The financial world’s ‘most important number’ refuses to die

It’s proving more difficult to kill off the world’s most important number than the technocrats once thought.

The London Interbank Offered Rate, or LIBOR, has been the world’s key reference rate for financial transactions since the 1960s. It underpins trillions of dollars – an estimated $US400 trillion ($A516 trillion) of loans and derivative transactions globally.

The London Interbank Offered Rate refuses to die. Credit:Photo: Bloomberg

LIBOR creates reference rates for short term unsecured loans that are used to price the yields for almost all floating rate financial products – corporate debt, securitised mortgages, derivatives – and has a range of maturities, from overnight to 12 months.

Unfortunately, the way the rate has been calculated in the past – a daily survey of a relatively small number of large banks of their estimated borrowing costs – made it vulnerable to manipulation.

Not surprisingly, given what we know of the way some banks and their traders have behaved in pursuit of profit, it was manipulated.

In 2012 traders were sent to jail, a number of the banks involved paid fines totalling about US10 billion ($A13 billion) and the UK’s Financial Conduct Authority announced, in 2017, that LIBOR would be phased out by the end of this year.

That’s proved to be easier said than done. LIBOR is embedded in a myriad of loan and derivatives contracts, some which expire beyond this year and some – perpetual notes and bonds and some hybrid securities, for instance – that never expire.

The plan was, and is, to migrate existing LIBOR-embedded contracts and any new contracts to new reference rates. In the UK that is the “Sterling Overnight Interest Rate” (SONIA) and in the US the “Secured Overnight Financing Rate (SOFR). The dominance of the US dollar should make SOFR the key global benchmark rate.

Apart from the mundane difficulties of trying to rewrite existing contractual obligations, which means poring over every financial contract and then renegotiating the terms, there is another rather more complicated problem.

SOFR and the other planned LIBOR substitutes aren’t LIBOR.

LIBOR is unsecured but SOFR is secured. LIBOR comes with a range of tenors, or maturities. SOFR is an overnight rate based on the US overnight “repo” market, a market that has experienced bursts of extreme volatility in recent years.

The range of maturities LIBOR provides creates term premia (the premiums for being exposed to the risks of lending for longer periods). As an overnight rate SOFR doesn’t provide pricing for term risk.

It isn’t, therefore, as simple as changing a rate from LIBOR plus a spread, or margin, to SOFR with a spread. The potential for one side of a renegotiation of a contract to replace LIBOR with SONIA or SOFR to lose, perhaps heavily, is significant.

In the UK and Europe the 31 December deadline for the end of LIBOR this year remains intact. The UK authorities have said that almost all sterling-denominated derivative contracts now either contain “fall-back” clauses to allow pricing to be switched to SONIA or have been written based on SONIA. Indeed, most global derivative contracts have been rewritten to phase out LIBOR.

Monday of this week LIBOR’s administrators ended any consultation over the end of LIBOR and restated that the sterling, yen, Swiss franc and euro settings would end on 31 December. A new fall-back protocol for contracts entered into before Monday also came into force.

There were, however, five key exceptions – five US dollar LIBOR settings, where LIBOR will continue to be used for legacy transactions until June 2023, albeit not for new transactions.

It has, apparently, proven far more difficult for the US dollar-denominated LIBOR contracts to be renegotiated, with the lack of a term rate in SOFR cited as a significant factor.

Market participants want a benchmark that reflects expected movements in interest rates over time. LIBOR, even as it was being rigged to create profit, provided that.

The extra time given to displace LIBOR with SOFR in existing contracts has already caused some turmoil. Hedge funds had laid bets on a transition being completed this year and reportedly lost hundreds of millions of dollars, if not billions, when, late last year, the demise of US dollar LIBOR was deferred to 2023.

That underscores how delicate the transition is. The data on US interest rate swap trades – swapping a stream of fixed interest for a floating rate tied to LIBOR or the mirror trade – suggests a majority of outstanding US dollar derivative transactions using US dollar-denominated LIBOR rates expire after June 2023.

Participants in those trades now have more time to renegotiate the terms but the hurdles for renegotiation remain.

The absence, so far, of a term premium for SOFR and weak acceptance of SOFR as a LIBOR substitute for US dollar-denominated contracts means there isn’t much liquidity for SOFR derivatives, which can create inefficient pricing and a deterrent to trading.

With the Federal Reserve Board directing banks and other institutions to stop writing new LIBOR-based contracts by the end of this year, and work continuing on the development of a forward-looking reference rate for SOFR that would help create term premia, the market for SOFR-reference transactions might deepen.

If it doesn’t an already more complex environment as the world transitions unevenly away from LIBOR will become more complex, and risky.

Uncertainty generates risk and the question mark over the adoption of SOFR is generating uncertainty about the development of a lending market with the liquidity and depth of the LIBOR-based market it is supposed to displace.

That poses risks to the participants and, more broadly, financial stability and in turns explains why the regulators and market participants are moving so cautiously.

Market participants want a benchmark that reflects movements and expected movements in interest rates over time. LIBOR, even as it was being rigged to create profit for some banks and their traders, provided that.

Replacing such an ubiquitous benchmark that’s been the world’s key reference point for borrowing costs and interest rate swaps for more than half a century with new and unproven alternatives was, given the size of the sums involved, never going to be straightforward or without risk. The experience of the creeping transition away from LIBOR is confirming that.

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