LONDON (Reuters Breakingviews) - Reports of the death of the London Interbank Offered Rate are premature. It’s true that Andrew Bailey, the head of Britain’s financial watchdog, gave banks, investors, and businesses notice on July 27 that they could not count on the discredited benchmark surviving indefinitely in its current form. But killing off Libor will be a long and messy business. Especially since those who issued its death sentence are keen to keep the rate alive for several years to avoid market and economic disruption.
Libor is based on what banks say it costs to borrow from each other for a range of time periods, in a range of different currencies. It became shorthand for greed when it emerged that a network of traders at big global banks had for years conspired to try and rig the rate by massaging submissions.
Though Libor was revamped so that banks’ based their contributions on actual transactions, the rate is still based on the judgment of individuals. That’s because the interbank lending market from which the figures are drawn is less active than before the financial crisis.
Fewer than a third of three-month U.S. dollar Libor submissions were based on actual transactions in the fourth quarter of 2015, according to ICE, which administers the benchmark. For three-month sterling Libor, less than one in four were real loans.
True, this approach permits rates to be calculated daily regardless of market activity. But international regulators prefer benchmarks to be based on transactions. And some banks are uncomfortable about relying on judgment rather than actual activity. The stiff fines, reputational damage and – in some cases – prison sentences that await those found guilty of manipulating benchmarks are fresh in the memory.
An estimated $350 trillion of contracts are linked to Libor, according to ICE Benchmark Administration. It is the foundation for pricing retail products such as mortgages and student loans, and more specialist instruments like interest rate swaps. Some of the contracts that use it as a reference won’t expire for another five decades – longer than the benchmark has been around. Bankers, lawyers and officials are therefore keen to ensure its demise doesn’t cause economic and market ructions.
Successors will be based on actual transactions but vary from country to country. In Britain, there’s backing for the sterling overnight index average – known as SONIA - which is administered by the central bank and tracks how much banks and building societies are charged for unsecured borrowing. Interest rate premiums would be added to the overnight rate to produce benchmark rates for different time periods. In the United States, it will be the broad Treasury repo financing rate, which is based on the cost of borrowing with U.S. government debt as collateral. Japan has picked an unsecured overnight borrowing rate called TONAR, while Switzerland has gone for SARON, which is based on the domestic repo market.
A while. Bailey said he had asked banks to voluntarily keep Libor alive until at least end-2021 – but also warned that he could legally compel them to contribute. That buys some time to figure out how to deal with outstanding contracts that use Libor as a reference rate. One problem is ensuring their value doesn’t change markedly when the switch is made from Libor – which incorporates bank credit risk – to new benchmarks that are closer to genuinely risk-free rates. Brand new successors, such as the U.S. alternative, will take time to establish and build up a track record. Banks could continue to contribute to Libor past 2021 and some businesses and investors might prefer to keep using the old benchmark.
The fact that both banks and regulators want to be shot of it. Some banks can’t wait to stop contributing to Libor – hence Bailey’s willingness to force contributions if necessary.
Companies and investors have more reason to drag their feet. However, regulators could force the pace of change by, for example, substantially increasing the amount of capital that banks have to set aside for derivatives based on Libor. Banks would pass these costs onto clients, giving them good reason to switch to new benchmarks.
The changeover will create some trading opportunities, not least because some of the substitutes will be based on secured lending markets, while others will continue to be unsecured.
For example benchmark rates could rise in one country but fall in another purely because of shifts in demand or supply of collateral. Any such divergences will feed activity in the cross-currency basis swaps market.
A trickier problem, which no lawyer will be able to solve, is that the changeover to the new benchmarks will occur just as central banks are removing some of the liquidity they have injected into financial markets over the past decade. Problems and quirks may come to light as markets become less distorted. They, rather than legal fineprint, may pose the biggest test to the plan to kill off Libor.
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