The Trillion Dollar Problem

While the entire world fights the Coronavirus pandemic, there is a battle of different order for the financial markets. Unlike its predecessors (Dodd Frank Act), this reform is not regulatory in nature, requiring an altogether different approach. The reform arises out of a risk to the existence of world’s best known benchmark. It’s difficult to say if there was a reform as big as this in the world of financial markets. The financial crisis of 2008 and the unearthed scandals highlighted the role of this benchmark in the markets and made nearly the whole world aware of this. 2021 could potentially be the most transformational year of the century for the financial markets should LIBOR cease to exist. It’s a problem worth hundreds of trillion dollars.

What is LIBOR ?

London Interbank Offered Rate, popularly and probably only known to the world as LIBOR, is a benchmark quoted in several currencies like US Dollar, British Pound Sterling, Swiss Franc, Japanese Yen and Euro for tenors ranging from overnight to 12 months. Today it’s administered by ICE who produce an average rate every day at 11 AM London time based on the submissions from the panel banks for each tenor and currency combination. As a note, the submissions by the panel banks is based on the interbank wholesale lending which is unsecured in nature (uncollateralized).

Today LIBOR is used extensively across the globe as a benchmark or as a reference rate for a wide range of financial instruments and products. This includes debt products like mortgages, floating rate notes, student loans, corporate loans and several financial derivatives like interest rate swaps, FX products, credit derivatives, securitized products.

At the moment of writing this article, USD LIBOR was the basis for atleast $ 250 trillion worth of contracts. Globally the amount linked to the LIBOR is expected to be in the range of $ 350–400 trillion or even more. No wonder why it’s called the most important benchmark in the world.

Is LIBOR phasing out ?

The simple and uncomplicated answer is “Yes”. It’s in the process of phasing out.

Around mid 2013, the Financial Stability Board (FSB), a task force set up by G20, decided to undertake a comprehensive review of the key interest rate benchmarks in light of the manipulation and scandals around LIBOR. There were several recommendations out of this review including the multiple-rate approach and phasing out of LIBOR.

Three years later, Andrew Bailey, then Chief Executive of the FCA (Financial Conduct Authority) spoke about sustainability of LIBOR and its future in a Bloomberg conference. Industry believes this is the key trigger for the cessation of LIBOR.

As it stands today, LIBOR may not exist at all or become highly unreliable to be used in a financial transaction at the end of 2021. This is the date recommended by FCA, the governing body for LIBOR. The preparations are in full swing to eliminate LIBOR from existing and new transactions and to switch from LIBOR to an alternative benchmark beginning 2022 completely.

Why is LIBOR being phased out ?

To understand and appreciate why LIBOR is being phased out, we need to focus on few things like the 2008 financial crisis, interbank lending market and the Basel reforms around the capital and liquidity requirements.

After the 2008 crisis and in light of the manipulation of the benchmark by large bank traders, FCA started to regulate and monitor the process of LIBOR determination more closely. The investments occurred in multiple places, for instance IBA (ICE Benchmark Administration) instituted a governing body who acted as an oversight committee. This committee looked at every aspect of the process including but not limited to how the benchmark is determined (methodology) and the quality of submissions by the panel banks. IBA also requested the panel members to base their rate submission on actual transactions as much as possible along with including rates from corporate loans. The number of currency-tenor pairs were also reduced considering the liquidity. The panel banks also instituted various controls in the process such as a senior management oversight and higher responsibility in terms of submission process.

Now let’s touch upon the interbank lending market. This is the market where banks participate in unsecured lending for a short term ranging from overnight to a week. The primary use of such a market is to manage the liquidity within the bank.

The 2008 crisis, in particular, had a massive influence on the interbank lending market. Banks stopped lending unsecured credit to each other. This happened because the counterparty risk increased significantly in the short term and no bank felt they are immune to such a risk. This also led to credit tightening or credit crunch as we know it.

The second thing which contributed to the reduction in the interbank market was the changes in the capital and liquidity requirements which are now more stringent than ever. After the crisis in 2008, Basel came out with the new LCR (Liquidity Coverage Ratio) proposal which ensured that when banks lend credit on an unsecured basis in the short term, such lending is backed by high quality assets to the extent of 25 to 100% in some cases. This led to drastic reductions in the ability of banks to lend to each other in the interbank market.

In the recent times, the decrease in the interbank lending volumes has reached such an extent that the rates derived out of these volumes no longer are representative of the market situations. As described earlier in the article, these rates are the foundation of LIBOR and the lack of such an underlying market along with lack of high volume of transactions make these rates highly questionable.

Thus the rates which are submitted by the banks in several currency tenor combination are ending up based on “Best Judgement” rather than based on “Actual Transactions”. This kind of submission creates large legal and reputational risk for the bank themselves. All of this ultimately leading to significant deterioration in the quality of LIBOR.

People in the industry feel that LIBOR has run its course and is no longer suited to be a benchmark considering how easy it can be to manipulate this if the transaction volume goes significantly southward. There is also a view which suggests that for determining a 3 month rate, the most popular of LIBORs, why is LIBOR the only benchmark ? Why do we not have different benchmarks similar to how we have different stock exchanges for a single stock?

In conclusion, the manipulation of LIBOR is not the only reason why this benchmark is being phased out. There were other factors as highlighted above which played a more significant role in the decision.

What next after LIBOR

Well getting rid of LIBOR is only part of a much bigger problem. Considering that USD $ 350 trillion or even more is linked to this benchmark worldwide, the successor for this benchmark should be more sophisticated and must resolve all the issues which LIBOR faces today. Also the risks associated with the discontinuation of such a heavily used benchmark are significant and can cause severe upheaval in the financial markets and disruption in the business overall. For some of the firms like investment banks, investment management firms, broker dealers, the risk of disorderly transition could pose material risk because of the existing contracts on LIBOR.

Keeping in mind the recommendation from FSB, the countries and regulators have come together to form working groups on identifying the successor to LIBOR. The move is more towards a risk free rate alternative and a benchmark which is based on transaction volume. Most of the recommended alternatives are overnight rates based on repo transactions.

Here is a quick overview of the proposed alternatives so far along with the information on the working group:

Although new benchmarks are proposed for all the currencies, there are several issues which need to be ironed out for a successful transition. Here are a few

1. For instance, the proposed benchmarks are largely risk free whereas LIBOR currently has inbuilt credit risk premium in it. Usage of RFRs (Risk Free Rates) for transactions with maturity beyond 2021 can cause tremendous fluctuations in the valuation once LIBOR ceases to exist.
2. RFRs are overnight rates largely which are collateralized in nature. This is again not the case with LIBOR.
3. Today there is no term structure for RFRs where LIBOR has a term structure ranging from overnight to a year.
4. Finally the notional volume referencing SOFR (USD LIBOR replacement) as of 1Q of 2020 is merely 0.4% of the total traded notional in the IRD market.

There is no doubt that transition to alternate reference rates is moving swiftly and financial institutions along with industry bodies like ISDA, FED, BoE, ECB have made tremendous progress on this front. But the arrival of COVID-19 has also put severe stress on the financial system and in some cases halted the progress on LIBOR transition.

Nevertheless navigating the nuances of LIBOR transition will remain the top most priority for the financial institutions until atleast Dec 2021. The financial markets are definitely in their most interesting and exciting times ever !!

References

• Staff Statement on LIBOR Transition. https://www.sec.gov/news/public-statement/libor-transition#_ftn5
• Can the US interbank market be revived? https://www.federalreserve.gov/econres/feds/files/2018088pap.pdf
• Eclipsing LIBOR. https://www.moneyandbanking.com/commentary/2017/9/3/eclipsing-libor
• Reforming Major Interest Rate Benchmarks https://www.fsb.org/wp-content/uploads/r_140722.pdf
• The future of LIBOR https://www.fca.org.uk/news/speeches/the-future-of-libor