Over the next two years, the transition to a post-London Interbank Offered Rate (LIBOR) world will be a fast-paced and challenging journey. LIBOR rates are deeply entrenched in the global financial services industry and serve as a basis for pricing hundreds of trillions of dollars of derivatives, structured products, mortgages, and commercial loans. Although large financial institutions have become adept since the post-crisis era at addressing complex regulatory changes, the migration to alternative risk-free rates (RFR) presents a particular set of new challenges. By the end of 2021, most central banks and regulators around the world will no longer treat LIBOR rates as official benchmarks although use of LIBOR rates beyond that timeframe will not be explicitly prohibited. However, given the long-term uncertainty surrounding LIBOR rates, banking institutions globally are preparing themselves for a new RFR-based future.

LIBOR transition is progressing at different rates across the various jurisdictions. In the United States, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) has published a ‘paced transition plan’ to guide the adoption of the Secured Overnight Financing Rate (SOFR), which represents the US RFR variant. Much of the progress will depend on the development of a robust and liquid market for SOFR products, related client demand, and the strategy and approach pursued by individual banking institutions. In the near term, banks should focus on analyzing their exposure to LIBOR-based transactions and assess the downstream implications for their risk, finance, legal, operations and IT functions.

Background

LIBOR represents the average interest rate that major banking institutions charge each other to borrow and lend funds. LIBOR is a widely used benchmark that serves as the reference rate for trillions of dollars of lending agreements, swaps and other derivatives agreements and has been commonly used since the late 1960s. Currently, LIBOR rates are set daily based on the information provided by major London-based financial institutions, available for five currencies (i.e. USD, GBP, EUR, CHF, JPY) across seven maturity dates. Starting in 2012, LIBOR rates began to be calculated by the ICE Benchmark Administration (IBA) based on rates provided by a consortium of banks that are members of the ICE LIBOR panel.

LIBOR Timeline

The collection and publication process for LIBOR rates was formalized in 1986 and did not change significantly until the 2008-2011 financial crisis. During the crisis, several panel members were found to have intentionally manipulated LIBOR submissions to publish lower rates than prevailed during stressed market conditions. Subsequent investigations uncovered that LIBOR rates had been subject to manipulation in both directions for many years prior, depending on market trends and positioning of panel members who had a direct financial stake in the final published rates.

The discovery of widespread market manipulation resulted in multiple regulatory studies and prompted the US Department of Justice and congressional panels to launch investigations. During high-profile hearings in 2012, key US lawmakers vouched to “hold accountable bankers and regulators who failed to ‘stop wrongdoing that they knew, or should have known, about.’”[1] Many financial institutions were penalized and sanctioned by US and European regulators and law enforcement agencies in subsequent years. Law enforcement actions related to LIBOR manipulations culminated in 2015 when several UK traders received multi-year jail sentences for their participation in the schemes.

What Changed?

In the immediate aftermath of the financial crisis, LIBOR manipulation concerns were on top of the regulatory agenda. The Wheatley Review, published in 2012 and authored by the namesake first chairman of the UK Financial Conduct Authority (FCA), argued that stronger controls around the LIBOR rate setting process would address the most pressing manipulation issues. This proved to be true, given that intentional and coordinated manipulations of LIBOR mostly stopped following the transition to the IBA-administrated benchmark setting process in 2012. Regardless, LIBOR rates are approaching the end of their useful life. So, what has changed?

Stricter capital requirements have prompted banks to enhance their capital bases and seek longer term, less volatile funding sources. As a result, reliance on unsecured interbank loans has dropped significantly and it is often not possible to set LIBOR rates based on empirical market transactions. This is especially true for the least liquid of the five LIBOR currencies (e.g. CHF, JPY) and for tenors exceeding three months. As a result, the setting of LIBOR rates is often based on judgment of submitters, rather than current market rates. In addition, LIBOR rates capture the counterparty credit risk of the borrowing banks. Prior to Lehman’s failure in 2008, credit spreads for banks were relatively small and fairly uniform across market participants. Regulators are now concerned that by tying rates for large derivatives as well as both corporate and retail lending to a shrinking and illiquid market for interbank loans will ultimately exacerbate market volatility and cause funding difficulties during periods of economic stress which is clearly not a desirable outcome.

In 2017, Andrew Bailey, chairman of the FCA, announced that the UK banking authorities would no longer support LIBOR as an official benchmark rate post 2021. Prior to the FCA’s announcement, the U.S. Federal Reserve Bank had formed ARRC to explore alternatives to the US LIBOR rate. SOFR has been published daily since April of 2018 and a SOFR futures contract is actively trading on the Chicago Mercantile Exchange (CME). Similar initiatives to progress the transition to RFRs are currently underway in all impacted jurisdictions.

Replacement Rates Around the World

Regulators in all LIBOR jurisdictions have developed RFR replacements for their respective LIBOR rates. All of the RFRs reflect overnight funding transactions, but they are customized to reflect the idiosyncrasies of the funding and credit markets in the respective geographies.

The RFRs differ significantly from existing LIBOR rates given they are reflective of short-term borrowing transactions. Calibrating the RFRs to LIBOR will represent a significant challenge that banks need to address during the transition to a LIBOR-free future. Although the ARRC is actively seeking to create a liquid market with a forward-looking term structure, this currently remains a challenge.

The following exhibits are based on ISDA data reflecting LIBOR and RFR transactions reported to swap data repositories and do not include exchange traded futures. As of October 2019, the global market share for RFR products amounted to 5% of overall trading volumes. The RFR market share varies widely across the different LIBOR legacy currencies. While SONIA accounts for over 40% of current trading volume for GBP denominated instruments, that market share for US RFR products is currently below 1%. Globally, the market share for RFR products has increased from around 3% at the beginning of 2019 to over 5% at the beginning of Q4 2019. This trend will have to significantly accelerate in coming quarters to meet the 2021 deadline for LIBOR replacement in the US.

Just how big is the issue?

LIBOR rates impact an estimated $350 trillion of global underlying assets with US LIBOR accounting for over $200 trillion of that total. The following major asset classes are currently dependent on LIBOR rates and will need to transition to a successor rate in the near future:

Interest rate, foreign exchange and commodity derivatives
Lending products:
- Corporate loans
- Consumer loans
- Mortgages
Securities:
- Corporate and public sector bonds
- Asset-backed securities
- CDO/CLOs and other structured securities

It will be important that the cash and derivatives markets adopt RFRs in a synchronized fashion to avoid basis risks. This could occur if a bond investment and a related derivatives hedge are priced off different benchmark rates during the transition period. ARRC, market infrastructures (e.g. central counterparties) and the International Swaps and Derivatives Association (ISDA) are developing approaches for fallback language and amendments to standardize swap contracts to assist in the transition to RFRs. Banks should carefully monitor these developments and ensure that the key implications are reflected into their transition plans.

Why Monticello?

Monticello consultants have extensive experience in the implementation of large-scale regulatory initiatives. Our firm understands the importance of diligent analysis, careful program management, and collaboration across teams within major financial institutions and across the industry. Our current work on LIBOR Transition, Uncleared Margin Rules (UMR), Qualified Financial Contract (QFC) Record Keeping and US Stay regulations demonstrates the important regulatory expertise our consultants bring to our clients. Our teams possess deep knowledge of capital markets instruments, legal agreements and operational processes, as well as the related data and information systems impacts that will be in focus for the migration to RFRs. Monticello teams are dynamic, flexible, and highly motivated to assist you in your transition to a post-LIBOR future.

[1]https://www.washingtonpost.com/business/economy/geithner-drawn-into-libor-scandal/2012/07/12/gJQArDhbgW_story.html)