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Aug. 04, 2017

LIBOR Replacements Take Shape as LIBOR’s Days Are Numbered

The U.K.’s Financial Conduct Authority (FCA) has announced that it plans to phase out LIBOR by the end of 2021. The announcement was made in a speech by Andrew Bailey, the chief executive of the FCA, at a conference in London on July 27. Bailey explained that despite improvements in the quality of governance around LIBOR submissions, the underlying market that LIBOR seeks to measure is no longer sufficiently active with actual interbank lending to provide robust transaction data for bank submissions. Despite its efforts to maintain and improve LIBOR, the FCA has decided that it is “potentially unsustainable, but also undesirable, for market participants to rely indefinitely” on a benchmark without an active underlying market. Bailey added that setting a firm deadline will help a “planned and orderly” transition from LIBOR to begin in earnest. The four-year time frame was arrived at by consensus after FCA’s discussion with panel banks, as well as central banks and regulatory authorities in other jurisdictions.

As a result of the scandals involving illegal manipulation in the rate-setting process that emerged several years ago, market participants have released reports detailing their proposed alternative transaction-based benchmarks. In June, the New York Federal Reserve Bank’s Alternative Reference Rate Committee (ARRC) announced that it prefers a broad Treasury repo financing rate. The rate is linked to the cost of overnight borrowings collateralized by U.S. Treasury securities, and the New York Federal Reserve Bank proposes to publish the rate in cooperation with the federal government’s Office of Financial Research. The ARRC selected the Treasury repo financing rate for the depth of the underlying market, which comprises approximately $660 billion in daily transactions. Its drawbacks are that it is a secured rate, and thus lower than LIBOR, and also an overnight rate. Earlier, in April, the U.K.’s Risk Free Rate Working Group (RFRWG) selected SONIA (the Sterling Overnight Index Average) as its preferred alternative. SONIA is based on actual trades in the U.K. overnight unsecured lending and borrowing market, and is administered by the Bank of England.

However, no single proposal has emerged as the most likely candidate. Bailey emphasized the importance of a replacement benchmark being anchored in active markets and not in expert judgment. He explained that this would enhance the replacement rate’s resistance to manipulation and ability to respond to stressed market conditions.

The FCA is technically empowered to compel banks to contribute to production of a LIBOR rate. However, it has asked for voluntary support from panel banks until the rate is ultimately phased out. The FCA is seeking to avoid sudden changes to the representativeness and robustness of LIBOR, as well as a worst-case scenario where panel banks depart and make voluntary production of a LIBOR rate impossible.

The Loan Syndications and Trading Association (LTSA) has expressed the view that it is uncertain whether regulatory agencies and market participants believe that LIBOR or LIBOR fallback language in loan documents could or should be replaced, and if so, whether the broad Treasury repo financing rate would necessarily be the replacement. The LTSA noted that new credit agreement language would have to be developed for a LIBOR replacement. It further noted that industry discussions are just beginning, and any decision and transition process would take years.

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