The discontinuation of Libor promises to be one of the most significant changes to financial markets in decades.
With just three years to go until the regulator stops supporting Libor’s publication, in this week’s bulletin we take a look at what we know so far about its replacement.
When will Libor be discontinued?
The Financial Conduct Authority intends to stop supporting the publication of Libor from the end of 2021. Due to its association with misconduct and scandal, many of the banks currently contributing to the benchmark’s calculation are doing so reluctantly and only at the request of the regulator. As a result, it is highly likely that Libor will quickly fall away altogether, or cease to be robust enough to use in contracts.
What will replace it?
The Working Group on Sterling Risk-Free Reference Rates – a group of major dealers active in the interest rate swaps market, set up by the Bank of England to manage the transition away from Libor – has selected Sonia as the preferred benchmark for future financial contracts and derivatives. Like Libor, Sonia is published on a daily basis and aims to measure the cost of funding in the wholesale lending market.
Sonia has a number of key advantages. First and most importantly, it is based on actual transactions rather than judgment-based submissions, making it much less prone to the kind of manipulation scandal that damaged Libor’s reputation. Moreover, the market it is based on is highly active, whereas the one that Libor aims to measure all but dried up in the wake of the financial crisis.. Being an overnight rate, Sonia also excludes the implicit premium in Libor representing the banking sector’s credit risk – and is therefore much closer to a true “risk-free” rate of interest. This makes it much more appropriate as a reference rate for ordinary companies’ loans and derivatives than one that is in fact a measure of banks’ funding costs.
What problems might borrowers face in the transition to Sonia?
There is little doubt that Sonia is a more robust and suitable benchmark than Libor, but this does not mean that the transition will be easy. The most obvious problem is the vast number of outstanding loans and derivative contracts that still reference Libor and will remain in force after 2021. Most of these contracts will contain ‘fall-back’ language providing for the event that Libor is not published. However, such clauses have largely been written envisaging a temporary lack of availability, rather than a full-scale replacement.
Both ISDA and the LMA (the industry bodies for derivatives and loan markets respectively) are collaborating closely with the Bank of England’s Working Group to ease the transition. Most likely, this will involve the associations drafting standard amendments that all counterparties can agree to in the event that Libor is permanently discontinued. Nevertheless, a number of important issues remain. As well as being a strength, the fact that Sonia measures overnight funding rates is also a weakness. Overnight funding may be commonplace in the wholesale markets that the new benchmark measures, but for ordinary businesses, it is not. Companies will need a way to pay a floating rate of interest that refers to much longer borrowing periods (typically three or six months), and to be notified of what this floating rate will be with sufficient time to manage the associated cash flows. Moreover, if firms are to continue to be able to hedge their interest rate risk using derivatives, they will need the interest rate derivatives market to develop in exactly the same way as the loans market. At present, it is far from clear how either problem will be solved.
The group treasurer of Deutsche Bank recently described the discontinuation of Libor as ‘bigger than Brexit’ for the financial sector – and given its prevalence in portfolios and financial models throughout the industry, his assessment is probably not too far off the mark. For non-financial companies, the burden of the transition will be much lighter. But for any firm that borrows or hedges based on the benchmark, it is an issue that cannot be ignored for long. Watch this space.
For more information, please contact Joshua Roberts, Associate at JCRA, at Joshua.firstname.lastname@example.org.