Around $200 trillion. That’s the Alternative Reference Rates Committee's (ARRC) estimate on the size of notional in contracts linked to USD LIBOR across a range of asset classes. But much like the famous choice of colour for Henry Ford’s Model-T, this dependency has grown to an impressive scale without many options for selecting the right tool for the job at hand. With that in mind, efforts are now underway to take a coordinated approach to deprecating the use of that most (in)famous of benchmarks.
The scale is daunting, but it’s not the size that matters, it’s the complexity and the interconnectedness. LIBOR ( the London Inter-bank Offered Rate) represents the average of interest rates estimated by each of the leading banks in London and is widely used for short term interest rates. Swap markets, loan markets, bond markets, even some agency mortgage backed markets depend on LIBOR in a way that connects issuers, investors, intermediaries, tools providers, regulators and lawyers alike. Arguably, LIBOR’s use as a reference rate has grown beyond its original intended use as a measure of the market for unsecured term lending to banks, but that’s a matter for the history books. What concerns regulators and others in the industry now is finding a way to reduce the dependency on a benchmark whose underlying markets are less active than before.
In July 2017, Andrew Bailey—then Chief Executive of the Financial Conduct Authority—made it clear that the UK regulator would no longer seek to persuade or compel banks to submit to the publication process of LIBOR after 2021. The market needs to band together to find alternatives and work to integrate them into the complex system of transactions, clearing, settlement and risk management processes that has grown up over the last 40 years.
One year on, working groups manned by buy side, sell side, CCPs and others chaired by regulators on both sides of the Atlantic as well as in many other jurisdictions are well underway in examining the ideas for alternative rates and working on building an ecosystem of transactions that will bring liquidity to them. The UK and the US have already chosen the “alternative reference rates” SONIA (reformed) and SOFR, both representing overnight index swap (OIS) rates. One is based on unsecured funding transactions and the other on the near-trillion dollar-a-day treasury repo market. Swaps are already trading and liquidity is building. Three-month futures linked to these rates have recently been announced, and there is an expectation that liquidity should build in line with the swaps market. From the sell side’s perspective, the basic hedging building blocks appear to be falling into place. Most recently, on June 28, the ECB announced the launch of ESTER, a new unsecured OIS to be published by October 2019.
But questions remain, such as whether there is a need for term rates that are based on these alternative reference rates? Many on the buy side seem to think so, but is this a need or just a perception of a need? The only way to determine that is for the buy side, including the asset owners, to raise their awareness of these initiatives and express their views in the numerous consultations and working groups that are out there on these topics. And what of the existing book of business linked to LIBOR? How can those transactions be marked to market in a post-2021 world where it is estimated that a significant proportion (30-40%) will continue to be extant even when LIBOR has been deprecated? This is as much a matter for revision of contractual provisions as it is for clearing, marking to market and hedging. ISDA is already looking at new protocols for fallback provisions and other working groups are studying contractual positions in earnest in a variety of markets.
Are we moving to a world where multiple alternative rates exist in a given currency so that there is a choice of the most appropriate rate to use for a given purpose? If so, that strikes us as a positive development and, for our part, FTSE Russell is following closely the discussion in the market about the need for a term rate. Whatever the rates are that are selected and used, governance will be a crucial piece of the puzzle and so, as a Benchmark Administrator, we aim to bring to bear all the robust governance processes and procedures that apply in all our widely used benchmarks, in line with the highest standards out there.
For more information on FTSE Russell's role as a Benchmark Administrator authorised by the FCA pursuant to the European Benchmark Regulation, please visit this link.
 Reuters, 3/5/18
 These include the Financial Conduct Authority (FCA), International Capital Markets Association (ICMA), the Loan market Association (LMA), the Association of Corporate Treasurers (ACT), the Interrnational Swaps and Derivatives Association (ISDA),and the Securities Industry and Financial Markets Association (SIFMA), and others.
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