On New Year’s Day a piece of financial history will be made: the tainted Libor benchmark will take a decisive step towards being phased out after 45 years as a fixture of global markets.
From January, the lending rate cannot be used as the reference rate in any new derivatives contracts, loans and credit card offers.
It will continue to live, in a lesser form, for the $230tn of existing contracts that rely on it as the basis for interest payments. But for regulators and banks, next month represents the moment when four years of arduous preparation to live without it goes into effect.
“It’s one of the biggest transitions in financial markets in decades,” said Dixit Joshi, group treasurer of Deutsche Bank. “This is a milestone for the regulators since the great financial crisis about lessons learned.”
Libor limped along after it was blighted by scandal when traders at the world’s big investment banks were caught trying to rig the rate in their favour, and were hit with $10bn of fines as punishment. But even as it tried to reform the tainted lending rate its chief regulator, the UK Financial Conduct Authority, fretted over an even more substantial issue: a number announced every day at about 11.55am in London posed a serious risk to the stability of the financial system.
While the rate acted as a reference price for contracts that affected millions of consumers, the bank funding activity it was supposed to reflect no longer existed. The daily submissions from banks for the daily fixing were largely estimates. Moreover, after the bruising scandals, the banks no longer wanted the job.
By 2017, the FCA and other regulators arrived at a more radical solution: switch off the 35 different rates, spread across five currencies, from the start of 2022. Thousands of contracts would lose the rate that forms the basis of their value.
There was no like-for-like substitute for Libor, which reflected investors’ expectations of future rates. It also included a component for banks’ credit risk. Users, such as corporations and asset managers, liked it because they would know in advance the size of their interest rate payments.
Authorities wanted the replacement to be based on overnight lending rates, which were based on transactions that took place the day before. That stripped out the bank credit risk component, making them “risk free”. They were more attuned to domestic interest rates but reflected deals done, not the future. Not all countries had a ready-made alternative. The UK could turn to Sonia, a well-used overnight lending rate; the US had to create a new rate, Sofr, from scratch.For banks and regulators, it meant not only developing new benchmarks but drawing up alternative legal safeguards, and constantly pounding the drum that the market needed to be ready. The pandemic-induced market volatility last year, when global interest rates were cut, has only strengthened regulators’ resolve.
“As we saw in March and April 2020, [Libor rates] were going up in times of economic stress,” said Edwin Schooling Latter, who is leading the push to switch at the FCA. “One could argue the banks were passing on to their customers the bank’s own cost of funding . . . Our view is that the banks are better placed to manage that risk than retail customers.”
The transition has sometimes resembled an energy-sapping marathon. Many felt it was impossible not only to create risk-free rates but also build up trading in futures markets, which would supply investors’ expectations of future rates. “If you’d asked anyone at the end of 2017 if this was going to happen by the end of 2021, they’d have laughed at you,” said Sarah Boyce of the UK’s Association of Corporate Treasurers.
That scepticism has been partially vindicated. Even as the year began, contracts worth $265tn were still attached to Libor. Embedding an alternative for US dollar Libor has been particularly tricky because it was a new rate.
To ease the burden, UK and US authorities have allowed US dollar Libor for existing contracts to continue until mid-2023, although new business is barred after December. The FCA also allowed “synthetic” versions of sterling and yen Libor for a year to wean more stubborn contracts off the rate. Even so, daily publication of 24 Libor rates will go after December.
Those who have not switched their contracts will be relying on the temporary versions of Libor, which will be based on a set formula, and their fallbacks, which track the difference between the new risk-free rates and Libor.
Moody’s, the credit rating agency, has estimated that 68 out of the 262 non-US dollar Libor structured finance transactions it had originally rated will rely on “synthetic” Libor rates.
In the final months, the marathon has turned into a dash. The majority of volumes of new privately negotiated swaps deals in the UK pound, Japanese yen, Swiss franc and Singapore dollar, now largely uses the new so-called risk-free rates.
Clearing houses switched large batches of open contracts in the weekends leading up to Christmas. London’s LCH converted 285,000 sterling, Swiss franc, euro and yen swaps, with a notional value of $20tn, from Libor into their risk-free equivalents. ICE Clear Europe converted 3.5m contracts. Consequently, many expect the switchover in rates such as sterling and the Swiss franc to produce few fireworks in the first days of trading. The Sonia benchmark is about 0.2 per cent, similar to the three-month dollar Libor rate.
That leaves authorities focused on the stubbornly slower take-up of US dollar Libor, representing about $230tn of deals. The overnight Sofr rate is 0.05 per cent, compared with three-month dollar Libor of about 0.2 per cent. Roughly 70 per cent of new swaps still referenced Libor in November, according to data from Osttra. US regulators’ efforts over the summer to move futures on to Sofr have had only limited success.
“Telling people to stop using Libor is like reimposing prohibition. People will keep drinking right up until the last moment,” said Mark Cabana, head of US rates strategy at Bank of America.
Regulators warn that these may be the last concessions. “Market participants have all the tools they need to meet this deadline. The responsibility is on market participants to take the action needed to prepare for a world with no new Libor,” said Tom Wipf, a senior executive at Morgan Stanley, who chairs the industry body to lead the shift from US dollar Libor.
The FCA has not decided whether it will continue with synthetic versions of US dollar Libor after June 2023, and will make a decision towards the end of next year. Schooling Latter warned that synthetic versions would not last for ever. “People should not assume there will be a synthetic version of US dollar Libor,” he said.
Even so, the market accepts change is coming. At CME Group, the world’s largest futures market, open positions in Sofr-linked futures outstripped Libor-linked futures for the first time in December.
“This transition has been like open-heart surgery on the financial system. Now we need to use the tools, knowledge and partnerships we have built to get to the next level,” said Tal Reback, who leads the global Libor transition effort at KKR. “It’s no small feat.”
