Abandon Libor Now or Else, U.K. Agency Warns Finance Firms

(Bloomberg) -- The U.K. Financial Conduct Authority warned traders to speed up their moves away from products based on Libor or risk falling foul of the regulator when the 50-year-old borrowing benchmark disappears.

Financial institutions still hold about $170 trillion in swap contracts based on Libor, or the London interbank offered rate, and about a third of those mature after 2021, when the benchmark rate will disappear, FCA Chief Executive Officer Andrew Bailey said Thursday in a speech at Bloomberg’s headquarters in London.

“Firms that we supervise will need to be able to demonstrate to FCA supervisors and their Prudential Regulation Authority counterparts that they have plans in place to mitigate the risks and to reduce dependencies on Libor,” Bailey said. "Misplaced confidence is a risk to financial stability as well as to individual firms. The pace of that transition is not yet fast enough."

Bailey’s FCA is among the regulators and industry groups globally pressuring traders on the matter. Federal Reserve of New York, the Financial Stability Board and the International Swaps and Derivatives Association are also involved in the effort.

Regulators are pushing for a quick phase-out of Libor because it’s antiquated, brings too much risk for derivatives and is vulnerable to abuse. While regulators in the U.K., U.S., and Japan are among those suggesting alternatives, the issue remains of how to deal with the legacy of contracts that reference it -- the so-called back book.

U.S. Commodity Futures Trading Commission officials also pressed for movement away from Libor during an advisory committee meeting in Washington on Thursday.

Rostin Behnam, the commissioner who oversees the CFTC’s Market Risk Advisory panel, said industry input on the matter could help inform work by the agency, which has levied billions of dollars in penalties against firms for cases involving benchmark manipulation since 2012.

“There is still a lot to be done,” CFTC Chairman J. Christopher Giancarlo said at the meeting. “Yet, the forward course is clear -- it is away from Libor.”

Winners and Losers

Alongside the difficulties in changing contracts while they are still in effect, there’s the problem that a new rate will be at a different level to the old one. That will create winners and losers, giving those who miss out an incentive to turn to the courts.

ISDA, a derivatives industry trade group, estimates that about 80 percent of current derivative exposure will expire by the end of 2021. That will reduce the size of the problem only if new contracts don’t rely on it. Given that potential replacements lack the liquidity of Libor, traders are still opening new Libor-based positions, according to ISDA.

“There is substantial consensus that the largest part of the market currently relying on Libor -- that is the bulk of interest-rate derivatives -- does not need term rates,” Bailey said, adding that “synthetic solutions” created to replace Libor weren’t viable.

On Thursday, ISDA proposed different ways to apply the new reference rates to existing contracts, but with adjustments to help the deals continue to function as intended. The tweaks seek to ensure that the new overnight rates can adequately replace Libor and other benchmarks that have much longer duration.

Risk-Free Rates

Bailey said transactions should now be based on “risk-free” rates such as Sonia, or the Sterling Overnight Index Average, a reformed version of which the Bank of England started publishing in April. Since then, Sonia-based transactions have grown four-fold, he said. Bailey said he couldn’t give a timetable for the transition to Sonia and other alternatives.

Banks are increasingly reluctant to take part in the panels that supply estimates of the cost of borrowing from other banks, an activity that has anyway become increasingly rare. A regulator finding that Libor or another rate is no longer admissible could lead to enforcement actions against banks.

“It’s measuring something that used to exist but doesn’t anymore,” Bailey said. “It may die of its own accord or we may have to conclude it’s not representative. We haven’t done that yet, which is why it makes perfect sense to go full steam ahead on the replacements.”

Scandal-Linked

Banks may be happy to see the end of Libor. They’ve been fined more than $10 billion for Libor rigging by traders, according to an April analysis by Bloomberg Intelligence. Several bankers have been found guilty in U.K. and U.S. courts for participating in the rigging schemes. The scandals provided part of the justification for the regulators to do away with the benchmark.

“Bailey has given his clearest signal yet to the market that the bell tolls for Libor,” Mairead Duncan-Jones, capital markets lawyer at Linklaters, said in an email. “Firms need to consider this issue seriously, quantify their exposure to Libor and have concrete plans on how to transition. After this morning’s speech the “wait and see” approach is not likely to be sufficient.”

Bailey said last year that from 2021, the FCA will no longer force banks to be on the panels that estimate the various Libor rates. While Intercontinental Exchange Inc., the company that administers Libor, plans to continue publishing the gauge after that date, liquidity in the interbank markets that those estimates are based upon is declining.

Steady Decline

If Libor were no longer available, the terms of many bonds that reference it typically would mean the interest rate being fixed at the most recent rate for that issue, according to the International Capital Market Association.

The benchmark is the average rate at which a group of 20 banks estimate they’d be able to borrow funds from each other in five different currencies across seven time periods, and is submitted by a panel of lenders every morning. Its administration was overhauled in the wake of the scandal, with Intercontinental Exchange taking over from the then-named British Bankers’ Association with the aim of making the rate more transaction-based.

©2018 Bloomberg L.P.

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