Change can be good. But when it comes to financial contracts worth hundreds of trillions of dollars, change can create a whole new meaning. Take LIBOR (the London Interbank Offered Rate) around $370 trillion of financial contracts, spread globally across derivatives, loans and bonds, currently reference this global short-term interest rate benchmark. This alone is enough to attract interest from any central bank or regulator across key jurisdictions. Add to this changing to a new benchmark or reference rate and you have the makings of a gigantic headache for the whole industry.
Surprise? Not really. Looking back it’s clear that change was always going to be inevitable:
- its time has passed: since the introduction of Basel III’s liquidity risk rules (which make it far more difficult for banks to lend to other banks through short-term, unsecured markets) LIBOR’s use has significantly decreased; and
- it’s fundamentally flawed: LIBOR is based on the submissions from panel banks, which in turn are largely based on expert judgment rather than actual transactions. This enabled traders collectively to manipulate benchmarks for their own personal gain, exposing a clear lack of governance and transparency, as the latest convictions for wire fraud and conspiracy all too clearly show.
Partly as a result of recent scandals, new proposals are underway to replace the various LIBORs with a more practical near Risk Free Rate (RFR). The US is already well placed, having selected their new RFR curve earlier this year in the form of Secured Overnight Financing Rate (SOFR). By contrast, the Bank of England has only recently ordered measures to replace LIBOR with Sterling Overnight Interbank Average Rate (SONIA) by 2021 .
With the approximate value of deals referencing LIBOR in the hundreds of trillions of dollars, making the transition from LIBOR to a new RFR may need to be a gradual process to minimise economic instability while liquidity in these new RFRs develops. But of course this all depends on how quickly market participants look to adopt them.
Andrew Bailey, head of the Financial Conduct Authority has already raised questions about the large legacy of financial contracts and the inability and the instability created around changing this rate. In his view, it is potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them.
LIBOR has played a central role in financial markets for approximately 40 years and permeates through the life-cycle of millions of transactions. It’s embedded across financial institutions’ operations. Safe to say, therefore, that any change would affect multiple areas of the bank, given the hard-wiring into risk, valuations, performance modelling and commercial contracts, just for starters.
But perhaps the biggest challenge is the Herculean task for the market to transition away from USD$370 trillion in exposures from LIBOR to an RFR across the wide ranging asset classes and financial instruments within a couple of years.
As we know, financial institutions’ legacy architectures and technology are not always swiftly scalable or adaptable. Transitioning on such a large-scale will demand innovative solutions combined with continuous collaboration across the industry as whole.
Over the coming weeks, we’ll explore the areas impacted and the practical approaches needed to make the move away from LIBOR successful. We’ll focus on the scale, urgency and practical obstacles that lie ahead and show what market participants should consider – and prioritise now – including:
- market adoption
- valuations and risk management
- liquidity risk
- credit spread risk
- term structure
- operations and technology change
- litigation, reputation and conduct risk
- the overall transition plan
In my next Libor blog, I focus on LIBOR reform and market adoption; are RFRs friend or foe? while in the third blog in this series, I examine issues surrounding valuations and risk management, before moving on to the IBOR to RFR transition.
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Note: This opinion piece was first published by Catalyst prior to the Sionic merger