LONDON (Reuters Breakingviews) - Finance and business will find Libor a painful and expensive habit to kick. Financial contracts worth more than $300 trillion are linked to the discredited London Interbank Offered Rate. Switching to new benchmark interest rates could disrupt economies as well as markets. Avoiding that outcome will take a lot of money, time, and a willingness to reconcile conflicting interests. Breakingviews explains what’s at stake.
The benchmark is used throughout the financial system. Not only does it determine borrowing costs and the prices of many derivatives, it’s important in accounting and risk management. Its reach even extends to consumer finance: some mortgage rates in the United States are linked to Libor.
Bankers compare the switch to preparing computers for the new millennium, or the launch of the euro. Consulting firm EY estimates that updating systems and switching to new benchmarks could cost the largest globally important financial institutions $300 million to $400 million each.
But the logistical challenge may be even bigger. Intercontinental Exchange, which administers Libor, plans to keep publishing the benchmark so companies know there’s no hard deadline. That may encourage procrastination and make the transition more hazardous.
If only. The new benchmark rates chosen by central banks are superior to Libor because they are based on actual transactions rather than banks’ judgments about their borrowing costs – a system that was open to attempted rigging. The proposed replacements are risk-free overnight rates, such as the sterling overnight index average, or SONIA, in Britain, and the secured overnight financing rate, SOFR, in the United States.
These alternatives differ from Libor in two important ways. First, they are overnight rates, rather than the longer time periods that Libor is generally used for. Second, Libor measures the average rate at which banks can obtain unsecured funding, and therefore incorporates a premium for bank credit risk. The new rates are risk-free. The new benchmarks are therefore only a starting point.
One way to calculate benchmark rates for various time periods would be to use derivatives prices to construct this so-called term structure. But that would mean prices from other markets would start feeding into the calculations.
The alternative is to compound the overnight rate to arrive at a longer-term measure. For example, data from the past quarter could be used to calculate a forward-looking three-month rate. The drawback is that this measure would take no account of future expectations.
A more accurate approach would be to observe overnight rates for the period in question, and compound them to get the final rate. That would deliver a more accurate measure, but borrowers would not know for sure what the rate was until the end of the period.
A similar problem arises when figuring out how big a risk premium to add to new benchmark rates to make them more like Libor. This spread could be based on past data on the gap between Libor and the risk-free rates – possibly including a period of financial stress. Fixing this spread in stone would, however, fail to reflect current market conditions. All the more so since the end of the period of loose monetary policy could affect market prices and liquidity.
Not really. That is when the hard work of switching over existing Libor-linked contracts begins. This is relatively easy for those derivatives that have passed through central clearing houses since there’s more visibility about who did which transactions with whom. Over-the-counter contracts are a trickier proposition since all banks and corporates involved have to be tracked down. With luck, work underway by central bank working groups, the International Swaps and Derivatives Association (ISDA) and others could help all sides come to an agreement about how the second group of financial instruments will be handled. Then each bank could aim to secure a blanket accord with each client that would apply to all their bilateral dealings.
The hardest of all will be securities and loans. The former are more dispersed than derivatives. Nor does their documentation contain the just-in-case language that exists in derivatives contracts to provide for the eventuality that Libor rates are not available. Getting every bondholder or individual who has entered into a syndicated loan agreement to switch to new benchmarks could be difficult. There’s plenty of scope for litigation.
Andrew Bailey, the head of Britain’s financial watchdog, wants banks to switch from Libor by the end of 2021 and the Bank of England last month wrote to the chief executives of British lenders and insurers to tell them to take steps to prepare for the transition. Big financial institutions and companies are likely to be ready in time, as will some markets, such as the one in derivatives. But smaller businesses and some markets such as syndicated loans may struggle with that deadline. Optimists say that as long as the majority switch over, policymakers will tolerate stragglers. That may, however, be an invitation for the sort of prevarication that would spell a much longer and bumpier transition.
Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.
Sign up for a free trial of our full service at https://www.breakingviews.com/trial and follow us on Twitter @Breakingviews and at www.breakingviews.com. All opinions expressed are those of the authors.