UK regulators have given the industry a sharp reminder that they are not doing enough to transition from Libor to alternative rates, giving the whole project a new sense of urgency.
What is happening?
The move by the UK regulators to transition away from the sterling London Interbank Offered Rate (Libor) was aimed at the sterling cash market because they felt industry was not showing enough urgency in its transition preparations. Typically involving products such as syndicated bank loans, this sector has lagged derivatives and to an extent even fixed income.
The regulators’ principal aim is to see an end to the issuance of cash products linked to the sterling Libor by the third quarter of 2020, and that the Libor alternative, the Sterling Overnight Index Average (Sonia), should be easily accessible and usable.
The regulators also want more activity shifted to Sonia in the derivatives markets and for a transition framework to be established for legacy Libor products. They also want the current stock of Libor-referencing contracts to be reduced substantially by the first quarter of 2021.
Many industry sources believe that some firms are indeed struggling to keep up with the sheer volume of work needing to be done, among even the largest banks.
Why is it happening?
The big hurry is because after 2021, the UK’s Financial Conduct Authority says it will no longer compel panel banks to carry on compiling Libor for sterling and other currencies. This could result in banks dropping out of Libor panels, meaning that the benchmark becomes less reliable and usable as a reference rate.
As if to ram the message home, the Bank of England has threatened to use supervisory measures – potentially capital charges – against companies that are found to be seriously behind in transitioning. As for the cessation of sterling Libor post-2021, the central bank has warned: “No firm should plan otherwise.”
What do the bankers say?
Privately, many bankers believe switching to a different reference rate is overkill. Some argue that making the methodology for compiling Libor more robust would have been sufficient.
This is because moving entire markets onto a new benchmark is proving to be extremely resource-intensive, given that Libor is deeply embedded in the financial system.
Another problem is that, whereas Libor is a forward-looking term rate, Sonia is a backward-looking overnight compounding rate. This difference has not proved a major stumbling block for derivatives and much of the fixed-income complex, but it has caused problems for the cash market.
Corporate treasurers, for example, like the fact that with Libor they can fix the interest rate on loans for three months knowing exactly how much interest they will pay in advance. With Sonia, they have to wait until three months is up to know how much interest they will pay, which creates uncertainty and requires more monitoring. Also, it transpires that Libor and Sonia, which is a risk-free rate, can behave in differently ways.
No doubt banks will find ways to give treasurers the certainty they crave – but probably at a cost.
Also, much of the sterling bond issuance has continued on Libor, with many Sonia bonds initially being swapped straight back into Libor. Efforts are being made to change this, but the Sonia bond market remains underdeveloped, as do Sonia derivatives. Some banks are still doing Sonia bonds manually rather than through automated systems.
Will it provide the incentives?
Given the way it is compiled, Sonia should prove more robust than Libor and has been around since 1997.
However, the situation for US dollars is more challenging, and not just because it is such a huge global market. The US authorities are attempting to shift dollar Libor onto the Secured Overnight Financing Rate (SOFR), a process which is causing its own unique challenges.
Last year’s spikes in the repo market, which feeds into SOFR, have caused concern over the new benchmark’s design. Also, US regional banks do not believe SOFR properly reflects their funding costs and prefer the American Interbank Offered Rate.
Given all these factors, the US is some way behind the UK in its transition arrangements, yet industry sources do not believe a strongly worded statement similar to that issued by UK regulators regarding cash markets is imminent.
Indeed, US regulators are still asking the industry about its preparations and trying to gauge how to progress transition arrangements.
Once the transition is complete, whenever that might be, many in the industry are likely to ponder whether it was all worthwhile.
