It’s been eight months since the UK’s Financial Conduct Authority (FCA) announced its intention to phase out Libor as a benchmark interest rate by 2021, and consultations to find a replacement have yet to start. With three years to go, it’s time to get the ball rolling. Melodie Michel reports.
The speech FCA chief executive Andrew Bailey delivered about the future of Libor on July 27, 2017 did not exactly come as a shock. For almost 10 years, the London Interbank Borrowing Overnight Rate had been the subject of scandal after scandal, with every headline chipping away at its credibility. Journalistic and regulatory investigations into the alleged manipulation of the rate started as early as 2008, and by 2013, eight of the world’s largest banks (Barclays, UBS, Rabobank, Lloyds, Citi, Deutsche Bank, JP Morgan and RBS) had agreed to pay hefty fines for Libor rigging.
When Libor was introduced in the mid-1980s, it brought uniformity to the fairly new world of interest rate swaps, foreign currency options and forward rate agreements. Most of this business happened in the London interbank market, so in order to ensure the sustainability of the growth, the British Bankers Association (BBA) worked to establish and fix an interest rate standard, to be used across the industry. The system was based on trust: every day before 11am, all panel bank members submitted the rate at which they could borrow money from other banks, for a number of different currencies and terms. The BBA then calculated the average, which was published by 11.30am.
Fast-forward to 2008: with the collapse of Lehman Brothers, banks found themselves under extreme scrutiny, and suddenly, submitting a high Libor prediction meant admitting the institution’s instability.
“Banks were reportedly loath to suggest that they were having trouble obtaining funds by reporting a rate higher than other banks were being charged. So to mask its liquidity problems, a bank with funding problems had an incentive to report lower rates than it really believed it would be offered. Indeed, a number of studies have suggested that banks submitted lowball rates after the collapse of the investment bank Bear Stearns in March 2008 as well as after the Lehman collapse six months later,” wrote John Kiff, senior financial sector expert at the International Monetary Fund (IMF), in a 2012 paper.
Banks were able to manipulate the rate so easily due to Libor’s biggest flaw: banks tend to loan each other money for a week or less, so Libor rates for longer maturities are set on the basis of educated guesses – not actual transactions. Yet according to Kiff, almost 95% of transactions that use the rate present maturities of three months or longer.
So now, 10 years after the beginning of the controversy, the FCA (which took over management of the Libor rate from the BBA in 2013 in an effort to regulate it better) is throwing in the towel. Most in the market have come to terms with Libor’s problematic nature – the name of the rate alone is so tainted that ditching it would make a lot of PR sense for banks.
But it’s not that easy. First, over US$300tn of financial transactions are currently tied to Libor – certainly the most widespread benchmark rate. Second, since the whole problem comes from Libor’s unreliability, whatever replaces it needs to be rock solid.
Could Libor continue to exist?
A lot of work needs to be done, yet conversations with the market reveal that most Libor users are still quite relaxed about it. Peter Jameson, co-head of global transaction services at Bank of America Merrill Lynch (BofAML), says: “I have not personally received a single question on this topic. It doesn’t seem to be high up on the agenda of clients and certainly when I talk to my peers in the trade finance industry, it’s not something that I’ve heard mentioned yet. Perhaps once the consultations start, that’s when we might hear clients talking about it.”
For one, the 2021 deadline given by the FCA seems to be taken only half-seriously. According to experts, there is a possibility that the FCA might extend this deadline, particularly if no suitable replacement has been found. But even if the FCA stuck to its initial deadline, the rate could, in theory, continue to exist.
“The UK authorities can say they want to cut off Libor, but it is a private rate, so it may continue even if some countries would plan to discontinue its use,” Kiff tells GTR.
“One solution may be that someone continues to produce a Libor rate at least to wind down all these contracts – some of which will go on up to 30 years.”
According to Michael Green, counsel within Allen & Overy’s banking practice, Libor’s continued existence is likely to depend on the willingness of panel banks to continue to make their submissions.
“In November, the FCA confirmed that all 20 of the panel banks have agreed to support Libor until the end of 2021. After then, the FCA has made it clear that it will no longer persuade or compel them to make submissions. From our perspective, it seems likely that panel banks will no longer wish to make submissions because they’re concerned about the risks involved in making them based on expert judgment, rather than hard transaction data,” he says.
Some have argued that existing contracts could continue on Libor until they run out, with only new contracts using the new rate.
“Even if the FCA stops regulating it, you could just trust the market: for example, cryptocurrencies operate in unregulated markets, so there could be some market participants that are happy to keep using an unregulated Libor,” says Kiff.
But there seem to be a number of incentives for banks to adopt the new rate as soon as possible. First, considering the regulatory pressure they are under, they will be more than hesitant to use an unregulated rate – and potentially appear to violate competition rules. Second, banks like clarity, especially when it comes to insurance pay-outs in case of default, and insurers may not agree to continue working with Libor, even on contracts that have already been signed.
Ralph Lerch, former global head of export finance at Commerzbank, says that the negative interest rate situation of 2014 served as a good reminder that contracts need to be crystal clear.
“We rely on export credit agency (ECA) cover not only for the principal payments but also for interests. When interest rates became negative, the borrowers were informed that we would change the regime to increase the baseline and bring the rate to 0%, without changing the contract.
“Most borrowers accepted, because all banks did the same. But ECAs simply focused on what was initially agreed, so even when it came into minus, they simply indemnified the contractually agreed interest rate. So even if borrowers easily accept and pay an alternative benchmark, you may need to adjust the contract in the ECA business, to have clarity about what would happen in a claim situation and what the appropriate interest rate would be,” he says.
Adjusting contracts: many hurdles ahead
While the trade finance sector, in which deals are short-term in nature, has plenty of time to prepare, export finance bankers already have deals in their portfolio that will run way past the FCA deadline, and as no other rate is yet available, they are still drafting transactions using Libor. This means that by 2021, they will have to update all their contracts to the new rate.
Luckily, many started including provisions allowing for a change of benchmark rate back in 2008, when interbank trust and counterparty credit risk appetite were at their lowest. The Loan Market Association’s (LMA’s) syndicated credit agreements include a standardised clause designed to facilitate this, though it only specifies that the new rate should be “accepted by the market”.
The LMA’s clause is widely used across Europe, but even with this protection, bankers fear that this will not be a straightforward exercise. André Gazal, global head of export finance at Crédit Agricole, tells GTR: “Looking at export financings, considering the duration of the loans, we’re going to hit some hurdles if in 2021 we have to completely stop using Libor as a benchmark. All our contracts will need to activate the clause of alternative funding and we don’t know where this could lead if an LMA standard is not agreed and regulated by then. These negotiations could be complicated.”
At Allen & Overy, Green recognises that “the repapering exercise is going to be significant”, and offers a number of recommendations to help bankers prepare for the change.
“First, it’s important that documents include fallbacks so that they can continue to function, even if only for a short time, if Libor is discontinued. Second, it’s still too early to include provisions specifying the replacement rate if and when Libor is discontinued. The replacement rate hasn’t yet been identified and it would be unwise to simply provide for a currently unknown replacement rate to apply automatically when it emerges, as any replacement rate will require quite substantial changes to documents. Third, the focus for now should be on including provisions in documents that will make amending the documents to cater for a replacement benchmark as straightforward as possible when the time comes – for example, in the context of a syndicated loan, making it a majority rather than an all lender decision,” he says.
Some regulators recently established working groups to work on standardising contract amendments: the loans sub-group of the market-led Risk-Free Rates Working Group created by the Bank of England and the FCA is looking at documentation issues for the loan market, and the bonds sub-group will be undertaking a similar exercise for the bond market.
To complicate matters, it looks like Libor will be replaced not by one, but by a number of different rates (see fact box), depending on factors such as currency and geography, resulting in a much more fragmented market, and in more complex contracts. Should there be two rates available to use for a specific contract? Who decides which one prevails? Most bankers are hoping that regulators will provide guidance on this topic, and all yearn for harmonisation.
“My expectation is that banks will somehow synchronise: it does not make sense for each bank to go for a different rate,” says Lerch. “I would expect them to try and find consistency, to avoid confusing borrowers, which could undermine the acceptance of these long-term financings. But this requires some discussions amongst the banks, which have not started – I don’t recall any discussions on the new Libor replacement.”
Banks’ desire to seek consistency through consultations could be hindered by stringent competition laws, but could find a solution in the technology sector.
“If our systems today capture a set of Libor price rates, are there any system changes that might be required, for example if the number of benchmarks that we could potentially use might increase?” asks BofAML’s Jameson.
Most experts don’t expect these changes to have a strong financial impact, but there could be some repercussions on funding costs and pricing, with banks needing to align client pricing to their own treasury benchmark.
Consultation and oversight are going to be key in transitioning away from Libor, but the slow start since the FCA’s July 2017 announcement is worrisome. As Gazal says: “It’s probably doable in three years, but we need to start mobilising soon as you need all stakeholders on board: this kind of thing cannot be done overnight. We can’t just wake up in 2020 and start the work.”
What are Libor’s most likely replacements?
It is too early to say which rate(s) will replace Libor as a benchmark, but some alternatives have been put forward – all “risk-free” (ie, based on real transactions).
In the UK, the reformed Sterling Overnight Index Average (Sonia) has been identified by authorities as a potential replacement.
In the US, the Federal Reserve plans to publish a Secured Overnight Financing Rate (SOFR) every day from Q2, 2018. It would be calculated in part based on Treasury-backed repurchasing agreements (repo).
For Swiss francs, the Swiss National Bank has also launched a repo-based rate called Aaron (Swiss Average Rate Overnight).
In Japan, a reference rate has been developed for yen transactions: the Tokyo Overnight Average Rate (TONAR), which is an overnight unsecured rate.
In the European Union, no formal alternative has been presented, but market participants and regulators are examining reforms to the Euro Overnight Index Average (Eonia), which has existed since 1999 and is an actively used unsecured overnight rate. Euribor, which is calculated on the same system as Libor (submissions by panel banks), is likely to be suffer the same fate as its UK cousin, with banks distancing themselves from benchmarks not based on actual market rates.
“The attraction of these rates is that they are firmly based on transaction data and, unlike Libor, do not involve any element of expert judgment in their determination,” says Michael Green, counsel at Allen & Overy.
But most experts agree that these alternative rates are an incomplete solution, since they are all backward-looking overnight rates. “The loan markets, for example, want a forward-looking term rate with different tenors,” adds Green. Back to the drawing board, then.
