Replacing LIBOR

After completing this reading, you should be able to:

• Explain the key issues that could cause systemic disruption when LIBOR ends.
• Explain the current state of the transition and the challenges that lie ahead.
• Describe the government institutions’ role in the transition.

The London Interbank Offered Rate (LIBOR) is the benchmark (reference) interest rate for millions of contracts worth about USD 400 trillion. That includes bonds, derivatives, securitizations, residential mortgages, and more. LIBOR comes in five different currencies, and its maturity ranges from overnight to twelve months.

Although it has been referred to as the “world’s most important reference rate,” LIBOR has had its own fair share of opposition. To determine LIBOR, a panel of banks submits their estimates to the Intercontinental Exchange, and then the final rate is worked out using a standardized transactions-based methodology. One of the major concerns has much to do with the fact that in these circumstances, LIBOR is sometimes subject to manipulation.  If there’s insufficient transaction data, financial institutions make their LIBOR submissions based purely on expert judgement. This means that there’s an opportunity for banks to manipulate the benchmark. In fact, some panel banks have been reluctant to submit data when they don’t have sufficient transaction data to validate their judgment.

As a result of these concerns, plans are underway to replace LIBOR with a new reference rate.

Risks When LIBOR Ends

We consider the systematic risk caused by the cessation of LIBOR. There are two key issues of concern:

(I) Contracts for which LIBOR is the reference interest rate

When LIBOR finally ends, the so-called legacy contracts (those established and running on the basis of LIBOR) that do not have an alternative arrangement may suddenly fall in value. In particular, large intermediaries with large amounts of legacy contracts may suffer huge losses. Their capital levels may be seriously compromised.  If this

What’s the current situation?

A 2016 report by the Alternative Reference Rates Committee (ARRC) revealed that there were about $38 trillion outstanding contracts expected to extend beyond 2021. Out of this amount, contracts worth about $15 trillion are expected to last beyond 2025. The report goes ahead to break down the contribution of each sub-market as follows:

$$ textbf{Table 1: US dollar LIBOR-linked contracts, end-2016 (trillion of US dollars, notional value)}

$$\small{\begin{array}{l|r|r|r}{}& \textbf{Volume} & \textbf{Extend after 2021} & \textbf{Extend after 2025}\\ \hline\text{OTC Derivatives} & 145 & 33.9 & 14.8\\ \hline\text{Exchange-traded Derivatives} & 45 & 0.5 & 0.0\\ \hline\text{Business and Consumer} & 4.7 & 2.7 & 0.3\\ \hline\text{Bonds (FRN/VRNs)} & 1.8 & 0.3 & 0.1\\ \hline\text{Securitizations} & 1.8 & 0.9 & 0.4\\ \hline\text{Total} & 199 & 38.3 & 15.6\\ \end{array}}$$

Notes: OTC = over the counter; FRN = floating-rate note; VRN = variable-rate note. Source: Based on Table 1 in ARRC (2018).

(II) Adequate substitute source of funding for intermediaries

It’s also worth considering what the end of LIBOR will spell for the lending market. There may not be enough in terms of replacements (substitutes). In particular, there’s a risk of banks and other financial intermediaries being unable to raise funds for their own operations. This is important because for an intermediary to fund consumers by disbursing loans, they themselves have to be funded adequately. If intermediaries cannot fund themselves, this could ultimately result in a decrease in the availability of credit for consumers at the lower end of the funding spectrum.

Challenges that Lie Ahead

A lack of a central repository for fallback language

In the world of financial contracts, fallback language refers to a set of provisions that should guide the process of identifying a replacement for the benchmark rate if the existing one is not available. Fallback language goes further to specify the events that could trigger such a transition and the spread adjustment that would be needed in order to align the replacement rate with the benchmark that’s on its way out.

In this regard, there are concerns that most contracts right now do not have a fallback language. In its absence, there’s likely to be a lot of confusion regarding the true value of assets, especially long-term assets such as bonds. Players on both ends of the trade (buyers and sellers) could disagree and seek legal intervention. This could create a flood of long, messy lawsuits that might serve to further destabilize markets.

Luckily, the International Swaps and Dealers Association (ISDA) has taken up the initiative and is currently working on the modalities of a fallback language that could be voluntarily adopted by both dealers and customers.

In addition, the Alternative Rates Reference Committee has also been developing a fallback language for bond contracts, securitizations, and floating-rate notes. Unfortunately, the whole process has not gained much momentum, and it’s hard to tell just how fast firms are moving to renegotiate legacy contracts.

We do not have a satisfactory replacement as of yet

A lot goes into developing a replacement for a benchmark rate. There are many aspects to consider, including market depth, liquidity, and security. Although the process to identify a replacement has been ongoing, it could take years before the final decision is made. In order to come up with a good enough replacement, the private sector has to work closely with the public sector to iron out key parameters.

The Role of SOFR

The secured overnight financing rate (SOFR) ticks most boxes as a benchmark rate. In particular, it edges LIBOR in terms of market depth and liquidity and is widely seen as the most likely replacement. SOFR transactions have been steadily increasing in recent years. As the graph below shows, the daily value of SOFR transactions routinely exceeds $1 trillion. In contrast, the daily value of dollar LIBOR transactions ranges between $2 billion and $3 billion.

$$ textbf{Figure1: Value SOFR transactions (2015-2019)}

However, market data strongly shows that a majority of participants still prefer LIBOR to SOFR. The sluggish start to life under SOFR can be attributed to certain reasons:

1. Having used LIBOR for over 30 years, most market participants are used to it and have over time developed an excellent understanding of its dynamics. For this reason, most of them are hesitant to let it go.
2. Moving to a new benchmark rate is expensive. There will be contracts to rewrite and new risk assessment software to develop. Additionally, costs will be incurred training investors, regulators, as well as clients.
3. LIBOR holds a competitive edge over SOFR in that it incorporates a bank credit risk premium. This implies that assets priced under LIBOR have a natural hedge for bank funding risk. What’s more, dollar LIBOR is still more calibrated and more granular than SOFR. To put that in context, LIBOR comes in 7 maturities (overnight, 1 week and 1, 2, 3, 6, and 12 months) but only the overnight rate for SOFR.

Fortunately, regulators in the U.S. and elsewhere are aware of all the risks that will come with the transition process. They have begun pushing LIBOR users to prepare for life without LIBOR.

The Government’s Role in the Transition

The government has a key role to play in the transition from LIBOR to a new benchmark rate. Let’s look at four important roles for government officials:

Setting a hard deadline

A hard end date for LIBOR will speed up the transition process because it will force financial institutions and investors to set in motion plans to ensure that their legacy contracts do not face turbulence when that day finally comes. In the same vein, the government should intensify warnings about continuous reliance on LIBOR.

Special focus on systematically important banks

The collapse of a systematically important bank can trigger a financial crisis. When LIBOR ends, LIBOR-linked assets will inevitably be rendered illiquid, a situation that could result in banks that do not have a fallback language being unable to fund their operations. For this reason, supervisors should ensure that SIBs lead the transition process. At the very least, these banks should make sure that their business partners, creditors, investors, as well as employees understand the risks that the institution faces due to continuous reliance on LIBOR. Supervisors must also ensure that SIBs update their risk management systems to facilitate the transition.

Frequent status updates

The government should regularly publish data showing the evolution of LIBOR-linked assets. As the LIBOR end date nears, we expect to see a decline in the volume of LIBOR-linked transactions. Regular status updates on the transition process will instill a sense of urgency among financial institutions. It will make it easier to identify the sectors and individual financial institutions that are leading in the transition as well as those lagging behind. It will then be easier for supervisors to follow up and know exactly where to focus their efforts.

Ideally, data on LIBOR-linked assets should be published every quarter.

Promoting public awareness

The effects of replacing LIBOR will be felt by everyone, including individual households and small and medium enterprises. For this reason, the government should launch a public awareness campaign to ensure that everyone is ready for the changes. The Consumer Financial Protection Bureau has a major role to play in this process.