A creation of the mid-1980s, the London Interbank Offered rate (LIBOR) became immensely influential over the three decades that followed. It became a reference rate for both finance and commerce for the rate of nearly risk-free interest, and in the process it spawned other IBORs, including EURIBOR and Japan’s TIBOR.
LIBOR came to be published in ten currency specific versions, though in recent years that number has fallen to five: the USD, GBP, EUR, CHF, and JPY.
Operating firms came to hedge their exposures with over-the-counter derivatives calculated with reference to an IBOR, banks serving as intermediaries between end users and derivatives exchanges did likewise. Corporations issued debt whose payments were to be calculated using an IBOR.
Unfortunately, reliance on the IBORs can be a problem, as became obvious in the spring of 2008, when the Wall Street Journal headlines, “Bankers Cast Doubt on Key Rate Amid Crisis.”
From Denial to Acceptance
The first response of officialdom was to deny that there was a problem at all. In October of that year the IMF decreed that “U.S. dollar Libor remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding.”
But it wasn’t. By the end of 2008 the Governor of the Bank of England, Mervyn King, told Parliament that Libor is actually “in many ways the rate at which banks do not lend to each other.” Further, it was becoming obvious that banks were misreporting their offered rates not (or not only) because they wanted to signal confidence in themselves or the economy, but because they were misreporting pursuant to manipulation of the derivatives markets.
As Professor Lo said in an interview we ran in AllAboutAlpha in 2012, “If you have a large enough portfolio of fixed-income instruments, it would be to your advantage to be able to move LIBOR, even by 1 or 2 basis points, in one direction or the other.”
The Need for a Map
Market-led risk-free rate (RFR) working groups are in place in several jurisdictions, and they are looking to develop alternative risk-finding systems, and to ease the transition out of the IBORs.
The International Swaps and Derivatives Association, in partnership with other industry groups, has published a 2018 Transition Roadmap, with the goal of assisting the market participants, and their regulators, “who are leading the global transition initiatives” so that they can “reach parts of the market which have yet to fully engage in the process.”
The introduction to this roadmap quotes Andrew Bailey, chief executive of the UK’s Financial Conduct Authority, who said recently that the FCA will not persuade or attempt to compel banks to make LIBOR submissions after 2021. So transition is not really optional: there is some question whether LIBOR will even still be available after 2021.
The authors of the roadmap estimate that the total outstanding notional exposure to the various IBORs is in excess of $370 trillion.
Landmarks on the Road
In July 2013, the International Organization of Securities Commissions published its “Principles for Financial Benchmarks.” The issues on which IOSCO focused included the governance of the determination process; benchmark quality; and methodology.
A year later, the Financial Stability Board’s Official Sector Steering Group recommended a “multiple-rate” approach with on the one hand reference rates that would include a bank credit risk component and alternative RFRs for products that do not require such a component.
In December 2016, the Tokyo Overnight Average Rate (TONA) was established as the preferred alternative RFR for JPY.
Ongoing transition work can be broken down into four parts. First, existing IBORs can be improved through the development of better underpinning transaction data; second, the identification of new or existing RFRs must proceed; third, there have to be strategies for the migration of cash and derivative products into IOSCO compliant RFRs (one of the problems here is that, as the roadmap observes, the “transition of legacy contracts could potentially result in less effective hedges and/or market valuation issues, and may require adjustments to address inherent differences between IBORs and alternative RFRs”). Finally, contractual robustness should be improved, mitigating risks associated with that migration.
Aside from ISDA, the associations involved in the road map’s creation include AFME, ICMA, SIFMA and SIFMA AMG.