Consider the following scenario. Enough banks stop making LIBOR submissions to mean publication of LIBOR is no longer viable. An announcement is made that LIBOR cannot be published. Firms scramble to mobilise enough lawyers to sift through each of their thousands of derivatives, loan, bond and mortgage contracts to work out what rate should be used instead. The contractual language either isn’t clear, or requires the calculation agent for each trade to call dealers to provide an estimate – not realistic over the long term, even supposing dealers are willing to do it. The result: trillions of dollars worth of contracts referenced to LIBOR effectively grind to a halt.
This isn’t entirely farfetched. The unsecured bank funding market – the basis for LIBOR and other interbank offered rates (IBORs) – has all but dried up. Actual transactions are few are far between, and panel banks are uncomfortable about providing submissions based on judgement. The lack of an active underlying market has led to real doubts about whether the IBORs are sustainable in the long term.
Concern about the systemic implications of an IBOR ceasing to exist has prompted a global effort to reform interest rate benchmarks. This has been catalysed by a declaration from the UK Financial Conduct Authority that it will not compel or persuade banks to make LIBOR submissions after the end of 2021.
A key strand of this work is adoption of alternative risk-free rates recommended by various public-/private-sector working groups. The other critical component is to implement fallback language within contracts that reference an IBOR to ensure a robust alternative is clearly specified in the event an IBOR ceases to be published.
Significant progress has been made so far – in the US, for instance, the industry and official sector are working through a paced transition plan for adoption of the Secured Overnight Financing Rate. But it’s crucial that all parts of the market engage with the process and start preparing. That means establishing a formal IBOR transition programme, allocating budget and staff, and quantifying exposure to the IBORs and the anticipated roll off. The scale of the task means this is not something that can be left to the last moment.
This issue of IQfocuses on benchmark reform. The full issue is available by clicking on the PDF link below.