its economic equivalent.
For consumers with floating-rate loans or mortgages, this means they could get a letter in the mail in the near future, informing them that their borrowing rates will change.
In addition, consultations are ongoing for defining alternative reference rates that are forward-looking, with a term structure, to suit cash markets as these markets require certainty of cash flows to function.
Will bank stocks be affected?
It's too early to estimate how the transition from Libor will impact banks’ earnings.
Morgan Stanley analysts believe that US banks first need a functioning SOFR derivatives market to enable the hedging required to manage their balance-sheet risk.
As the derivatives market linked to SOFR grows, it should also help increase market depth and the liquidity needed to assess credit spreads.
“This is a bit of a ‘chicken or the egg’ scenario, in which issuers want to see more liquidity before they adopt SOFR, but this liquidity hinges on more issuers embracing SOFR before Libor is gone for good,” the analysts said.
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