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The Long Hunt for an Incorruptible Successor to Libor: QuickTake

Why It's So Hard to Replace Libor: QuickTake

(Bloomberg) -- Libor, the London interbank offered rate, for decades was a reliable benchmark set daily by banks to determine interest rates on everything from student loans and mortgages to derivatives and credit cards. But ever since European and U.S. banks were found to have manipulated rates to benefit their own portfolios, the benchmark has been seen as tainted. Along with its kinfolk -- Euribor for the euro and Tibor for the yen -- Libor is probably headed for history’s scrap heap in a few years. But with more than $370 trillion in financial contracts pegged to Libor, it can’t just disappear. That has presented bankers with a big headache: figuring out how to cause the least amount of market disruption in the transition to more reliable and transparent substitutes.

1. What will replace Libor?

Regulators, bankers, lawyers and investors globally are in the process of figuring that out. The challenge is to find nearly risk-free, all-purpose benchmarks for a variety of loans and contracts. They also must cover maturities running from overnight to many years in the future -- and deal with five major currencies. That implies using actual transactions as a baseline, versus the current system in which banks rely on a mix of transactions and market data to estimate what they think their short-term borrowing costs will be. If the new system relies on real loans backed by collateral or on a very liquid market, such as derivatives, the rates will almost always be lower than on riskier, unsecured loans. This will create winners and losers.

2. Where are we now?

So far, most countries have picked a rate to use as a starting point for a Libor successor. In the U.S., a committee of Wall Street banks and regulators decided to base a new rate on the cost of overnight loans, called repurchase agreements, or repos, that use U.S. government debt as collateral. It’s called the Secured Overnight Financing Rate, or SOFR. The Swiss have plumped for Saron, as the Swiss Average Rate Overnight is known, which is also pegged to repo rates. The U.K. has chosen a different method, the updated Sterling Overnight Index Average, or Sonia, which reflects bank and building societies’ unsecured overnight funding rates. And in Japan, it’s the unsecured Tokyo Overnight Average, or TONA, administered by the Bank of Japan and based on money-market rates. The European Central Bank has decided it will develop, before 2020, an unsecured overnight rate, but one that will be based on transaction data already available to member central banks.

3. So there will be many new rates instead of one? 

Yes, even though there were already many Libor rates. ICE Benchmark Administration Ltd., the part of the Intercontinental Exchange that has administered the benchmarks since 2014, publishes daily rates in five currencies and seven maturities. The new benchmarks, all based on overnight rates, will be more official, administered -- at least for now -- by central banks with one exception: Saron, the Libor successor for contracts in Swiss francs, will be administered by Switzerland’s SIX Swiss Exchange.

4. Who cares?

Lots of people do. They include asset managers like pension funds and mutual funds, insurance companies, lenders big and small and Wall Street banks that package loans into securities. Equipment leases, commercial paper, sovereign bonds, student and auto loans, bank deposits and mortgages are among the $370 trillion of financial products that the International Swaps and Derivatives Association says are tied to Libor. But the biggest use is for derivatives like interest-rate swaps, which companies, banks and investors use to hedge risk or to speculate.

The Long Hunt for an Incorruptible Successor to Libor: QuickTake

5. How did Libor become so popular?

It grew out of the euro-currency markets, where from the mid-1960s banks in Europe lent each other cash -- mainly dollars -- that depositors had stashed offshore, sometimes to avoid taxes. The London-based BBA formalized the gauge in 1986 when it needed a way to price syndicated loans, which are spread over groups of banks, and interest-rate swaps. Libor therefore developed as an unsecured, risk-free rate plus a little added on for the chance the borrowing bank would default before the loan matured. It offered a handy benchmark for a host of deals in other markets when they developed.

6. Why not just stick with Libor?

Last year, Andrew Bailey, the head of the U.K. Financial Conduct Authority, the regulator for British financial companies and markets, said that from 2021 the agency no longer intended to oblige banks to provide quotes for the various Libor rates. Lenders are leery of the cost and legal risk they are taking on by supplying estimates, while regulators worry about the benchmark’s vulnerability to manipulation. The interbank lending on which Libor is based has also shrunk, which means fewer transactions on which to base the rate and therefore greater risk.

7. Does this mean the end of Libor?

Not completely. ICE says it will continue publishing them, with banks submitting estimates on a voluntary basis. While this would be helpful for Libor-linked contracts that haven’t been shifted to a new index, it shouldn’t be relied on, Bailey said. Some banks already would have quit submitting estimates had his office not persuaded them to continue, he said.

8. What happens to existing contracts using Libor?

This is the $370 trillion question. Contracts will need to be amended and the ease of doing that depends on the market involved, according to Deepak Sitlani, derivatives partner at London law firm Linklaters. He points out that derivatives contracts can be amended by the use of a protocol, a process which is easier and quicker than convening bondholder meetings to amend the documentation of individual bonds. In his speech, Bailey held out the hope that it might be possible to create a synthetic, or derivative-based, Libor proxy to tackle the problem. He didn’t specify how that would work, saying only that it would probably be a risk-free rate with a credit spread added on to reflect bank risk. The FCA is “encouraging this issue to be assessed as soon as possible,” he said.

The Reference Shelf

  • Bloomberg QuickTake explainers on past manipulation, collusion and other issues with benchmarks, how the U.S. plans to replace Libor and how U.K. regulators view it.
  • The rise and fall of Libor.
  • A financial industry report on its roadmap for replacing interbank offered rates.
  • The Alternative Reference Rate Committee’s June 2017 background materials.
  • A Bloomberg story detailing the unfolding of the Libor scandal.

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net.

To contact the editors responsible for this story: Neil Callanan at ncallanan@bloomberg.net, Paula Dwyer, Patrick Henry

©2018 Bloomberg L.P.