Finance & economics | Fifty ways to leave your LIBOR

LIBOR is due to die in 2021. Hurry up and drop it, say regulators

Too late to get a new plan

JUST DROP off the key. Yes, it means breaking a complicated yet rewarding long-term relationship: $240trn-worth of derivatives, loans and bonds are priced off LIBOR, the London Interbank Offered Rate; $200trn-odd are in dollars alone. But this key interest rate is due to die. Almost two years ago Andrew Bailey, the head of Britain’s Financial Conduct Authority (FCA), LIBOR’s regulator, in effect said it would expire at the end of 2021. In recent days American and British supervisors have again urged banks: hop on the bus.

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A few years ago LIBOR was undermined by a rate-rigging scandal which highlighted ills that might anyway have proved fatal. Notionally, it is the rate at which banks can borrow from each other, for up to a year, in dollars, sterling, Swiss francs, yen and euros. It is calculated from daily submissions of panels of 11 to 16 banks. But banks now scarcely tap interbank markets. On June 5th Sir Dave Ramsden, a deputy governor of the Bank of England, said that in the first quarter of 2019 on average only nine deposits totalling just £81m ($105m) a day underpinned six-month sterling LIBOR.

Regulators want markets to move to new benchmarks based on overnight rates and a far richer seam of transactions. America’s Alternative Reference Rates Committee (ARRC), a group of market participants convened by the Federal Reserve, plumped for the Secured Overnight Financing Rate (SOFR), derived from $1.1trn-worth of transactions daily, mainly Treasury repos. British supervisors are promoting the Sterling Overnight Index Average (SONIA), an unsecured rate dating back to 1997 but reformed last year. Its average daily base is £40bn.

The shift has begun. But as a new report by Oliver Wyman, a consulting firm, makes clear, there is still much to do, especially in the dollar markets, where SOFR had to start from scratch, and cash markets (for example corporate loans and mortgages). Thus SONIA’s share of sterling swaps is up to 40%, but there is little liquidity at the longer end; SOFR accounts for less than 0.5% of dollar LIBOR swap volumes. In the dollar futures market almost $1trn-worth of SOFR contracts were cleared in March, but that is just 1% of the LIBOR tally. In the sterling cash market SONIA floating-rate notes made up over three-quarters of the total in the first quarter. Some 80 SOFR dollar bonds have been issued, but mainly by government agencies.

Virtually no loans linked to the new rates have been made at all. In cash markets, Oliver Wyman says, “LIBOR-based contracts are still being entered into at a rate little reduced from 2017.” Little has been done to move existing contracts, of which many last beyond 2021, off LIBOR.

Several factors have held up progress. One is a lack of adequate “fallback” terms in contracts, stating what rate should apply when LIBOR vanishes. Existing contracts may say that if LIBOR is not published the previous day’s rate must be used, but that is meant only as a temporary fix. Using LIBOR’s last value could mean large gains and losses; but so could switching to a new benchmark. A second factor is that overnight rates lack the term structure—one-, three-, six- and 12-month rates—intrinsic to LIBOR. It is not hard to calculate backward-looking averages, but it is a big change from LIBOR. Borrowers are used to fixing interest payments in advance, rather than having to wait until the end of the period to know the precise rate they face.

Regulators say there’s no need to be coy. Recently the ARRC proposed new fallback language; in any case, Randal Quarles, the Fed’s vice-chair for supervision, told an ARRC conference in New York on June 3rd, the “easier path…is simply to stop using LIBOR”. Familiar as the old rate is, it is going to disappear. Stick with it, and “history may not view that decision kindly”. Although forward-looking term rates may not be ready by the end of 2021, David Bowman, a Fed official, urged banks not to wait. Ditto Mr Bailey in London two days later.

Banks point to a third problem: unlike LIBOR, SOFR, being based on Treasury repos, does not reflect their funding costs. In times of stress SOFR could fall while those costs rise. Simply adding a fixed spread will leave banks vulnerable if it is too thin and rile customers if too fat. (Such difficulties help explain why European regulators have extended the life of EURIBOR, the basis of many euro-zone mortgages.)

ICE Benchmark Administration, which calculates LIBOR, thinks that data on trades in international banks’ bonds could be used to add a spread to a SOFR-based yield curve. The resulting index would do the same job as dollar LIBOR while using the Fed’s preferred rate. Separately, the American Financial Exchange, a marketplace for interbank lending with 150 members (and indirectly serving 1,000 banks), has derived AMERIBOR, a benchmark rate for regional and community banks. So far a couple have used it to price loans. It plans to launch AMERIBOR futures this summer.

To hasten the handover, Oliver Wyman recommends that regulators remove disincentives, eg in margin requirements and taxes, to switch from LIBOR-based derivatives; and make up their minds about credit-sensitive benchmarks. Clearing houses should move faster to base their rules on SOFR, which would foster demand for derivatives. And banks should stop procrastinating. Set yourself free.

This article appeared in the Finance & economics section of the print edition under the headline "Fifty ways to leave your LIBOR"

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