The future of Libor?
Few benchmarks can have been subject to as much debate as Libor - the London Interbank Offered Rate. On 1 February 2014, after a series of regulatory interventions, the UK’s Financial Conduct Authority (FCA) transferred oversight to the US Intercontinental Exchange (ICE) Benchmark Administration to provide a stronger governance framework.
Now, says Robert Gall, Insight’s head of market strategy, the next 12 months could see crucial choices made by various working groups in major countries which will ultimately influence the fate of Libor and how the global standard for risk-free rates will evolve. The benchmark, he says, plays a crucial role in determining the value of various assets and its reform or abolition has the potential for significant economic impact.
In a July 2017 speech, Andrew Bailey, CEO of the FCA, noted as much. He said the current panel of banks that submit data to determine the benchmark had committed to doing so for an additional four- to five-year period – but emphasised they had no obligation to do so beyond that date. Instead, he highlighted how market participants must “take responsibility for their individual transition plans but we and other authorities will be ready to assist and support efforts to co-ordinate that work”. Understandably, his comments were widely interpreted as implying that Libor, in all currencies and tenors, will be phased out by the end of 2021.
In his speech, Bailey also noted that one of the FCA’s main concerns at present is that the unsecured lending market, on which Libor is based, is no longer sufficiently active and that the fall in the number of transactions could cause the rate to become unreliable. In turn, he said, this could potentially cause significant disruption to financial markets. The authority’s stance therefore is that it needs to encourage market participants to undertake the work required to move to alternative interest rate benchmarks.
Despite this apparent mandate for change, the short-term market reaction to the speech remained muted, with the basis between Libor and the Sterling Overnight Index Average (SONIA – a proposed alternative for Libor) rates widening by just two basis points at the 30-year maturity very shortly after the speech, then moving 2bp wider later. Shorter dated contracts moved in the opposite direction.
For Gall, the predominant mood at present is one of uncertainty. He notes how much work is going on behind the scenes on the future of lending rates. “This includes reviews of (and changes to) overnight rates, as well as term rates, in most major markets,” he says. “Potential Libor replacements in certain markets are also being considered. Within the UK, for example, a consultation on the use of ‘reformed’ SONIA as the Sterling Risk-Free Reference Rate drew out concerns over the term structure and use of unsecured versus secured rates. There will need to be further consideration given to how that risk-free rate might evolve.”
Yet even though reform is in the air, it is far from certain that Libor will disappear after this period, or how alternative markets will develop, says Gall. One particular challenge of a switch away from using Libor-based derivatives, he notes, is the lack of liquidity for derivatives on other interest rates in longer maturity tenors. Liquidity in derivatives markets for SONIA, for example, is largely focused in maturities out to 30 years, whereas Libor swaps remain the more liquid instrument and trade out to 50-year maturities.
Meanwhile, it has been reported that Libor’s current administrator, ICE, which has undertaken a series of consultations to reform the Libor data, is committed to continuing to produce it beyond the five-year period. It may be that the benchmark survives yet.
Libor: How it works
Libor is calculated based on the average interest rate that a basket of large banks would charge to lend to other large banks. The banks submit a quote which is not necessarily based on actual market transactions. This average interest rate is calculated for a range of different lending periods and currencies. These Libor rates are used in calculations for over US$350 trillion of derivatives, loans and other financial products. Libor is also commonly used as a benchmark rate for many short-term investment funds and products.
The international response
Concerns over Libor have led to working groups being established in all of the major countries that use the benchmark:
US: In December 2014, the Federal Reserve established a group of representatives from major banks and regulators which it called the ARRC. The ARRC has recommended that US dollar Libor be replaced by a new benchmark rate calculated from transactions in the US Treasury sale and repurchase agreement (repo) market.
As such, the new benchmark will be based on secured borrowing and lending rates. This rate will be published by the Federal Reserve Bank of New York which is expected to outline a timeframe over which financial markets will be asked to move to this new methodology.
UK: In the UK, the Bank of England (BoE) set up the Working Group on Sterling Risk-Free Reference Rates in March 2015. In April 2017 the group selected a reformed version of SONIA, which was originally established in 1997 and taken over by the BoE in 2016. SONIA is calculated based on all overnight sterling transactions of £25m or more conducted in London by listed money market institutions and is an unsecured rate – at odds with the US approach.
The FCA has, after a consultation, announced that it has the agreement of 20 banks that they will submit rates to enable Libor calculations for at least the next five years. During this period the FCA aims to work with market participants to transition away from Libor and towards alternative rates in an orderly way. The FCA has stated that it does not believe markets can rely on Libor continuing to be available indefinitely and that market participants must take responsibility for their own transition plans.
Eurozone: The European Money Markets Institute chose to continue with current Euribor methodology after a six-month review to establish whether it could switch to a transaction-based calculation. The Institute is reportedly continuing to look at ways to evolve the rate and is believed to be considering a hybrid method, combining transaction data with estimates. The European Central Bank has announced that it will start to produce an unsecured overnight index before 2020. The Financial Services and Markets Authority (FSMA), the European Securities and Markets Authority (ESMA), the European Central Bank (ECB) and the European Commission have announced the creation of a new working group tasked with the identification and adoption of a risk-free overnight rate for financial instruments and contracts in the euro area.
Switzerland: The Swiss National Bank (SNB) set up a working group in 2013 and although initially market participants expressed a reluctance to switch away from Libor, the group moved to select two potential replacement candidates. The Swiss Average Rate Overnight (Saron) rate has evolved as the leading candidate with the alternative Tois rate to be discontinued by the end of 2017.
The Swiss are now in the process of developing the swap market based on the Saron rate. Following the speech by Andrew Bailey, the SNB released a statement saying that “the SNB will announce in a timely away an alternative to [Swiss] franc Libor for its monetary policy concept”.
Japan: The Study Group on Risk-Free Reference Rates was established in April 2015, comprising 12 financial institutions active in the Tokyo market. In a report published in December 2016 on the identification of a Japanese yen risk-free rate, the group announced that it considers the uncollateralised overnight call rate (Tonar) as the primary potential candidate for a risk-free rate.This is not investment advice. Regulatory Disclosure