LIBOR: BETTER TO FADE AWAY THAN BURN OUT.
Dan Barnes looks at the different moving parts in LIBOR.
Like the Brent crude benchmark, interbank offered rates (IBORs) carry a huge notional burden based on ever-shrinking real-world underlying deals. The Financial Stability Board (FSB) and Financial Stability Oversight Council (FSOC) have estimated that contracts with around $200tn in gross notional exposure were referencing US dollar London Interbank Offered Rate (USD LIBOR) by the end of 2016, including both derivatives and cash instruments such as floating rate bonds. Yet less than $1bn is traded each day in three-month funding transactions, with three-month LIBOR being the most heavily referenced tenor of USD LIBOR in contracts.
Meanwhile, the panel of banks providing input for the Euro Interbank Offered Rate (EURIBOR) panel decreased from 43 to 20 firms since 2013. At a time of rising interest rates floating rate notes become more popular, making certainty around the use of benchmarks more common.
“I know of a significant number of LDI (liability driven investment) funds that are trading in 30-year OIS (overnight index swaps) rather than LIBOR swaps, because the benchmark is changing, and even if it is still published it might not track in the same way,” says Andy Ross, CEO of CurveGlobal. “That is quite a big risk in the market, and so making that switch is about risk management for them.”
If the benchmarks were ceased to be published tomorrow, there would be serious consequences. They not only underpin many existing financial contracts, but there are no alternative benchmarks that are used in contracts with sufficient liquidity to act as alternatives.
However, the manipulation of IBORs first proven in court during 2012, demonstrated that using a submission-based rate was too unreliable, and support for them has been dwindling ever since. The authorities need to shift these elephants onto the backs of something that can carry them forward. A move towards the use of alternative nearly risk-free rates (alternative RFRs) has been undertaken by major markets.
There are several key risks that might impact trading desks during the migration process. The first is the potential reduction of liquidity across contracts as a result of a patchy shift. “Not everybody is going to move at the same speed, which is where the risk lies in transition,” says Stuart Giles, managing director for strategy and business development at interdealer broker, Tradition.
The second is the lack of any fall-back language in long-term contracts that currently cite LIBOR, to support those contracts in the event LIBOR ceases to be published. “The absence of such language creates the potential for large-scale disorder in global financial markets should LIBOR go away,” said Bill Dudley, chief executive officer of the Federal Reserve Bank of New York, speaking at the Bank of England’s Markets Forum on 24 May 2018.
The Federal Reserve Bank and Bank of England have since built roadmaps to support the shift to alternative rates while in other jurisdictions, existing IBORs are under review. These include the ICE Benchmark administered LIBOR, which is published in pound sterling (GBP), US dollar (USD), euro (EUR), Swiss franc (CHF) and Japanese yen (JPY).
Also on the list are the Tokyo interbank offered rate (TIBOR) which is offered in the Japan interbank market used for over $5tn in contracts and administered by the Japanese Bankers Association TIBOR Administration as well as the euro interbank offered rate (EURIBOR) which is found in the euro interbank market and run by the European Money Markets Institute (EMMI) underpinning more than $150tn in contracts.
The market-led, central bank-governed approach has led to both confusion and division over the RFRs being adopted. In the US the Alternative Reference Rates Committee (ARRC) which consists of market participants, chose the Secured Overnight Financing Rate as the alternative to US-dollar LIBOR. SOFR is the overnight rate for borrowing cash using US Treasury securities as collateral and is entirely based on transactions that are assessed by the Fed as having a daily volume of more than $700bn.
ARRC also developed the transition plan to facilitate the adoption of these rates in a voluntary programme.
The UK’s Working Group on Sterling Risk-Free Reference Rates determined that Sterling Overnight Index Average (SONIA), a benchmark now administered by the Bank of England since April 2018, should be used. It measures the rate at which interest is paid on sterling short-term wholesale funds, underpins the OIS market and is supported by £50bn average daily volume.
In Europe, the low volume of transactions to underpin EURIBOR has led to an alternative model being investigated, whilst the TIBOR administrator, JBATA which took over administration in 2014, became subject to the Financial Instruments and Exchange Act in 2015. This involved rules regarding the calculation, publication and administration of the benchmark rate.
Time to breathe
The expected drop off for LIBOR will occur in three years after which contributing banks will no longer automatically make submissions. Andrew Bailey, chief executive of the UK’s Financial Conduct Authority said in 2017 that “the survival of LIBOR on the current basis… could not and would not be guaranteed” beyond 2021. That timeframe is giving firms room to breathe – in some cases the switch is not expected to take place until forced to by the risk that the rate will no longer be published.
The global head of fixed income trading, for a Tier One investment manager, speaking anonymously, says, “It is a massive change. However, its two years down the line before LIBOR goes away and we are not actively doing anything that is not LIBOR right now.”
Managing the switch for contracts has driven some firms towards an early migration to alternatives, especially where long-dated contracts need to be pinned down now.
Ann Battle, assistant general counsel at the International Swap Dealers Association (ISDA) believes the main issues at this point around adoption relate to the level of take-up for the alternative rates outside of the interdealer derivatives market.
“I think all signs are good that in the interdealer derivatives market we are going to see adoption of risk free rates (RFRs) as an alternative to LIBOR on a going forward basis and, as a result, you will see the notional value of derivatives that reference LIBOR in all of the currencies decline over the next 2½ years,” she says.
Giles believes that the timing for that migration will depend upon the dealer-to-client market. However, the conduit for making the transition will be the dealer-to-dealer market. “If you are going to move from LIBOR to SONIA the key to that will be the efficiency of the SONIA/LIBOR basis market, which is the transition trade that allows you to go from LIBOR to SONIA,” he says. “The interbank market will allow that basis market to develop, to move that position from LIBOR to SONIA. It is the conduit, while the trigger is the buy-side.”
Firms will not only need to monitor how the rest of the market is changing, they will need to look at their own books and assess the treatment of their existing contracts. Battle says, “An unknown is the extent to which people will close out their existing LIBOR transactions and replace them.”
The concern that Dudley has noted is the risk that firms have not set up the measures needed to move contracts across from one rate to another, and that will require support from authorities.
Speaking on 24 May, Dudley said, “Put simply, this is an unacceptable risk. The ISDA has been working on this issue for the derivatives market and is expected to issue a consultative document soon that should prove instrumental in making further progress. The ARRC has also been co-ordinating a similar effort across cash products of all types. The goal is to achieve consensus on a consistent approach across markets whenever feasible.”