Regulators expect that the interest rate benchmark Libor will finally disappear by the end of 2021. But even with two-and-a-half years to go, the longer firms delay switching to alternative rates, the more costly it could be for them.
The London interbank offered rate underpins $400 trillion of contracts across markets from bonds and derivatives, to loans and cash, according to a paper published by the Bank for International Settlements in March (The financial consultancy Oliver Wyman puts the total amount benchmarked to Libor at $240 trillion). In the U.S., Libor is often used as the basis for mortgages, too, though much less so in the U.K.
Libor, first used by banks in a deal with the Shah of Iran 50 years ago, is set by a panel of up to 20 banks, in five currencies and over seven borrowing periods. The banks use their expert judgment to produce the average interest rate at which they can borrow from each other. But Libor is going to be phased out because it has proved prey to manipulation. Numerous banks have been fined, and bankers have been jailed, for reporting artificially low or high interest rates to benefit their derivatives’ traders.
The banks setting the rate have agreed to carry on till the end of 2021, but no later. The Financial Conduct Authority has said it will not oblige them to do so after that date.
"There is now widespread recognition that Libor will come to an end," said Edwin Schooling Latter, director of markets and wholesale policy at the FCA.
Will it really end in 2021?
Quite when it will end in practice, however, is not so clear-cut. Schooling Latter, speaking a Cass Business School conference on Libor on June 19, cited a straw poll he conducted at the International Swaps and Derivatives Association, or ISDA: only just over half the audience thought Libor would stop before end-2022.
Regulators in the U.K. and the U.S. want banks to switch to overnight risk-free rates that are based on the actual cost of bank borrowing for overnight deposits. These, however, are overnight rates and lack the forward-looking element which makes Libor so attractive to market participants who want to know how much interest rates will be on a contract in three or six months’ time.
Because Libor is typically, but not always, higher than secured overnight rates like the Bank of England’s sterling overnight index average, or Sonia, or the Federal Reserve Board's secured overnight financing rate, Sofr, an effect known as "the term premium," the receiver of Libor on a legacy contract is likely to demand compensation in order to agree to a conversion to the new rate.
The risks of switching to a new rate can be mitigated if market participants convert contracts early and if regulators announce the date of Libor’s demise well in advance, said Darrell Duffie, professor of finance at the Stanford Graduate School of Business.
His estimate of the spread between Libor and the secured average financing rate, or Safr, a compound average of Sofr, in the run up to cessation of Libor moves from 0.5 basis points in the second quarter of 2019 to almost five basis points in the third quarter of 2021. That difference could mean significant compensation costs for receivers of Libor-based contracts. Randal Quarles, the Fed's vice-chairman for supervision, first floated the idea of Safr to make it easier for cash markets to move away from Libor.
"Compensation is what this is all about, compensating for the gap between Libor and the new rates. The cessation date should be announced as soon as possible to reduce volatility," said Duffie.
READ MORE: As Libor ambles toward phase-out, regulators press banks to prepare
As an example of a smooth transition a long way ahead of the switch, Associated British Ports became the first borrower in June to strike a deal with its lenders to switch existing debt from Libor to the new benchmark interest rate Sonia. ABP issued debt based on Sonia after owners of £65 million in its floating rate consented to flipping from one benchmark to the other. The longer others delay, the more expensive such a move is likely to become.
Meanwhile, a study by the International Swaps and Derivatives Association shows that Libor is not going away just yet. Only 2.5% of $70 trillion contracts traded in the first quarter of 2019 were tied to Libor’s intended replacement rates. Even more concerning for regulators is that $10.3 trillion of derivatives traded in the first quarter of the year have maturity dates beyond 2022.
Switching contracts from Libor to risk-free rates is no small task. Duffie called the transition from Libor "the biggest financial engineering project the world has ever seen. It is an order of magnitude bigger than the creation of the eurozone."
Schooling Latter said that if some banks continue to set Libor after 2021, but some banks drop out, then the regulator may regard the rate-setting panel as "unrepresentative." He has raised the possibility of enforcement action against those firms that use such a rate.
"Most firms would be extremely reluctant to engage their clients with a rate which regulators said was not representative," he said.
Schooling Latter said financial market participants should be actively managing their Libor-linked back books away from the benchmark to alternatives.
Nor should they rely on the contractual fallbacks common to many Libor-linked contracts that outline the interest rate to be used if Libor is not available. Such fallbacks are usually only intended for short-term use.
"We think that the best and smoothest transition from Libor will be one in which contracts that reference Libor are replaced or amended before fallback provisions are triggered," he said.
The market, led by ISDA, is itself working on a fallback rate that could replace Libor in outstanding contracts. This would enable the term element of Libor, its use over monthly periods that makes it so attractive in the derivatives market, to be replicated by compounding the overnight rates at the end of the relevant term.
Duffie, however, urged those affected by the demise of Libor to take action sooner rather than later.
"[F]allback is not a first option. The first option is to trade out of your legacy position," said Duffie.