Cyprus: Challenges replacing Libor
Libor [London interbank offered rate] is the primary benchmark, along with Euribor, for short-term interest rates around the world. Libor rates are calculated for five currencies and seven borrowing periods, ranging from overnight to one year, and are published each business day. Libor is based on submissions provided by a selection of large international panel banks. These submissions are intended to reflect the interest rate at which banks could lend one another unsecured funds. Many financial institutions, mortgage lenders, and credit card agencies set their own rates based on this. However, in 2017, the UK's Financial Conduct Authority (FCA) announced that after 2021 it would no longer require the panel banks to submit the rates needed to calculate Libor. Libor will no longer be published after the end of 2021, and market participants are urged to transition to alternative reference rates (ARRs).
The reason for this change of policy is the fact that the number of deposits held between banks in the London market have been reduced significantly. A result of the financial crisis has been that the interbank deposit market stalled, and the quoted rates were to a great degree guessed, that is, based on an assumed rate that would be in place if the transactions were taking place. There have also been allegations of manipulation. In June 2012, multiple criminal settlements revealed significant fraud and collusion by member banks connected to the rate submissions, leading to the Libor scandal. This resulted in fines being imposed on some banks and prosecutions of individual traders.
Since the financial crisis, fewer market participants are willing to lend on an unsecured basis, particularly for a term longer than overnight (e.g., three-month). Liquidity in the interbank market has been reduced since the 1990s and disappeared entirely during the financial crisis. Banks have moved away from this market.
In light of the above, the EU introduced the 2016 Benchmarks Regulation, which secured control over benchmarks and their providers. It entered into effect on January 1 2018. This new regulation refers to indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds. It introduces a framework to ensure the integrity of benchmarks referenced in financial instruments, financial contracts or investment funds in the EU. The aim of this framework is to contribute to the improved functioning of the internal market. A high level of consumer and investor protection is an additional aim of this legislative effort. The relevant ARR concept in the EU is the euro short-term rate (€STR).
Moreover, there has been preparation for the operational substitution of Libor in various jurisdictions. In the US, the secured overnight financing rate (SOFR) launched in mid-2018, following the growing trend in trading in derivatives such as futures and swaps. A problem with SOFR is that the issuance of its notes is made mainly by state-linked entities and financial institutions, thus resulting in it having a rather exclusive nature.
In the UK, the replacement rate is called the sterling overnight index average (Sonia). The Bank of England administers this rate. In Switzerland, the relevant ARR is called Swiss average rate overnight (Saron) and it is a secured rate that reflects interest paid on the interbank overnight repo rate. In Japan, there is the Tokyo overnight average rate (Tonar), which is an unsecured rate that captures the overnight call market rate.
To summarise, on the one hand these initiatives, the function of which will be controlled by the authorities, will represent relatively risk-free overnight interest rates for lending to banks overnight and will be quoted daily early in the morning. On the other hand, however, all replacement efforts seem to suffer from a perceived lack of a forward-looking term rate.
The disruption in funding markets over the past few months has highlighted the importance of shifting from Libor to a new benchmark rate. The spreading Covid-19 pandemic can be seen as a potential obstacle to reform. However, in our view, this disruption has drawn some of Libor's flaws to the attention of analysts. It is expected that, in the context of the US government's rescue package for the US economy, the US Treasury will launch its first SOFR-linked floating rate notes this year to help fund increasing deficits.
Banks have been somewhat reluctant to submit quotes in the framework of a mostly inactive market, due to the risk of exposure to litigation. However, currently, the banks' ability to make the transition away from Libor by the end of 2021 is not clear, while the risks arising from the transition are increasing. If not well prepared, banks may face material risks, including unanticipated operational and conduct risks. The result of this could be reputational damage, fines, and lawsuits.
Banks are not the only ones that should be alerted to the dangers entailed of the upcoming transition. Market players should be cautious, in general, of the risks of the shift. One such risk is an excessive reliance on fallback clauses.
Fallback language consists of three key components: fallback trigger event, benchmark replacement, and benchmark replacement adjustment. Market participants may face increased operational risk if they finally rely on updated fallback clauses for their transition from Libor when Libor becomes unavailable. New interest payments, valuations, and collateral requirements calculations will be required, which means changes for thousands of contracts. Moreover, there are doubts about the level of consistency in fallback terms and triggers. New fallback language being drafted by industry bodies like ISDA [International Swaps and Derivatives Association] and the LMA [Loan Market Association] is an encouraging initiative; however, there might be discrepancies in fallback language for subsets of transactions, which could induce increased basis risk.
In addition to the fallback language, firms will also need to be cautious of other critical contractual matters that may have an impact on the shift, such as maturity dates, the firm's role in the contract, governing law and jurisdiction, and force majeure provisions. There will be broader needs for transitional documentation, which would permit a smoother succession from Libor.
Another aspect that should be highlighted is that the process of repapering will most probably be threatened by conduct risk and data complexity. Banks will require a full review of their exposures to each counterparty and the estimated economic impact of transition on all products and currencies. This may be particularly burdensome in cases of products related to different businesses and sectors of the economy.
The trading volume of products linked to Libor is expected to decrease as we approach 2021. Disengaging from these current positions may become more difficult as market activity will be reduced. Moreover, this reduction of liquidity will inevitably induce various changes to risks in corporate portfolios between now and the end of 2021. Market players should undertake initiatives to make the Libor transition faster, safer, and more efficient. Regulators should remove disincentives for market participants to switch from Libor-linked to ARR-linked derivatives.
The common view is that banks should develop loan products based on ARRs. For example, adjustments to interest observation periods may be necessary to achieve advance visibility on cashflows. At the time when ARRs are established, products utilising these rates could be added to allow customers (and banks) to make their choices. In the meantime, banks should avoid procrastination and complacency, as well as the assumption that there is plenty of time left to proceed with the transitions.
Currently, in Cyprus, the majority of credit positions utilise LMA standard wording, which is linked to Libor. Unfortunately, many corporate market participants in our country may not be that sophisticated, and may not appreciate the impact and plans for the shift.
It is estimated that the shift will have an impact of different kinds on transactions, across different products. This may engender the need for potentially costly changes to models, data, analytics and technology. Companies will need to apply inventory models across all departments that rely on Libor for updates. The appropriate approvals of any model changes should be obtained, while there should also be an improvement of current systems that may not be equipped to support contracts referencing ARRs. Such efforts will certainly be time-consuming to develop due to the complexity of bank systems and organisations.
Moreover, consistent methodology for renegotiation and appropriate programme governance structures with prudent board oversight, including stakeholders from all businesses that are expected to be impacted, will be necessary. The interested entities should develop a communication strategy for regulators, investors, and company personnel, that describes the company's transition plan and strategy. Companies that offer Libor-related finance to clients should develop plans to handle the way clients are approached on these matters, and to handle contract remediation so that clients are treated equitably.
Notwithstanding the progress that has been made, Libor-related products are still being sold across all currencies and jurisdictions. It seems unlikely that all Libor exposures will have been converted to the new reference rates by the end of 2021, or even that firms will have ceased engaging in Libor transactions. The industry will face considerable problems in transitioning legacy positions if meaningful volumes and liquidity have not developed in the alternative rate markets. This will significantly increase the risk caused by the probability of Libor discontinuation after 2021. Parties to Libor-based contracts may face unpredictable transfers of value, even with the adoption of new fallback clauses, which aim to – but cannot guarantee to – mitigate value transfer upon Libor discontinuation.
Demetris Roti and Ioannis Sidiropoulos