The UK regulator’s decision to axe the London Interbank Offered Rate (Libor), the disgraced universal interest rate benchmark, will fragment global markets.
The chief executive of the Financial Conduct Authority (FCA), Andrew Bailey, announced last week that Libor would be phased out between now and 2021.
The regulator was keen to stress that the decision is in no way related to any past or present scandal, but Libor’s tarnished reputation is difficult to get away from. After traders were caught manipulating the rate in the years leading up to and during the financial crisis, the term is practically synonymous with corruption.
But that’s not why it will soon be over for the controversial rate. The FCA’s official line, as outlined by Bailey, is that the rate is no longer sustainable because of a lack of transaction data. He has a point; Libor dictates the unsecured lending rate but now that swaps are centrally cleared they’re fully secured with very little credit component left. Banks have been required to submit rates for markets that see very little activity, some as few as 20 transactions per year.
It’s difficult to argue with the logic: a market rate backed by real transactions is surely more effective than one based on bankers’ opinions. But the task of finding a replacement, which regulators have already spent years on, shouldn’t be underestimated.
“Libor didn’t start out flawed, but post-crisis regulation has reduced its effectiveness,” said Mary Beth Fisher, a visiting professor at Duke University.
“All the same, its ability to take a credit check on the banking sector is incredibly important. It’s not like there’s never going to be another financial crisis again, and we will need Libor when there is.”
- The UK regulators’ decision to kill off the disgraced interest rate benchmark Libor will create more fragmented global markets in future;
- With no viable single like-for-like replacement available, market participants predict a range of rates being adopted by different players, with some coming in and out of fashion;
- Post-crisis clearing obligations for swaps have reduced the effectiveness of Libor so migrating away from it does make sense, but there’s no perfect solution;
- The process will take years and be expensive and resource-consuming for banks.
Transition protocol is also not yet clear. The end of 2021 is a while away yet but with $350 trillion worth of securities reliant on it, transaction lawyers will have their work cut out for them.
Contracts will have to be drafted more flexibly to incorporate the ambiguity, which will endure for years – a 30-year swap entered into last week will need Libor around, at least on a legacy basis.
“Creating a new reference market and making it liquid and transparent is expensive, cumbersome, and kind of the last thing banks need right now,” said Fisher. “They will need these products to be incredibly liquid before people even think about transitioning. That’s definitely a challenge for regulators and exchanges.”
Possibly the most credible replacement is a model based on repo rates, pitched by US regulators including the New York Fed. The Alternative Reference Rates Committee’s (ARRC) model is a Treasury repo rate based on daily transactions. The Fed will start publishing it next year.
"It's not like there's never going to be another financial crisis again"
“That makes sense, but the downside is losing that unsecured rate, the canary in the coalmine,” said Fisher.
Collateral-based lending reduces the need for highly sensitive credit investigations, and the ARRC’s model also includes buyside trades. Losing that pulse-check of the banking sector in particular would be problematic.
“When you move to a transaction-based benchmark system it’s inevitably backward-looking, and potentially limited by the liquidity in that particular market over time,” said Harriet Territt, partner at Jones Day in London. “In contrast, Libor is forward-looking and flexible in its approach.”
Another alternative is the reformed sterling overnight index average, or Sonia, which is overseen by the Bank of England. Sonia works perfectly well for short-term sterling rates but elsewhere faces the same lack-of-underlying-market issue as Libor. Similar European and Japanese benchmarks, Eonia and Tonar, were established when these markets stopped modelling theirs on the London interbank rate.
But none of these can be presented as a like-for-like replacement for Libor, whose enduring popularity would appear to be not just down to its relative susceptibility to manipulation. It’s also incredibly flexible.
Territt thinks a form of hybrid, incorporating an element of forward-looking opinions into transaction-based rates, would be a better approach.
“Otherwise there’s a risk of over-fragmentation in the market, with users picking reference rates tied to individual markets that come in and out of fashion,” she added. “Markets are changing so much and in many ways, Libor would be the ideal rate to account for this as it’s flexible enough to ride out these issues.”
Fisher is optimistic that regulatory cooperation will prevent too much fragmentation.
“Saying that, there’s nothing stopping someone in Hong Kong developing a product that looks exactly like Libor to quote against,” she said. “Jockeying to keep Libor alive would not surprise me.”
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