Closing the door on Libor
16 May 2018
Fran Garritt of RMA and Frank Devlin of The RMA Journal discuss the possible transition from a London interbank offered rate to new risk-free rates
Image: Shutterstock
The London interbank offered rate, better known as Libor, has had a long and influential run. Devised in 1969 as a method to price a syndicated loan deal with the Shah of Iran, Libor, which is an estimate of the interest rate that London banks would pay to borrow from each other, was later formally published by the British Bankers Association and grew to become an international go-to benchmark.
Today, an estimated $160 trillion of US dollar exposures is tied to the swings of Libor. Globally, Libor-related exposure has been estimated at up to $400 trillion in dollar terms, covering auto and student loans, commercial and residential mortgages, corporate and syndicated loans, and various derivatives.
But now Libor’s days of influence may be numbered. In fact, they number somewhere in the range of 1,300 days, if things go according to plan. In its place will be alternative risk-free reference rates based on transactions that include overnight funding and repurchase agreements.
Concerns with Libor’s continued viability
Last July, Andrew Bailey, chief executive of the UK Financial Conduct Authority (FCA), the agency that oversees Libor, announced that the 20 rate-submitting banks have agreed to contribute to Libor until the end of 2021. While banks may voluntarily submit rates thereafter, Bailey has said that the FCA will not compel them to do so. Most in the industry agree that the FCA’s announcement sounded the death knell for Libor as we know it.
Libor came under scrutiny with coverage of the manipulation scandals emanating from the financial crisis. To either downplay their credit problems or enhance their market gains, some banks participating in Libor-setting were gaming the rate by understating or overstating their perceived borrowing rates.
In response, the FCA stepped in to oversee Libor regulation. In 2014, Libor underwent the transition to a new administrator, the ICE Benchmark Administration, which has taken steps to formalise the rate submissions process and establish an oversight committee. However, despite these efforts to professionalise the rate and the submission process, Libor has continued to lose the industry’s confidence.
A key source of the concern is that, over the years, as the number of actual interbank borrowing deals has fallen off, the rates have grown more dependent on the estimates of submitting banks. In other words, because of low transaction volumes, more and more submitting banks have to respond to Libor surveys by providing an estimated rate based on “expert judgment” instead of a rate they have actually paid or are paying.
In a recent article, Forbes, citing Barclays Bank, noted that “submissions based on ‘expert judgment’ rather than real transactions now make up 70 percent of the daily three-month Libor submissions”.
Federal Reserve chairman Jerome Powell has said that “many banks are now understandably uncomfortable with being asked to provide judgment about something they do very little of”.
Powell has cautioned: “Libor may remain viable well past 2021, but we do not think that market participants can safely assume that it will.”
“The absence of active underlying markets,” Bailey has said, “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?”
Transition to new risk-free rates
While the continued viability of Libor is in question, it is clear that transitioning to agreed-upon benchmarks that can match Libor’s load of tenors (one day, one week, one month, two months, three months, six months, one year) and currencies (US dollar, euro, British pound, Japanese yen, Swiss franc) will also be a complex and costly challenge.
A RBC Capital Markets report calls the transition from Libor a “Herculean task [...] across wide ranging asset classes and financial instruments. For benchmark reform to be successful, there will need to be broad market adoption of the alternative [rates]”.
For US dollar transactions, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) has recommended replacing US Libor with the secured overnight funding rate (SOFR). SOFR is set to include triparty repo data from Bank of New York Mellon, cleared bilateral repo transactions, and general collateral finance repo data from the Depository Trust & Clearing Corporation.
Following the ARRC’s recommendation, Federal Reserve chair Powell and Commodity Futures Trading Commission (CFTC) chair Christopher Giancarlo noted in a Wall Street Journal commentary that SOFR “resolves the central problem with Libor, because it will be based on actual market transactions currently reflecting roughly $800 billion in daily activity. That will make it far more robust than Libor”.
The ARRC released its second report in March, which summarises the choice of SOFR as its recommended replacement rate and offers an enhanced paced transition plan, which seeks to promote the use of SOFR on a voluntary basis. The report also includes an initial examination of the contractual language commonly used in products referencing Libor, with a particular focus on fallback language.
Key milestones in the ARRC’s transition timeline include the following:
At first, the SOFR will be just what its name suggests: an overnight rate—a spot market with no offerings to match Libor’s various tenors. It will take time, well into 2021, some say, to develop the longer tenors that will make SOFR an adequate benchmark to replace Libor.
For the British pound, the Bank of England is putting forth the sterling overnight interbank average rate (SONIA) to replace Libor. SONIA has been in use since 1997, but the Bank of England has been working on a new methodology to make it a more suitable Libor replacement. Details are expected later this year.
There are also alternatives in place or being planned for the Japanese yen, the Euro, and the Swiss franc.
The end of 2021 may seem distant, but many in the industry believe that achieving the switch to new benchmarks in less than four years is an aggressive goal. To be sure, many say, market participants and regulators must begin acting now to be able to ensure a smooth transition.
Key transition concerns
Any such transition raises a number of issues that will have to be addressed by regulators and the industry. Concerns and approaches vary across asset classes.
A fundamental issue is the spread that is certain to exist between interbank offered rates (IBORs) and risk-free reference rates (RFRs). For example, because Libor is an unsecured rate based on interbank borrowing, it includes an element of credit risk tied to the strength of banks and the banking industry.
Transitioning to SOFR will necessitate adjustments. Whatever those may be, industry groups are stressing that they should be simple, transparent, fair, and minimise “winners and losers”.
According to RBC Capital Markets, “there is no industry consensus yet on credit spread methodology for broad market adoption [of RFRs]. However, the methodologies under consideration are evaluated against a number of principles”, including the following:
“There is some market consensus emerging that the credit spread should be fixed as of the date of an announcement of an IBOR being discontinued,” RBC noted, “regardless of whether that is prior to, or simultaneous with, the actual discontinuation of an IBOR.”
However, some fear there may be difficulties in convincing customers that the new, converted rates are fair. If borrowers are accustomed to paying a rate of, say, Libor plus 2 basis points, will they understand that their new rate of, say, SOFR plus 2.5 basis points is equivalent?
Some industry watchers fear that banks will feel pressured to sacrifice spreads and reprice transactions to the benefit of borrowers rather than face their wrath. Any such losses would be on top of the millions of dollars the transition will cost banks and the industry.
How the Libor transition is managed is particularly important to derivatives markets. According to the International Swaps and Derivatives Association (ISDA), nearly two-thirds of interest rate swaps (a $107 trillion market), forward rate agreements ($29 trillion), interest rate options ($13 trillion), and cross currency swaps ($22 trillion) are Libor related.
Many transactions include language regarding fallback rates should Libor become unavailable. But the RBC report cautions that many of the fallback rates “are appropriate for short-term disruptions to Libor but are not practical if Libor is permanently discontinued. As an example, under the 2006 International Swaps and Derivatives Association definitions, which typically apply to over-the-counter (OTC) interest rate swaps, if the specified rate source for USD Libor is unavailable, the ‘calculation agent’ must solicit USD Libor quotes from four banks in the London interbank market”. If that approach isn’t possible, New York banks must be surveyed.
“Once Libor is permanently discontinued, it is impractical to continuously approach banks for quotes,” the RBC report pointed out. “If existing fallbacks to the IBORs fail to provide parties with a rate and the parties fail to agree to an alternative rate,” it said, contracts will be terminated or end up in litigation.
ISDA is working to revise its 2006 definitions so that they reflect a revised risk-free rate and is also developing a protocol that will allow for a fallback in existing Libor contracts to the risk-free rates in the event Libor is permanently discontinued. To achieve this fallback, it is devising a spread methodology that would be used to convert such Libor swaps into the risk-free rates at the time of Libor’s cessation.
“Other asset classes and financial instruments have their own unique challenges because of the structure of the contracts, particularly where the agreements are bespoke and thus a protocol mechanism would not be available,” RBC noted.
RBC added: “For example, bonds’ terms and conditions are not entirely consistent across different issues. If Libor is discontinued and legacy contracts are not amended, many of the legacy bonds could revert to a fixed rate (being the last available floating rate) for the remaining term of the bonds.
This is clearly not the outcome either the issuers or the bond holders would want. Amendments to bond terms and conditions are difficult, costly, and time consuming for issuers and bond holders and with an uncertain outcome.”
The cash markets are also contemplating the issues they will face with any transition. In particular, in addition to concerns about spread “fairness”, there are likely to be concerns about the treatment of legacy transactions should Libor cease, where the consent of a majority of note/bond holders may be required to amend transaction terms.
Given the array of potential issues and impacts, banks, the buy side, end users, and the regulators need to work together and come to grips with the size of affected populations and develop detailed plans to manage the transition over the coming years.
RBC Capital Markets had this advice for clients in its report:
Outlook
A transition is going to require buy-in in every corner and practice of the industry.
“A smooth transition for the market from IBORs to alternative RFRs will depend heavily on liquidity,” the RBC report said. “Of most importance, there must be deep liquidity in the derivatives markets as derivatives markets referencing RFRs will be key to broad market adoption. As the expression goes, ‘liquidity begets liquidity.’” It will take a lot of work, but the Federal Reserve says the move will ultimately be worth it, noting this on its website: “Greater reliance on alternative reference interest rates will make financial markets more robust and thus enhance the safety and soundness of individual institutions, make financial markets more resilient, and support financial stability in the US.”
RMA, its Market Risk Council, and its Securities Lending Committee agree that robust, yet stable, financial markets, coupled with safe and sound institutions, are a laudable goal. To that end, they are monitoring the transition to a Libor replacement and taking steps to ensure RMA members are prepared to thrive under a new benchmark system.
Throughout the process, RMA will promulgate information and best practices, host informative round tables and other events, and welcome communications with members who have thoughts and concerns.
Today, an estimated $160 trillion of US dollar exposures is tied to the swings of Libor. Globally, Libor-related exposure has been estimated at up to $400 trillion in dollar terms, covering auto and student loans, commercial and residential mortgages, corporate and syndicated loans, and various derivatives.
But now Libor’s days of influence may be numbered. In fact, they number somewhere in the range of 1,300 days, if things go according to plan. In its place will be alternative risk-free reference rates based on transactions that include overnight funding and repurchase agreements.
Concerns with Libor’s continued viability
Last July, Andrew Bailey, chief executive of the UK Financial Conduct Authority (FCA), the agency that oversees Libor, announced that the 20 rate-submitting banks have agreed to contribute to Libor until the end of 2021. While banks may voluntarily submit rates thereafter, Bailey has said that the FCA will not compel them to do so. Most in the industry agree that the FCA’s announcement sounded the death knell for Libor as we know it.
Libor came under scrutiny with coverage of the manipulation scandals emanating from the financial crisis. To either downplay their credit problems or enhance their market gains, some banks participating in Libor-setting were gaming the rate by understating or overstating their perceived borrowing rates.
In response, the FCA stepped in to oversee Libor regulation. In 2014, Libor underwent the transition to a new administrator, the ICE Benchmark Administration, which has taken steps to formalise the rate submissions process and establish an oversight committee. However, despite these efforts to professionalise the rate and the submission process, Libor has continued to lose the industry’s confidence.
A key source of the concern is that, over the years, as the number of actual interbank borrowing deals has fallen off, the rates have grown more dependent on the estimates of submitting banks. In other words, because of low transaction volumes, more and more submitting banks have to respond to Libor surveys by providing an estimated rate based on “expert judgment” instead of a rate they have actually paid or are paying.
In a recent article, Forbes, citing Barclays Bank, noted that “submissions based on ‘expert judgment’ rather than real transactions now make up 70 percent of the daily three-month Libor submissions”.
Federal Reserve chairman Jerome Powell has said that “many banks are now understandably uncomfortable with being asked to provide judgment about something they do very little of”.
Powell has cautioned: “Libor may remain viable well past 2021, but we do not think that market participants can safely assume that it will.”
“The absence of active underlying markets,” Bailey has said, “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?”
Transition to new risk-free rates
While the continued viability of Libor is in question, it is clear that transitioning to agreed-upon benchmarks that can match Libor’s load of tenors (one day, one week, one month, two months, three months, six months, one year) and currencies (US dollar, euro, British pound, Japanese yen, Swiss franc) will also be a complex and costly challenge.
A RBC Capital Markets report calls the transition from Libor a “Herculean task [...] across wide ranging asset classes and financial instruments. For benchmark reform to be successful, there will need to be broad market adoption of the alternative [rates]”.
For US dollar transactions, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) has recommended replacing US Libor with the secured overnight funding rate (SOFR). SOFR is set to include triparty repo data from Bank of New York Mellon, cleared bilateral repo transactions, and general collateral finance repo data from the Depository Trust & Clearing Corporation.
Following the ARRC’s recommendation, Federal Reserve chair Powell and Commodity Futures Trading Commission (CFTC) chair Christopher Giancarlo noted in a Wall Street Journal commentary that SOFR “resolves the central problem with Libor, because it will be based on actual market transactions currently reflecting roughly $800 billion in daily activity. That will make it far more robust than Libor”.
The ARRC released its second report in March, which summarises the choice of SOFR as its recommended replacement rate and offers an enhanced paced transition plan, which seeks to promote the use of SOFR on a voluntary basis. The report also includes an initial examination of the contractual language commonly used in products referencing Libor, with a particular focus on fallback language.
Key milestones in the ARRC’s transition timeline include the following:
- 3 April 2018: The New York Fed began publication of the Treasury repo reference rates
- 7 May 2018: CME Group was set to launch futures on Libor alternative
- H2 2018: Trading in bilateral, uncleared SOFR swaps begins
- Q1 2019: Trading begins in cleared SOFR swaps with Fed funds as price alignment interest (PAI)
- Q1 2020: Central counterparties (CCPs) offer SOFR as an alternative PAI
- Q2 2021: CCPs will only accept new swap contracts for clearing using SOFR (instead of fed funds effective discounting)
At first, the SOFR will be just what its name suggests: an overnight rate—a spot market with no offerings to match Libor’s various tenors. It will take time, well into 2021, some say, to develop the longer tenors that will make SOFR an adequate benchmark to replace Libor.
For the British pound, the Bank of England is putting forth the sterling overnight interbank average rate (SONIA) to replace Libor. SONIA has been in use since 1997, but the Bank of England has been working on a new methodology to make it a more suitable Libor replacement. Details are expected later this year.
There are also alternatives in place or being planned for the Japanese yen, the Euro, and the Swiss franc.
The end of 2021 may seem distant, but many in the industry believe that achieving the switch to new benchmarks in less than four years is an aggressive goal. To be sure, many say, market participants and regulators must begin acting now to be able to ensure a smooth transition.
Key transition concerns
Any such transition raises a number of issues that will have to be addressed by regulators and the industry. Concerns and approaches vary across asset classes.
A fundamental issue is the spread that is certain to exist between interbank offered rates (IBORs) and risk-free reference rates (RFRs). For example, because Libor is an unsecured rate based on interbank borrowing, it includes an element of credit risk tied to the strength of banks and the banking industry.
Transitioning to SOFR will necessitate adjustments. Whatever those may be, industry groups are stressing that they should be simple, transparent, fair, and minimise “winners and losers”.
According to RBC Capital Markets, “there is no industry consensus yet on credit spread methodology for broad market adoption [of RFRs]. However, the methodologies under consideration are evaluated against a number of principles”, including the following:
- Elimination of or minimisation of value transfer of the contract at the time IBOR is transitioned to an alternative RFR
- Elimination or minimisation of any potential for manipulation—structuring the methodology to avoid the use of easily predictable or easily influenced data points
- Mitigation of and minimisation of regulatory and legal risks (including litigation risks)
- Minimisation of market disruption for all market participants
“There is some market consensus emerging that the credit spread should be fixed as of the date of an announcement of an IBOR being discontinued,” RBC noted, “regardless of whether that is prior to, or simultaneous with, the actual discontinuation of an IBOR.”
However, some fear there may be difficulties in convincing customers that the new, converted rates are fair. If borrowers are accustomed to paying a rate of, say, Libor plus 2 basis points, will they understand that their new rate of, say, SOFR plus 2.5 basis points is equivalent?
Some industry watchers fear that banks will feel pressured to sacrifice spreads and reprice transactions to the benefit of borrowers rather than face their wrath. Any such losses would be on top of the millions of dollars the transition will cost banks and the industry.
How the Libor transition is managed is particularly important to derivatives markets. According to the International Swaps and Derivatives Association (ISDA), nearly two-thirds of interest rate swaps (a $107 trillion market), forward rate agreements ($29 trillion), interest rate options ($13 trillion), and cross currency swaps ($22 trillion) are Libor related.
Many transactions include language regarding fallback rates should Libor become unavailable. But the RBC report cautions that many of the fallback rates “are appropriate for short-term disruptions to Libor but are not practical if Libor is permanently discontinued. As an example, under the 2006 International Swaps and Derivatives Association definitions, which typically apply to over-the-counter (OTC) interest rate swaps, if the specified rate source for USD Libor is unavailable, the ‘calculation agent’ must solicit USD Libor quotes from four banks in the London interbank market”. If that approach isn’t possible, New York banks must be surveyed.
“Once Libor is permanently discontinued, it is impractical to continuously approach banks for quotes,” the RBC report pointed out. “If existing fallbacks to the IBORs fail to provide parties with a rate and the parties fail to agree to an alternative rate,” it said, contracts will be terminated or end up in litigation.
ISDA is working to revise its 2006 definitions so that they reflect a revised risk-free rate and is also developing a protocol that will allow for a fallback in existing Libor contracts to the risk-free rates in the event Libor is permanently discontinued. To achieve this fallback, it is devising a spread methodology that would be used to convert such Libor swaps into the risk-free rates at the time of Libor’s cessation.
“Other asset classes and financial instruments have their own unique challenges because of the structure of the contracts, particularly where the agreements are bespoke and thus a protocol mechanism would not be available,” RBC noted.
RBC added: “For example, bonds’ terms and conditions are not entirely consistent across different issues. If Libor is discontinued and legacy contracts are not amended, many of the legacy bonds could revert to a fixed rate (being the last available floating rate) for the remaining term of the bonds.
This is clearly not the outcome either the issuers or the bond holders would want. Amendments to bond terms and conditions are difficult, costly, and time consuming for issuers and bond holders and with an uncertain outcome.”
The cash markets are also contemplating the issues they will face with any transition. In particular, in addition to concerns about spread “fairness”, there are likely to be concerns about the treatment of legacy transactions should Libor cease, where the consent of a majority of note/bond holders may be required to amend transaction terms.
Given the array of potential issues and impacts, banks, the buy side, end users, and the regulators need to work together and come to grips with the size of affected populations and develop detailed plans to manage the transition over the coming years.
RBC Capital Markets had this advice for clients in its report:
- Understand exposures to Libors and other IBORs in your portfolio, including exposures to derivatives, loans, bonds, and other financial contracts
- Prepare for contract amendments of legacy contracts that will exist beyond the end of 2021
- Related tax and accounting (including hedge accounting) issues should be considered, particularly if valuation changes to contracts as a result of the transition from IBORs to RFRs are anticipated
- Lastly, investments to infrastructure, including technology and data infrastructure, may also be needed
Outlook
A transition is going to require buy-in in every corner and practice of the industry.
“A smooth transition for the market from IBORs to alternative RFRs will depend heavily on liquidity,” the RBC report said. “Of most importance, there must be deep liquidity in the derivatives markets as derivatives markets referencing RFRs will be key to broad market adoption. As the expression goes, ‘liquidity begets liquidity.’” It will take a lot of work, but the Federal Reserve says the move will ultimately be worth it, noting this on its website: “Greater reliance on alternative reference interest rates will make financial markets more robust and thus enhance the safety and soundness of individual institutions, make financial markets more resilient, and support financial stability in the US.”
RMA, its Market Risk Council, and its Securities Lending Committee agree that robust, yet stable, financial markets, coupled with safe and sound institutions, are a laudable goal. To that end, they are monitoring the transition to a Libor replacement and taking steps to ensure RMA members are prepared to thrive under a new benchmark system.
Throughout the process, RMA will promulgate information and best practices, host informative round tables and other events, and welcome communications with members who have thoughts and concerns.
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