A 2021 transition date is closer than it appears, and banks are scrambling to prepare for a world without the venerable benchmark.
What happens when the “world’s most important number,” the benchmark for more than $200 trillion worth of financial contracts, no longer commands the confidence of market participants? We’re about to find out.
As unsecured lending declined after the 2008 global financial crisis, Libor—the London Interbank Offered Rate—was less referenced. Four years later came a rates-rigging scandal, and suddenly the go-to benchmark rate for pricing risk and a host of financial instruments—loans, derivatives and mortgages—no longer commanded the confidence of financial markets.
Subsequently, the British Bankers’ Association—with some pressure from the government—surrendered its oversight of Libor to the UK’s Financial Conduct Authority (FCA). Then last July, the FCA announced that the panel of banks that currently submit rates required to calculate Libor will no longer be compelled to do so after 2021. Some will continue to participate, but presumably some will cease. That will weaken the value of Libor as a benchmark.
Other benchmark rates are already emerging to take its place. Financial institutions use benchmarks to set their own rates, and the usefulness of each benchmark rate derives in part from how accurately it tracks debt-market risk. As new benchmarks haven’t yet built up a long-term track record, transactions based on alternative benchmarks have so far been mostly short-term instruments.
So far, the leader of the alternative pack is the New York Federal Reserve Bank’s Secured Overnight Financing Rate (SOFR), which is based on the overnight interest rate received for lending cash against Treasury securities. As such debts are backed by the collateral of US Treasurys, SOFR is a secured rate, unlike Libor. SOFR is already being referenced in futures and overnight index swaps, and in some corporate debt, but all short-term.
“The Fed wants SOFR to become the new norm,” says Kirston Winters, managing director at provider IHS Markit and co-head of product management for MarkitSERV, a global service for processing over-the-counter (OTC) derivatives. “But the market needs to build up some data, otherwise firms can’t start making longer-dated trades.” On July 30, MarkitSERV announced that it had matched, confirmed and straight-through processed the first wave of OTC trades referencing SOFR.
Other alternative benchmarks include Saron (Swiss Average Rate Overnight) for Swiss francs, Sonia (Sterling Overnight Index Average) for pounds sterling and Tonar (Tokyo Overnight Average Rate) for yen. Before October 2019, the European Central Bank is expected to publish a new benchmark called Ester (Euro Short-Term Rate). Each is promulgated by a different authority with slightly different features in tenor, liquidity/market depth, credit risk and bad-actor risk. Unlike Libor, which was self-selected and regulated by a panel of banks, these new benchmarks will be overseen by central banks.
Stories of Libor’s demise may be somewhat premature, however; a benchmark that has underpinned pricing, valuations and risk modeling in financial markets for more than three decades is unlikely to disappear overnight. Winters sees a more multipolar approach emerging. “There will not be one global standard, but a standard or two in each currency,” he says. “The hope is that we don’t end up with too many more.”
The SOFR market has developed substantially faster than many anticipated, given that the new rate was first published in April by the New York Fed. Andrew Bailey, CEO of the FCA, noted in a speech in July that it was being taken up faster than eurodollar futures trading; there is already “$5 billion in daily volume of trading, with open interest recently reaching over 12,000 contracts.”
"Considerable Costs and Risks"
But a large number of traditional short-dated as well as 70- and 30-year swaps and a large population of loans still reference Libor. Switching them over to the new benchmarks will take time. “The transition from Libor will bring considerable costs and risks for financial firms,” management consultant firm Oliver Wyman observed last year in its report Changing the World’s Most Important Number: LIBOR Transition. “Since the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing Libor. The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design and hedging strategies.”
So if you’re a bank with a large portion of your loan book referenced to Libor, when is the right time to make the move to new benchmark rates like SOFR and Sonia? “You don’t want to start pricing your loan book off SOFR until there is a swap market for you to hedge your interest-rate risk,” says Carl Ryden, CEO and co-founder of PrecisionLender, which provides technology to help commercial banks better price and structure deals.
In the EU, a group of industry organizations—the International Swaps and Derivatives Association, the Global Financial Markets Association, the Futures Industry Association and EMTA (formerly the Emerging Markets Traders Association)—have called for an extension to the introduction of Ester to give the market time to prepare. This “would … allow time for trades which currently reference Eonia [Euro OverNight Index Average] (and potentially Euribor [Euro Interbank Offered Rate]) to expire and for their exposures to be replaced by reference to Ester,” they said in an official joint statement. “This would significantly reduce the number of ‘legacy’ positions which will require amendment in order to either reference Ester or include fallback provisions.”
After the FCA’s 2021 deadline, no one is clear what will happen next. Libor may die out swiftly, or some banks may continue to quote using the old benchmark. “If enough banks continue to quote in Libor, it could create a ‘zombie’ Libor rate, which will confuse the market,” says a Libor project lead at a US bank.
What happens to financial contracts that continue to reference the benchmark when it’s no longer available or considered reliable? “A large number of banks don’t have fallback language in their financial contracts,” says PrecisionLender’s Ryden, “so if Libor goes away, they’ll have to renegotiate.” Fallback language outlines what happens when Libor is unavailable for setting interest rates. “If the period of unavailability is brief, … the resulting losses and gains are manageable,” Oliver Wyman notes in its report. “But if fallback terms are used for the remaining life of the contract, the economic impact is likely to be significant.”
Todd Cuppia, a managing director at risk-management advisory firm Chatham Financial, recommends that new contracts include “broad language that gives the bank discretion in selecting an alternative or fallback rate in the event Libor is substantively discontinued.” He says it will be less challenging for derivatives markets, in which contracts are well standardized, than for loans.
Banks will need to determine which contracts have fallback language, how they are automatically repriced and how that is communicated to the customer. “How banks approach conversations with their customers will depend on how the market shakes out,” Ryden says. “The first thing a bank needs to do is get their relationship managers in a room to have these conversations. What is key is how banks handle the transition period.”
At the start of 2019, the Fed is expected to circulate letters checking US banks’ readiness for a new benchmark rate. Some market participants believe it will take longer than 2021 for Libor to go away. “It’s difficult to see how a rate could come out of nowhere and suddenly dominate,” says the Libor project lead. “Libor is a mature construct, deep-rooted in financial markets.”
But markets move at different speeds; and with the timeline for replacement likely to extend beyond 2021, a major volatility event occurring at the same time could be damaging.
The move away from Libor “is a big change,” says MarkitSERV’s Winters, who hopes to see the market coalesce around one or two benchmarks. “The derivatives market has always been innovative and evolved to accommodate change, but it is also important that the correct amount of time is spent on getting everything right.”
Hold on. We may be in for a bumpy ride away from Libor.