The authorities are determined to wean the financial system off using interbank offered rates. The problem is that the transition is happening painfully slowly and industry may not be ready in time. By Justin Pugsley.
What is happening?
At a recent conference, a senior UK regulator warned bankers not to run their businesses on the basis that the London Interbank Offered Rate (Libor) might somehow continue beyond 2021, and that they must focus on making alternative (nearly) risk-free reference rates (RFR) work.
After 2021 the UK’s Financial Conduct Authority will no longer compel banks to support London's interbank offered rates (Ibors), meaning they could just cease to exist. This would be a huge problem for legacy financial contracts, involving everything from floating rate mortgages through to swaps.
Regulators have sounded stern warnings about this for some time and banks operating in London have to show they have plans to transition towards a post-Ibor world.
The fallback options if Ibors are no longer available usually involves getting a quote from the relevant bank or banks. However, as the International Swaps & Derivatives Association (Isda) recently found – reflecting the results of a July consultation – is that if Ibors are discontinued, major dealers are unlikely to quote rates as stipulated in fallback arrangements in Isda contracts. And where they are available, there is likely to be considerable variation between banks.
Unless compelled by the regulator, banks may become reluctant to contribute to Ibors or quote interest rates as fallbacks for fear of falling foul of increasingly tough rules on financial benchmarks and conduct.
The regulatory focus has been on pricing being based on actual verifiable transactions rather than dealer opinions and this is the case with the RFRs. Most of the major currencies either have functioning RFRs or are working towards them. The most advanced are the Sterling Overnight Index Average (Sonia) in the UK and the Secured Overnight Financing Rate (SOFR) in the US. But these are overnight rates, while most loans and related derivatives are priced off term rates with one-month, three-month and six-month tenors being widely used, for example.
The industry is now trying to replicate the Ibor term structures around the RFRs, such as by compounding overnight rates on a daily basis or creating a forward-looking term rate.
A key issue with devising a forward-looking term rate is to make it based on real transactions rather than dealer opinions. The problem is for many of the dates in the Ibor term structure, days can pass with no actual transactions, and at this stage there is no strong reason to believe that the situation would be much different with RFRs. Regulators are quite uncomfortable about that for critical reference rates.
Why is it happening?
Ibors have been targeted for termination, or at least marginalisation, by regulators because of the scandals that emerged following the global financial crisis involving dealers manipulating them to boost their personal earnings.
This has led to global efforts to improve methodologies with the International Organisation of Securities Commissions (Iosco) devising guidelines on best practice and the G20-mandated Financial Stability Board pushing for global reforms to make interest rate benchmarks more robust and trustworthy.
To be fair, Ibors are now compiled much more robustly than previously and closely follow Iosco guidelines. But for most regulators that is not enough, though a few are still prepared to tolerate a multi-rate approach in their jurisdictions.
What do bankers say?
Bankers recognised that something had to change. Trillions of dollars of financial contracts cannot rely on benchmarks whose pricing is in the hands of a small cabal of dealers who can manipulate them at will. Considerable efforts are being made to promote the use of RFRs. Isda contracts are to reference RFRs as fallbacks in the event that Ibors cease. About a dozen bond deals have been priced off Sonia and some off SOFR so far – so there is still much work to do.
Will it provide the incentives?
The Ibors are proving remarkably resilient, however, with even more transactions priced off them now than were several years ago. Some in the industry do not think Ibors will be displaced even after 2021, and that banks will simply have to carry on supporting them because so much of their business relies on them.
Another possibility is that the RFRs gain a significant foothold, but that the Ibors cling on – creating a fragmented two-tier market for pricing money and meaning they undermine each other by splitting liquidity.
It is hard to tell if regulators will manage to sunset the Ibors – but if they do not it will not be for want of trying. But the industry should head those warnings. Some certainly are, but plenty are not, and work is needed to create viable RFR term pricing and to make sure it is used.
