Changes Ahead for LIBOR

What Comes Next?

by Kyle Patino and Derivative Products Group

On July 27, 2017, Andrew Bailey — chief executive of the U.K.’s Financial Conduct Authority (FCA), the regulator of The London Interbank Offered Rate (LIBOR) — publicized deficiencies in the thinly traded LIBOR market and indicated that the FCA would cease, requiring the submission of LIBOR quotes by LIBOR panel banks at the end of 2021.  The regulator expressed concerns over the future sustainability of LIBOR given an “absence of active underlying markets.”[1]

The purpose of Bailey’s speech was to motivate action toward choosing alternative benchmark interest rates based firmly on actual transactions and to allow sufficient time for an orderly transition.

As recent as November 24, 2017, the FCA confirmed that all 20 banks which provide for LIBOR benchmark quotes will continue to support the LIBOR benchmark until an alternative is identified in 2021.  This is an important step toward an orderly transition, further reducing potential market disruption.

What is LIBOR?

LIBOR is a benchmark interest rate for seven maturities (overnight to 12 months) quoted in five currencies. A panel of 11 to 17 banks is surveyed for each currency calculated. The result is the average of the interest rates these banks charge to provide unsecured funding in the London interbank market for a given period in a given currency to other banks.

LIBOR is widely used as a benchmark rate in lending, borrowing and derivative transactions, relating to an estimated $350 trillion of financial instruments. [2]

Why might LIBOR be phased out?

The FCA believes the markets supporting LIBOR are no longer “sufficiently active” to ensure the rate is representative of market conditions. According to Bailey, there is no longer enough meaningful transaction data to sustain the index. To illustrate, he noted an extreme example in one currency-tenor combination where there were only 15 observable transactions during 2016.

What is the FCA’s goal?

The FCA has stated its goal is to derive alternative interest rate benchmarks that are based on actual transactions rather than the judgment of submitting banks.

Haven’t changes already been made to LIBOR to improve its reliability?

Yes. A number of meaningful changes have recently been made to the oversight and calculation process for LIBOR.

  • In April 2013, the U.K.’s chancellor of the exchequer recommended that contributing to and administering LIBOR become regulated activities and that the FCA should be appointed as the regulator of LIBOR.
  • On February 1, 2014, the Intercontinental Exchange Benchmark Administration (IBA) took over as the administrator of LIBOR to bring greater transparency and a more robust governance and oversight framework.
  • The IBA established an independent oversight committee to monitor and scrutinize how it manages and calculates the benchmark.
  • LIBOR submission banks have improved controls around their submissions, with each bank now required to have a senior executive responsible for rate submissions.

According to Bailey, the goal of these reforms “has been to try to anchor LIBOR submissions and rates to the greatest extent possible to actual transactions. This is to ensure the rate is genuinely representative of market conditions. That change, however, has been more difficult to realize than the governance improvements. This is not because the administrator or panel banks do not want to base their submissions on transactions. It is not because the composition of the current panels is unrepresentative of the underlying market and transactions in that market. It is because the underlying market that LIBOR seeks to measure — the market for unsecured wholesale term lending to banks — is no longer sufficiently active.”[1]

Is LIBOR still a reliable index until the transition date?

Bailey was clear in his speech that his questioning of the sustainability of LIBOR was not because the FCA has any suspicion or evidence of any current wrongdoing. Rather, it was precipitated by a lack of market-based transactions to sustain the index over the long term.

In addition, the FCA has spoken to all of the current panel banks about agreeing voluntarily to continue LIBOR submissions until the end of 2021 to ensure its viability during the transition away from LIBOR.

Who is working on finding an alternative to LIBOR?

In the United States, work began on finding alternative interest rate benchmarks in November 2014. At that time, the Federal Reserve Board of New York convened a working group of industry participants, regulators and central banks known as the Alternative Reference Rates Committee (ARRC). The ARRC was convened to identify a set of alternative reference interest rates more firmly based on observable transactions and that comply with appropriate governance structures. The committee stated that its goal was not to eliminate USD LIBOR completely, but rather to move a significant portion of derivatives trading from instruments referencing USD LIBOR to a more robust alternative rate.[3]

Have alternative benchmarks been identified?

On June 22, 2017, the ARRC identified a broad Treasuries overnight repurchase agreement (repo) financing rate (the cost of borrowing cash overnight secured by U.S. Treasury Securities (SOFR) as the rate that represents best practice for use in certain U.S. dollar derivatives and other financial contracts. The ARRC believes SOFR meets requirements for “depth of the underlying market and its likely robustness over time; the rate’s usefulness to market participants; and whether the rate’s construction, governance, and accountability would be consistent with the International Organization of Securities Commissions (IOSCO)[4] Principles for Financial Benchmarks.”[5]

On August 22, 2017, the Federal Reserve Board requested public comment on a proposal for the Federal Reserve Bank of New York, in cooperation with the U.S. Office of Financial Research, to produce three new reference rates (including SOFR) based on overnight repurchase agreement transactions secured by U.S. Treasury Securities.

Does that mean SOFR will officially replace USD LIBOR?

No. At this point, the proposed SOFR is a concept that needs further refinement. There are a variety of pros and cons, operational challenges, and determinations of market acceptance that need to be evaluated and weighed even before an official index can be constructed.

What will happen to legacy agreements maturing after 2021?

If LIBOR ceases to be published, the 2006 ISDA Definitions allow for the calculation agent to poll a panel of reference banks to determine LIBOR. However, given the desire of most panel banks to rid themselves of the potential liability associated with providing these types of “judgment” rates, the emergence of a “private LIBOR” index seems unlikely.

Understanding this possibility, ISDA is currently working to establish fallback mechanisms that would apply in the event LIBOR is permanently discontinued. This includes working on an amendment to the 2006 ISDA Definitions to add selected fallback rates and the development of a proposed plan to amend legacy contracts referencing LIBOR to include the amended definitions. In this regard, ISDA is also in discussions on potential development of a protocol mechanism to facilitate multilateral amendments.

While ISDA can only state what remedies are available and proposed for derivatives, it understands the prevalence and importance of other LIBOR-based transactions, and it is trying to craft a solution that will be workable for the largest amount of instruments affected. Many industry observers are expecting an industrywide consensus to emerge around a replacement rate over time (for derivatives, loans, bonds, etc.).

At this early stage, SOFR proposed by ARRC appears to be the leading candidate for adoption by many loan and bond markets (based on the Fed’s sponsorship, the CME’s development of derivatives markets for the index, etc.), but details remain uncertain given the number of parties involved and length of time before adoption of a new standard occurs.

Ready to Help

Given the preliminary nature of information regarding the future of LIBOR, identification of an alternative reference rate, implementation timeline, ISDA Definition updates and market liquidity, please contact your Derivative Products group representative to discuss potential impacts to your firm. PNC is committed to providing you with the most relevant information possible concerning the future of LIBOR and partnering with you to help mitigate any impacts to your firm should LIBOR be replaced by an alternate reference rate.

Kyle Patino
CAIA, Managing Director and Senior Vice President
Derivative Products Group, PNC Capital Markets

kylepatino@pnc.com
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