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The Future(s) of Libor

28 July 2017 by Rob Ford

Back in the very early part of my career, I had the fortunate experience of spending a couple of years working as a futures and options trader on the London International Financial  Futures Exchange (LIFFE) in the days when trading still took place in open outcry trading “pits”. It gave me the amazing opportunity as a young trader to learn how to think and react on my feet (literally!), to read market flows and given the close proximity of all the different trading pits to see how different markets interact with each other.

When in the late 1980s, I moved on to set up a trading desk in a “new” market called RMBS – where I’ve subsequently spent the rest of my career – I thought that if it didn’t work out, I could always go back to LIFFE.  That option pretty much expired back in the year 2000, when the last of the open outcry pits was closed forever and the exchange moved to a fully electronic trading system, a totally different experience with none of the cut and thrust of open outcry trading; and then this week the final nail was put in the coffin.  I spent much of my time on LIFFE trading the Short Sterling contract – the futures contract based on Libor, the now infamous short-term interest rate benchmark – but this week the very future of Libor itself has been consigned to history as the UK regulator, the FCA, announced that Libor will be replaced with a new, as yet undetermined, benchmark rate by the end of 2021.

Much has been written about the Libor rigging scandals, and I won’t attempt to comment on any of that here, but the changes that were brought about as a result, have ultimately led to its demise.  The move to a more transaction-based submission process, rather than inputs based on a trader’s subjective opinion, has happened at a time when the volume of those very transactions has fallen off a cliff.  Libor is the London Inter-Bank Offered Rate – the rate at which banks will lend to each other, but with long-term record low interest rates, an abundance of QE and central bank funding mechanisms, significantly higher capital charges, the advent of the bail-in regime and banks with credit ratings that are multiple notches below where they were 10 years ago, banks have simply stopped borrowing from one another.

The lower credit rating point is also very important. The banks that contributed to the Libor index were generally considered to be the top players in the industry – almost bulletproof, and therefore almost credit-risk free, especially given the short term nature of the Libor periods.  But now, following those downgrades and regulatory changes, none of them can be considered to be risk-free.  What that means therefore, is that a much greater degree of credit-risk is now being priced into the Libor fixings; it’s become as much a measure of bank risk as it is an interest-rate benchmark, and therefore it’s probably right to come up with a new mechanism.

However, that is going to be a complex task – trillions of pounds worth of financial instruments and transactions are connected to Libor in one way or another; from millions of Floating Rate Note (FRN) bonds and loans, including much of the unsecured senior bank FRN market and virtually the entire ABS market, to untold numbers of interest rate swaps, and even billions of pounds of mortgages which have reversion rates linked to Libor.

That Short Sterling futures contract that I used to trade settles against Libor on pre-determined dates in the future – just the current contract has typically traded between 50,000 and 100,000 contracts a day this year and the whole series currently has open interest of about 2.85 million contracts, which at £500,000 per contract is almost £1.5 trillion of exposure! (Sources: Bloomberg, ICE). These contracts represent the first 3 years of the “forward Libor curve”, and it’s the present value of these forwards which effectively make up the swap rates we all reference on a daily basis in the bond markets.

It really is the cornerstone of all interest rate financial markets.

How the new benchmark will be created is yet to be decided – there are all kinds of ramifications to be taken into account, but it’s clear that it needs to be free from the bank credit implications and effectively become a “risk-free rate”.  There may be a place for a bank rate benchmark too, so that market players hedge their bank risk for example, but that is yet to be determined. The swaps market has already agreed to move to Sonia – the overnight rate – as its new risk-free rate, but how they will effect the changeover from Libor is still unknown. But if FRNs were to move to an overnight-rate index, but pay coupons quarterly as is typical, then they need a term rate (3 month Libor is the current standard) so how will this be achieved? Will a new basis have to be created between Sonia and the relevant term? The FCA have said they believe a transaction based index is their preferred choice and those huge volumes in the futures market prove that there are plenty of transactions, just not directly between the banks.

In the US, they are moving to a secured rate in the form of a broad Treasuries repo rate for their new benchmark, but there are currently no plans for that here.  In Europe, there have been no decisions over Euribor although the number of banks contributing to that reference rate has dwindled significantly over the last few years, which is a concern.

The transition will be long and drawn out.  2021 is just 4 years away but swaps, bonds, mortgages et al, all have exposure years and years after that – somehow their language will have to be replaced or amended by mechanisms as yet unknown. Once again the market is faced with renewed regulatory uncertainty. Probably the only certainty is that the lawyers will be even busier for the next few years!

In the short term there is unlikely to be any significant market reaction, and there’s every hope that a mostly smooth transition can be effected. However, it could be a ticking time-bomb, a bit like the Y2K millennium bug lead-up to the turn of the century, with no clarity to the long term implications but which eventually, for the most part, was uneventful. Let’s hope that the future Libor (it almost certainly won’t be called that) can ultimately have a similarly uneventful introduction and transition.

Whatever happens, there shouldn’t be any significant cause for concern for investors in Libor-linked floating-rate products. Whatever new benchmark is eventually developed, the returns and risk profiles for investors are not likely to be dissimilar to today – if anything the removal of the bank credit component will smooth the index even further.

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