The world’s most important number
Even if you’ve never worked in the financial services industry, it’s likely you will have at least heard of LIBOR (London Interbank Offered Rate) and probably for all the wrong reasons. The term has become synonymous with corrupt bankers, market manipulation and record-breaking financial penalties. As a result, by the end of 2021, what was once dubbed the “world’s most important number” will be phased out altogether.
Why is the Bank of England scrapping LIBOR?
The transactions used to calculate LIBOR do not occur anywhere near as frequently as they used to, meaning that banks now have to generate an estimate for their LIBOR rate submissions to the ICE Benchmark Administration (IBA) based on “market and transaction data-based expert judgment,” rather than on actual transactions. The number of banks who submit LIBOR rates (known as panel banks) has also decreased considerably since the 2008 financial crisis, reducing the sample size and making the rate even more vulnerable to manipulation. LIBOR used to be administered by the now-defunct BBA (British Bankers’ Association), but in February 2014, the BBA relinquished control to the IBA because it had failed to detect and prevent widespread manipulation of the benchmark.
In July of the same year, the Financial Stability Board published a review into major interest rate benchmarks including LIBOR, EURIBOR (European Interbank Offered Rate), and TIBOR (Tokyo Interbank Offered Rate) and concluded that banks should begin the process of phasing out LIBOR and replacing it with RFRs (risk-free rates) recommended by central banks. These rates include SONIA in the UK and SOFR in the US, among others.
Risk-free rates (RFRs) replacing LIBOR
The Sterling Overnight Index Average is the UK’s most likely candidate for replacing LIBOR. The benchmark has been in use for more than three decades and is calculated from the average interest rate paid on unsecured overnight lending. It was reformed in 2018 following several rounds of consultation. Almost the same number of pound-related swaps currently use SONIA as do LIBOR.
The Secured Overnight Funding Rate, or SOFR will replace LIBOR in the US. It is calculated as the median of rates paid by market participants to borrow cash overnight, using Treasurys as collateral.
The Euro Short Term Rate or ESTER reflects the overnight borrowing costs of banks based within the eurozone. It uses daily transaction data from the 52 largest eurozone banks. It will be used as an alternative to EURIBOR (Euro Interbank Offered Rate) and EONIA (Euro Overnight Index Average) which are being phased out with LIBOR for similar reasons.
TONAR (Tokyo Overnight Average Rate) will replace the TIBOR, JPY LIBOR (Japanese Yen LIBOR) and the Euroyen TIBOR, which have also been subject to manipulation, with a number of banks accused of conspiring to keep TIBOR rates artificially high. TONAR has been the recommended RFR in Japan since 2016. It is a transaction-based benchmark for the unsecured overnight rate using information provided by money market brokers.
How might the transition from LIBOR impact your firm?
Though the phasing out process has been moving along for some time, there are so many securities linked to LIBOR - many of which will be in effect beyond the end of 2021 - it is unlikely to be completed without some issues. Several major banks have expressed their concerns about the complexities of swapping the benchmark for risk-free alternatives, including Morgan Stanley. “Both SOFR and LIBOR reflect short-term borrowing costs, but key differences between them make the transition tricky,” it said in a research report it published in October 2019. “First of all, SOFR relies entirely on transaction data, whereas LIBOR is based partially on market-data ‘expert judgment.’ Secondly, SOFR is purely a daily rate - what’s called an overnight rate - vs. LIBOR's seven varying rates on terms of one day to one year. Finally, LIBOR incorporates a built-in credit-risk component because it represents the average cost of borrowing by a bank. In contrast, SOFR represents a ‘risk free’ rate because it is based on Treasurys. Given these differences, USD LIBOR can’t simply be ‘swapped out’ with SOFR in existing contracts that reference LIBOR - at least not without appropriate adjustments.”
It’s these “appropriate adjustments” that could potentially cause problems for many financial institutions. Not just due to the work involved in making them, but the potential litigation that could follow. The Federal Bank of New York has already warned that the fallout could be “a DEFCON 1 litigation event,” with lawsuits on a “massive scale.”
Michael Held, Executive Vice President and General Counsel at the New York Federal Reserve highlighted the enormity of the challenge in a speech in February 2019, explaining that if LIBOR was to be abolished (at that time the fate of the benchmark rate was still in question) the fallback solutions in existing contracts would become virtually impossible to manage or would “materially change” the economics of the contract. He gave this example: “Many contracts state that if a calculation agent cannot find a LIBOR quote for a given day in the usual Reuters screen, it will call three large London banks and ask them what their borrowing rate is for that day - basically try to privately replicate LIBOR. Imagine if every calculation agent for every transaction tried to do this every time they had to set LIBOR. There would be chaos, especially when those London banks had already decided to get out of the LIBOR-estimating business. Why would they even respond?”
“For some types of transactions - floating-rate notes, for example - there is a further fallback: to fix the interest rate at whatever the last LIBOR quote was. This is not a very satisfactory solution to either the issuers or the borrowers who thought they had an instrument that protected them against interest rate risk. Other transactions like syndicated loans may revert to prime rate loans - again, not what borrowers may want. And, for derivatives, there simply may be no further fallback. You can imagine the litigation risk when the reference rate for a 20-year contract disappears and there’s no clear path to replace it. Now imagine 190 trillion dollars’ worth of those contracts. This is a DEFCON 1 litigation event if I’ve ever seen one.”
These were powerful words back in February 2019, no doubt designed as a wakeup call for banks lagging behind in their LIBOR cessation contingency planning. But as we approach the end of 2020, has much changed? One person familiar with the matter - an operational risk professional currently working in a top tier bank in the US - said he was “not immediately concerned” about the impact of the transition on his firm, but is concerned about “potential issues emerging from other players, plus the low level of engagement/guidance of regulators around these changes.” He also raised the issue of a lack of testing for many of the replacement rates and reiterated Held’s warnings of potential litigation driven by RIM (Record and Information Management) issues.
It’s complicated - but necessary
As messy as this breakup will be for banks, many do agree that the alternative could have far worse implications. Despite the transactions used to calculate (or at least influence) LIBOR having drastically decreased, its use - even now - is still widespread. In his speech last year, Michael Held likened the industry’s reliance on LIBOR to an upside-down pyramid. “Every day, the payments on US$200tn of exposures are calculated based on a handful of transactions worth a few hundred million dollars at most. That’s like a very tall, very broad building built on a very narrow foundation. It’s not stable...it’s getting more rickety by the day. You don’t want to be standing near it when it comes down.”
Although much work has been done to prepare for the cessation of LIBOR, there is still much more to do. A live webinar held by the Professional Risk Managers’ International Association (PRMIA) in September highlighted the looming deadline and the level of uncertainty in the industry. With the COVID-19 pandemic only serving to compound these issues, could the deadline be pushed beyond 2022 - or even further? Tom Wipf, Vice Chairman, Institutional Securities at Morgan Stanley, thinks this is unlikely. “Even at the start of COVID-19, the FCA was really clear that this work needs to continue - the FSB weighed in. One of the things that we’ve seen which I think has kept this work on track in a big way is the consistent message from global regulators on this topic - there has been no wavering here.” Wipf pointed to a research paper published by the Bank of England and another by Liberty Street Economics (the New York Federal Reserve’s official blog) which looked at the impact of the stress period in March this year on LIBOR rates. He feels both papers helped to further reiterate just how pressing the issue is. “[They] created much more concern about LIBOR remaining very high, the impact on borrowers - and served to reignite what the original problems with LIBOR were,” he said.
Systems issues: are we prepared?
One of the key operational risks in the transition process is the potential impact on systems that have been working with LIBOR for so long - which is something financial institutions should already be preparing for. This was highlighted in the Bank of England’s Consultation on Term SONIA Reference Rates back in 2018: “Existing systems and settlement processes may not be able to accommodate payment amounts which are only known with certainty at the end of the interest accrual period. Material amendments to systems, process work-arounds, and new market conventions may be required.”
Alok Daga, CIO Commercial and Corporate Banking at BMO Financial Group, says there are three main areas the bank is currently focussing on to help ensure the LIBOR transition process is as pain-free as possible, particularly in relation to contracts: “We are looking at changes happening on our technology in redocs [re-documentation] and what technology can be infused in that process [to] make sure we cover 100% of it and get the right fallback language where it is needed,” he said at the PRMIA webinar. “For anyone not moving from LIBOR to ARRC [Alternative Reference Rates Committee], [we will look at] where are they moving to, what does that language look like...So we’re making sure we’ve got coverage for all of our legal agreements.”
The second, more-complex piece of work is around making sure systems can handle the variety of replacement rates from the ARRC, explains Daga. “Whether it’s component areas, looking backwards, what the lookback components are...enabling all of that...and the downstream impacts of that enablement.” The third and final area is making sure all underlying cost-of-funds and transfer pricing is accounted for as the firm transitions.
Time is of the essence
President of the New York Federal Reserve, John Williams, warned financial institutions against “sticking their metaphorical heads in the sand” last year. Time is ticking and as banks have been preoccupied with COVID-19 recovery efforts and the logistical challenge of moving much of the workforce to remote operations, LIBOR transition has no doubt taken a backseat for a large part of 2020. But with just over a year left to address the issue, regulators are already threatening tougher capital requirements for banks who have not made enough progress. “We are in the end game and it’s go time,” warned Wipf in his closing statement at the PRMIA webinar. “I think we are going to start seeing financial consequences on the horizon whether that be through the protocol or through the CCPs [Central Clearing Counterparty].” Banks need to ensure they understand not just the financial and credit-related risks involved with this transition, but all of the resultant operational, legal and regulatory issues that may not unfold until long after December 31st 2021. The time to act is now.