UK financial authorities had a clear message for banks and insurers last week: We are not kidding about the death of Libor, and you must be ready.
About $170tn of derivative contracts depend on the benchmark rate and traders at one investment bank in Canary Wharf are well aware that Libor’s days may be numbered. The 2021 switch-off “is really big,” said one.
Head to another floor at the same bank, however, and inquiries on the matter with senior bond-market executives are met with blank looks, even though the same benchmark is embedded in almost every outstanding debt instrument. The mismatch is a common sight.
Authorities appear to have run out of patience with these uncoordinated approaches. Last week the Prudential Regulation Authority and the Financial Conduct Authority sent letters to the heads of the biggest banks and insurance companies it regulates demanding detailed assessments of the risks related to terminating the outdated and scandal-tainted Libor.
To drive the point home, regulators demanded that plans are board-approved and that each institution names the senior manager responsible for overseeing it.
Serge Gwynne, a partner in corporate and institutional banking at consultancy Oliver Wyman, said this is as far as authorities can go short of regulation, which they are keen to avoid in favour of a “market-led” solution. “There’s a risk Libor doesn’t get the priority it should do, not least because of Brexit preparations,” he said.
Regulators’ urgency has been driven not just by the manipulation scandal that has landed traders in prison, but also by the evolution of markets after the financial crisis. Libor measures the cost of unsecured borrowing between banks for a specific period, usually over one, three and six months. It remains embedded in everything from mortgages to banks’ regulatory capital, with more than $370tn of deals tied to it, according to Isda, a trade body.
New rules after 2008 have encouraged banks to look at other sources that offer stable, long-term funding. “The market has moved on,” said Shankar Mukherjee, UK Financial Services Partner at EY.
But the pretence continues. To aid the daily calculation of Libor, banks have to submit estimates that rely on “expert judgment” rather than real activity. Faced with a reputational risk, many have quit the process. More of the remaining 20 would like to but have been persuaded to continue until the end of 2021 by the FCA. Beyond that deadline, it’s unclear whether and how the benchmark can continue to operate. The amount of contracts that reference Libor, but mature after 2021, meanwhile, continues to grow.
Without Libor, thousands of contracts lose the reference rate that forms the basis of their value. Efforts to get the implications across to broad range investors and bankers, however, have struggled while brain power has been focused on Brexit and Mifid regulations.
“This is a project that will require unprecedented coordination across different business functions, from derivatives to loans to mortgages,” said Scott O’Malia, chief executive of Isda.
Thousands of existing contracts that reference Libor will need to be changed, a particularly daunting prospect for a bond issue where borrowers may need to seek permission from each individual bondholder for the switch.
“Getting permission on a bond-by-bond basis would be a huge headache,” said one European banker responsible for arranging bonds.
Intercontinental Exchange, the current administrator, described the rate as a “very good safety net” for the existing business that cannot move, and has indicated it might be prepared to keep supporting it beyond 2021. That position has encouraged some market participants to hold fire from serious preparations.
The alternative is for borrowers to switch away from Libor when it ends, which could involve flipping floating-rate notes into fixed rates, a blow to investors in an environment where rates are rising.
Beyond floating-rate notes tied to Libor, any contract referring to mid-swaps also loops the benchmark into the mix.
“The problem looks so big that even if you have time to do it, some people have not mobilised,” said Francois Jourdain, a managing director at Barclays. “There will be a rump of people who will be late. However, the market is moving in the right direction.”
His bank is arranging an educational event on the issue of benchmark reform this week. Seats at the event have been in high demand, it said, particularly since the letter from UK authorities focused minds on the matter.
UK regulators would like the market to use a reformed benchmark called Sonia, a measure of the rate at which interest is paid on sterling short-term wholesale funds. New bonds referencing it are beginning to trickle out. Lloyds became the first in September; Santander and the Royal Bank of Canada have followed suit. ICE and CurveGlobal, a venue owned by investment banks and the London Stock Exchange Group, have begun trading Sonia futures, to establish market pricing.
These will help, said Michael Voisin, global head of capital markets at Linklaters. “The challenge is to create liquidity in products with the new benchmark . . . Then we look for solutions for the legacy bonds,” he said.
New bonds that still use Libor as their reference also now come with “fallback” elements in the documentation that permit the use of a new benchmark in the event that Libor ceases to exist, though lawyers say these clauses are vague and will probably be prone to disputes in future
For all its faults, Libor allowed borrowers to know what their cost of funds would be for a time period of their choice. Overnight rates can fluctuate dramatically, particularly in stressed markets. Normally, banks seek to manage their assets and liabilities precisely by using the same benchmark. As banks transition, they may have two books – one for Libor business, one for alternative rates.
“One of the big challenges for the banks is a fundamental change in the way loans are priced and the credit risk is managed internally,” said Mr Gwynne.
