In an unexpected announcement, earlier this week the U.K.’s top regulator, the Financial Conduct Authority which is tasked with overseeing Libor, announced that the world’s most important, and manipulated, benchmark rate will be phased out by 2021, catching countless FX, credit, derivative, and other traders by surprise because while much attention had been given to possible LIBOR alternatives across the globe (in a time when the credibility of the Libor was non-existent) this was the first time an end date had been suggested for the global benchmark, which as we explained on Thursday, had died from disuse over the past 5 years.
Commenting on the decision, NatWest Markets’ Blake Gwinn told Bloomberg that the decision was largely inevitable: “There had never been an answer as to how you get market participants to adopt a new benchmark. It was clear at some point authorities were going to force them. The FCA can compel people to participate in Libor. What can ICE do if they’ve lost the ability to get banks to submit Libor rates?”
And while the rationale for replacing Libor is well understood (for those unfamiliar, read David Enrich’s comprehensive account of Libor rigging “The Spider Network“), there are still no clear alternatives. Ultimately, as Bank of America calculates, “moving an existing $9.6 trillion retail mortgage market, $3.5 trillion commercial real estate market, $3.4 trillion loan market and a $350 trillion derivatives market is a herculean task.” A partial breakdown of the roughly $400 trillion in global Libor-referencing assets is shown in the table below.
And with nearly half a quadrillion dollar in securities referncing a benchmark that is set to expire in under 5 years, the biggest problem is one of continuity: as Bloomberg calculated last week, in addition to the hundreds of trillion in referencing securities, there is also currently an open interest of 170,000 eurodollar futures contracts expiring in 2022 and beyond – contracts that settle into a benchmark that will no longer exist. “What are existing contract holders and market makers supposed to do?”
Then there is the question of succession: with over $300 trillion in derivative trades, and countless billions in floating debt contracts, referening Libor, the pressing question is what will replace it, and how will the transition be implemented seamlessly?
According to Bank of America, one possible option to achieve the transition could be to move to a “fixed-spread” Libor benchmark. In this scenario, regulators and market participants could agree for Libor to be hardcoded as a fixed spread over the underlying benchmark of their choice (BTFR-broad Treasury financing rate in the US, SONIA in UK etc). This could help to ensure that contracts that rely on Libor could continue to have a reference rate while the rate itself would move based on the regulator’s preferred benchmark.
The option obviously would raise some concerns around what spread to be chosen, the term structure of the fixed spread (for 1m vs. 3m libor for example) – but these, BofA believes, would be easier challenges to address than renegotiating and re-hedging existing contracts.
There is a third problem: while the above scenario could be one option for a short term solution, the longer term concern continues to be the lack of a clear alternative for new contracts. Acccoring to BofA’s Mark Cabana, the FCA announcement likely increases activity in the OIS market (both receive and pay flows) – but ultimately, the OIS market (overnight indexed swaps) is based on a fed funds rate whose own future is unclear in a system of non-zero excess reserves dwindling underlying volumes (chart below).
Another option is the BTFR rate (broad Treasury financing rate) which was selected by the Alternative Reference Rates Committee or ARCC (which is having its inaugural meeting on August 1) – but the market has gone down this route before with little success in the GC futures market given declining GCF volumes.
In the end, BofA warns that the most likely emerging scenario is one “involving a fractured derivatives market with multiple underlying benchmarks across different countries developing.”Worse, note that the FCA suggests that the IBA and panel banks could continue to produce Libor but the FCA would no longer persuade panel banks to stay.
Finally, what makes the above especially problematic, is that 2021 is when the Fed’s balance sheet shrinkage is expected to conclude (according to NY Fed estimates), and when short term rates are to be at their tightening peaks according to sellside estimates. That this will come at a time when there is no effective way to trade, or hedge, unsecured short-term rates – which will by then be roughly 2% higher than where they are now according to the Fed’s dot plot…
… will make the Fed’s normalization, from a market standpoint, especially “interesting”, if not impossible.