Replacing Libor and its myriad lookalike interbank rates. It’s easy to say but based on progress to date, it’s going to be fiendishly difficult to achieve. But it’s incredibly important and there’s a lot at stake like the future functioning of financial markets.
The story of Libor and its debacle is well-known. You can agree or disagree with the way that regulators, law enforcement agencies and the judiciary have framed the issue and dealt with it, but as a theme, that’s so much water under the bridge. (Well, not for those who are serving prison terms for their roles, but that’s a story for another day.)
There’s only a couple of years left before the globally maligned submitted composite model is ditched and in principle substituted by a variety of alternative risk-free rates that will determine everything from the cost of retail and consumer borrowing, institutional funding costs, reference rates for swaps and other derivatives, and pretty much everything else where a reference number is required in a financial contract.
Hands up, I’m no world expert on this subject but I’ve been doing a bit of digging around it of late. Given the centrality of Libor to the workings on financial markets and the criticality of having a credible substitute, I would have expected better progress towards the end-game. That’s not at all to undermine the work being done by central banks and various focused committees throughout the world that are working on this day and night. But the number of letters being sent by regulators and central banks exhorting bank CEOs and others to push ahead with their planning initiatives infers a sense of concern.
One thing I have discovered is that IBOR Transition (as the broad project is known) has become a flourishing cottage industry and a serious money-spinner for consultants and advisors, who are happily taking commissions from stakeholders right across the financial sector value chain who in turn are starting to panic about how little they’ve actually done and the sheer scale of what remains to do.
There are several spokes to this story: legal and contractual, tax and accounting, and a multitude of knotty operational and product-specific issues. I was talking to a senior financial markets executive recently who told me Libor was his most feared and dreaded five-letter word. And he was talking as much about the future as the past.
Perhaps more tellingly, another said that while the UK’s Financial Conduct Authority (which is leading the charge of Libor substitution) would stop obliging banks to submit Libor levels after 2021, there would be nothing technically preventing banks from continuing to do so in order to create interbank rate continuity if the markets weren’t ready for the “New World”. Hope over expectation, perhaps.
The sense I get from the various conversations I’ve been having is that while large corporations and asset managers are broadly engaged in dealing with the substitution process, there is a very long tail of smaller players on both sides of the fence who are not. The same goes for the banks. Part of the perceived reticence stems from fear or lack of knowledge, some from counterparties wanting to avoid the considerable costs of switching, some from the lack of credible alternatives, some from not wanting to suffer perceived first-mover disadvantages.
In the UK, the Sterling Overnight Index Average (SONIA) is pretty well embedded and increasingly used by FRN issuers and derivatives counterparties. It’s probably too early to make a call on the future success of the euro short-term rate (€STR), the Swiss Average Rate Overnight rate (SARON), the Australia Overnight Index Average rate (AONIA), the Tokyo Overnight Average Rate (TONA), or others.
In the US, the Secured Overnight Financing Rate (SOFR) that is scheduled to take over from dollar Libor has received a perhaps more varied reception among debt issuers and other market users. The dramatic spike in repo rates in the US in September will have done nothing to calm the nerves of those ambivalent about the credibility of a rate that references overnight repo rates backed by US Treasury collateral.
One issue that does seem to be vexing stakeholders is how a by-definition backward-looking overnight rate can be used for term funding or for long-term financial contracts. The lack of progress on agreed and standardized methodologies for creating forward-looking rates – or in some cases the lack of agreement that there will be a term rate at all – is of concern to many.
Another pressure point is what happens to existing contracts that go beyond the end-2021 end-date. It means updating, novating, or amending millions of contacts through consent solicitations, liability management and other methods. Another is whether there is alignment on the calculation methods and methodologies.
There are just two calendar years left before the Big Shift is scheduled to happen. Like many, I’ve watched regulatory deadlines move back as matters of expediency and pragmatism. For sure, an awful lot can happen in two years. Call me a cynic but might I be the first to suggest that the end-2021 deadline might become more fluid the closer we get?