Called variously ‘bigger than Brexit’ or ‘the largest banking challenge you’ve never heard of’, one thing is certain; regulators have specified that the London Interbank Offered Rate (LIBOR) will cease to exist after 2021-end.
Affecting everything from derivatives, securities, loans and mortgages, LIBOR is estimated to underpin USD340 trillion in financial contracts and has held sway over the interest rates banks charge each other for short-term unsecured loans for decades.
During the 2007-2008 financial crisis, however, LIBOR began to behave in an unexpected manner compared to other market benchmarks. The UK and US regulators and prosecutors scrutinised the benchmark and how it was calculated, ultimately concluding that it was subject to manipulation.
This ‘LIBOR scandal’ sparked calls for deeper reform of the entire LIBOR system as regulators remained concerned that LIBOR was not a reliable benchmark given the relative lack of underlying transactions in the interbank lending market that LIBOR was meant to measure.
LIBOR panel banks – a selection of banks that lend one another unsecured funds on the London money market – were also increasingly reluctant to contribute quotes.
The industry now seeks a wholesale move to so-called risk-free rates (RFRs) anchored in actual transactions – with the preferred RFRs for the affected LIBOR currencies already identified by industry working groups. Indeed, the US Federal Reserve and the Bank of England have been publishing the calculated SOFR and SONIA rates, respectively, since April 2018. And in October 2019, the European Central Bank began calculating and publishing an alternative to LIBOR – ESTR (Euro short-term rate) – on the European market.
Where RFRs had previously lacked volume, the industry as a whole is now evolving to offer viable alternatives to the IBORs (interbank offered rates) in a post-LIBOR world, according to the Bank of International Settlements (BIS).
For banks, institutional investors and corporates, however, transition issues loom large, requiring resources in terms of manpower, money and cogent action plans.
According to BIS, there’s unlikely to be a “Swiss Army knife solution” for benchmark rates; each RFR – be it SONIA in the UK, SOFR in the US, TONA in Japan or ESTER in the European Union – is likely to grow according to its strengths. The value of bonds issued this year linked to SOFR has surged to USD73 billion, up from USD7.7 billion in 2018.
For other markets, given the importance of credit-sensitive term benchmarks, the ‘two-benchmark’ approach provides the flexibility for market participants to choose the benchmark that is most appropriate for their circumstances and market needs.
In this case, authorities have opted to complement the RFRs with reformed and improved local IBOR-type rates. In Japan, a reformed TIBOR will coexist with TONA; and in the euro area, there is an ongoing effort to reform EURIBOR to complement ESTER.
Indifference is not an option
The most pressing concern is the migration of legacy LIBOR-linked exposures to the new benchmarks when LIBOR publication ceases after 2021.
Trillions of dollars of legacy contracts will still be outstanding at that time and the results of not constructing adequate fallbacks in LIBOR-referencing contracts is potentially catastrophic.
The Financial Stability Board has highlighted good progress on the transition from LIBOR in many derivatives and securities markets, but progress in cash markets has been slower, and therefore needs to accelerate.
As we enter 2020, floating-rate note (FRN) issuers and investors are increasingly being urged to transition away from LIBOR-linked benchmarks towards the use of alternative RFRs in their new contracts – and to ensure their legacy contracts include sufficiently-robust fall-back language. This is to avoid the risk of their FRNs converting to fixed rates in the event of a permanent cessation of LIBOR, with the potential to create losses for the unwary and equally huge windfalls for others.
According to Andrew Dixon-Smith, Head of Legal, Global & Commercial Banking, Standard Chartered, the scale of the transition is largely underestimated.
“It's probably one of the biggest impacts in financial markets for decades,” he said. “And I don't think that the market quite appreciates that.”
“Indifference is simply not an option. It's important for corporates to not ignore it – and we would encourage more engagement and awareness across the market.”
Corporates are likely to have a varied number of products with the banking sector and in many cases, they would also be cross, or multi-banked, making transition issues all the more complex.
When it comes to transition, ultimately corporate treasurers would want the derivatives side to be aligned with the lending side.
“That's not necessarily the case right now,” said Dixon-Smith. “The market has not fully settled on the adjustments required for the risk-free rates as fallbacks – and there is a need to develop the liquidity in the RFR fallbacks required to make for an effective transition.”
Key to this transition will be repricing, he said, which will require critical changes to bank systems.
For John Ho, Standard Chartered’s Head of Legal, Financial Markets, corporates and banks need to realise that the changes will go beyond simply redrafting contracts.
“It's not just a repapering exercise, it's a wholesale change in respect to the way you price trade, to the way you structure, market or book trades. Regulators would expect firms to address any operational, financial resilience, business model and conduct risks posed by the transition” he said.
In September 2019, the Alternative Reference Rates Committee (ARRC) released a practical implementation checklist to help market participants transition away from USD LIBOR to using the SOFR. The checklist covers 10 key areas where action is needed in order for impacted firms to prepare for the transition to SOFR. These include governance, communications, risk management, contract remediation, and operational readiness.
When it comes to bank preparation, it’s as much about helping clients as it is about their own impact analysis. According to Dixon-Smith it’s incumbent on banks and their clients to keep the dialogue open and moving.
“We encourage corporates to interact with their banks,” he said.
Worryingly for many banks, contracts that require term rates are still being referenced to LIBOR. At the root of the problem is that while RFRs have a solid past based on actual transactions, they are overnight rates whereas LIBOR is published across a number of maturity periods. Unlike LIBOR, RFRs do not contain an embedded term or credit risk premium.
In contrast, a significant volume of cash products such as loans linked to LIBOR have forward-looking term rates, meaning borrowers have certainty over their future liabilities and can manage cash flows more easily. The transition will be most challenging for cash markets because of the bespoke nature of contracts and structurally tighter links to interbank offered rates. In reaction, the UK industry working group for transition has proposed to cease issuance of cash products linked to Sterling LIBOR by Q3 2020.
Whilst certain currency jurisdictions are working on forward-looking term rates, it is not certain that these will be developed before the end of 2021. According to Ho, global regulators have urged market participants to press on with LIBOR transition without waiting for these term rates to arrive.
Such benchmark reform is sure to create an administrational load as LIBOR’s demise draws near. While there are some that may be hoping benchmark headaches will be regulated out of existence by the time LIBOR is dead and buried, analysts say it’s a misplaced hope.
“I think it’s better to make appropriate proactive plans than to wait and see,” said Ho. “Transition will require mobilisation of significant resources to phase out of LIBOR and no one will want to be left hanging.
“The key message is that people need to start thinking about this, what it means for their organisation and to have a clear plan of action across a range of touchpoints. Firms with LIBOR exposure should fully understand their exposures and risks, seek to reduce reliance on LIBOR and engage in transition efforts.”
Given the degree of risk arising from the continued reliance on LIBOR, market participants should expect increasing regulatory scrutiny of their transition efforts as the end of 2021 approaches.
This article was also published in Bankable Insights, Edition 12