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End of the road for Libor

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“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?”

It is a question that many of the major banks in London have been answering every day since Minos Zombanakis arranged the syndication of an $80 million floating rate loan to the Iranian central bank in 1969. Following last Thursday’s announcement by the Financial Conduct Authority, however, we now know that it will soon cease to be asked. Libor, the London inter-bank offered rate that currently underpins a global market with a notional value of around $350 trillion, is to be discontinued by the end of 2021.
 
Given the four-million-fold expansion of the market over the half-century since Libor was first defined, many would say that the benchmark’s death knell is long overdue. Indeed, the process for determining the rate does seem rather shabby when one considers the size and economic impact of the market that now depends upon it. The daily fix published by Thomson Reuters at 11.30am each morning is calculated by responses submitted by each bank to the question above, discarding the four highest and four lowest answers, then averaging the rest. In theory, the result is a good approximation of the cost of funding on the inter-bank market for the specified currency and maturity, and is, therefore, a ‘fair’ floating rate for lenders to charge their borrowers (in addition to a fixed margin reflecting credit risk and profit).
 
This approach worked fairly well throughout the 1970s when submissions were made by the banks in the lending syndicate for each transaction, and banking was a gentlemen’s club in which one’s reputation for integrity was a much more important currency than, well, currency. By 1984, however, the market had grown to the point where a number of lenders began to feel uncomfortable about Libor’s ad-hoc nature, leading the British Banking Association (BBA) to consult on a standardised method for producing the benchmark. From 1 January 1986, the rate was revamped as ‘BBA Libor’, with a set group of banks submitting estimates. With the exception of the addition and removal of various currencies and maturities at various points, the process has hardly changed over the intervening 31 years.
 
In recent times, of course, Libor has taken on a different guise, instead becoming a byword for the corruption and conflicts of interest that the crisis of 2007-08 revealed to have been endemic within the financial sector. The issue was another incarnation of the classic principal-agent problem: banks were contributing estimates of their funding costs to calculate the same benchmark that determined the value of their trading books. In a situation where a 0.01% change to Libor could allow the bank’s traders to make millions of dollars of profits each day, could one really expect the submissions to be unbiased? The answer inevitably turned out to be ‘no’, with the resultant Libor scandal in 2012 engulfing many of the big names in banking. The investigations revealed that not only had many major banks been colluding to manipulate the benchmark, but that this malpractice had been going on for at least 20 years. The assertion of Tom Hayes, the UBS trader convicted of rigging Libor in August 2015, that he was ”just doing [his] job” did nothing to help the financial sector’s already battered reputation.

The much more fundamental problem with Libor, and the one that seems to have pushed it over the edge is that many of the funding rates it purports to measure simply do not exist in the market. In his statement announcing that it was to be phased out, Andrew Bailey, chief executive of the FCA, claimed that in some instances banks were estimating their costs of funding on a daily basis for currencies and maturities in which the actual frequency of transactions was less than 20 per year. Even before the Libor rigging scandal, a member of the Bank of England’s Monetary Policy Committee described the benchmark in 2008 as "the rate at which banks don’t lend to each other".
 
Looking ahead, it seems that whatever replaces Libor as the benchmark floating interest rate is most likely to be a transaction-based measure. Amongst the potential candidates, the lead contender is the Sterling Overnight Index Average (SONIA). This index is calculated each London business day as the weighted average of overnight, unsecured sterling transactions in reasonable market size. SONIA avoids a lot of the problems posed by Libor – the fact that it is based on actual transactions both prevents banks from making fraudulent contributions to its calculation and ensures that it is only based on a market where there is sufficient liquidity for the benchmark to be meaningful. Nevertheless, it is pointless to deny that it has its own disadvantages. The fact that SONIA fixes on a daily basis would mean that borrowers would be given far less notice as to how much interest they were required to pay for each period. Moreover, it does not capture the so-called ‘term structure’ of interest rates – i.e. their dependence on the length of interest period – that Libor does.
 
Another key question is how references to Libor in existing loan and derivatives documents will be interpreted once the rate ceases to fix. To this, there is again no obvious answer. Legal opinion is divided as to whether these references would automatically transfer to whatever replaces Libor as the market standard benchmark, or whether fallback procedures detailed in the documentation would be automatically activated, resulting in the floating rate being calculated on the basis of reference quotes by specified banks. Whatever the eventual outcome, the wording around such fallback procedures is sure to come under heavy scrutiny in the coming months.
 
Elsewhere, it was a largely quiet week for the markets, with the parliamentary recess in the UK providing a much-needed break from political melodrama. Mrs May’s current walking holiday in the Alps may give some pause for thought, though, given the fallout from the last idea she had while out hiking. Meanwhile, the US President seems to have decided that the most pressing issue facing his country at present is its soldiers’ genital arrangements.

This week, there are several significant data releases, with the eurozone second quarter GDP growth released on Tuesday, UK PMI and the ECB economic bulletin on Wednesday, the Bank of England’s Monetary Policy Committee announcement on Thursday, and US non-farm payrolls on Friday.

All views expressed here are the author’s own and are based on information and data available at the time of writing

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