Libor Remains a Big Problem, But At Least It’s Getting Smaller

By William Shaw and Alexandra Harris | January 25, 2021

Untangling the vast global derivatives industry from Libor just got a bit easier.

The London interbank offered rate is hardwired into swaps and other contracts worth hundreds of trillions of dollars, but it’s slated to disappear in the not-too-distant future. If the move to replacement rates doesn’t go smoothly, that could cause major discord in markets.

A fix that takes effect Monday eases that risk for a large swath of the market, although there are still many hurdles to overcome in the benchmark transition. A new protocol has been put into place that allows Libor to be yanked out automatically and another rate swapped into its place — provided counterparties accept legal terms governing the industry. And while it doesn’t cover everyone, nearly 12,000 entities — including big banks like Barclays Plc and JPMorgan Chase & Co. — have adopted this new method to obviate complicated negotiations with many trading partners.

“For the health and safety of the market, it’s an important day,” said Jason Granet, chief Libor transition officer at Goldman Sachs Group Inc. “Every new derivative trade will have the appropriate Libor fallbacks. This is going to update the fallback language in millions and millions and millions of trades. The more information that comes into the market and the more clarity that’s given, the better that is for a smoother overall transition.”

Pivotal dollar Libor rates will likely live on until mid-2023, yet other Libors around the world may well expire at year-end.

That’s not the only Libor milestone set to be passed on Monday. At 5 p.m. London time, the benchmark’s administrator will stop accepting feedback on its plan to extinguish the rate, setting the stage for an announcement, possibly within days, on when Libors around the world will end.

Analysts hope Monday’s events collectively will help address one of the greatest challenges of the Libor transition: how to get something like $200 trillion of derivatives shifted over to replacement rates in time, when obvious catalysts to get things moving run in ever shorter supply.

The new International Swaps and Derivatives Association protocol will help firms that haven’t made arrangements for exiting Libor do so without much additional effort.

“Having a fallback based on a clear, consistent and transparent methodology will significantly reduce the risk of market disruption if a key Ibor ceases to exist or Libor is deemed to be non-representative before transition efforts are complete,” Scott O’Malia, ISDA’s chief executive officer, said in a press release.

It’s “a really efficient and sound way for counterparties to address the legacy population,” said Tyler Wellensiek, a managing director in rates sales at Barclays. However, “it’s very much a safety net, and it’s not the only piece of the puzzle by any means.”

Complications

One of those other pieces is what to do about loans tied to Libor, since those aren’t covered by the ISDA framework. Parties to those deals will still have to manually hash out what to do when the rate expires.

“There are still many unresolved complications in this space, and certainly plenty of open questions,” said Padhraic Garvey, head of global debt and rates strategy at ING Groep NV. That includes how derivatives that have transitioned to fallback rates would behave relative to underlying loans, he added.

Help may be on the way to resolve some of these other issues. For instance, New York Governor Andrew Cuomo this month proposed legislation that would make it easier for Libor-linked contracts to move to another rate. A big section of the Libor market is governed by New York law.

Additionally, major derivatives clearinghouses LCH Ltd. and CME Group Inc. are floating plans to shift swaps worth more than $150 trillion off Libor in the weeks before the benchmark ends.

Libor Death

Focus is zeroing in when various Libor rates will expire, something ICE Benchmark Administration Ltd. is expected to clarify in the weeks ahead. Pivotal dollar Libor rates will likely live on until mid-2023, yet other Libors around the world may well expire at year-end.

This announcement would be the “biggest deal in the Libor transition” since 2017 and could result in “huge moves” in eurodollars, a key derivatives market that’s tethered to the rate, said Priya Misra, head of global rates strategy at TD Securities in New York.

That’s because the news would trigger Libor’s fallback spread calculations — essentially a math equation that determines the rate on Libor’s replacement. Speculation on the timing of the announcement jolted the eurodollar market in December, as even a minor shift in the spread calculations could ripple across portfolios.

On the announcement itself, eurodollars expiring in September 2023 or beyond could move as much as five basis points, Misra said.

However the market responds, regulators may strengthen their resolve if another watershed transition moment passes with little change. While some headway has been made, average open interest in three-month futures on the Secured Overnight Financing Rate — the heir apparent for Libor in the U.S. — barely topped 5% that of eurodollar contracts last month.

“For the last few years there was always this question, ‘Will it be carrot or stick?'” said Marcus Burnett, director of SOFR Academy, an education technology firm whose clients include banks, asset managers and law firms. “We now know. The supervisory sector will start applying more pressure on the banks. Central banks in a number of markets around the world are also thinking about what penalties they could implement.”

–With assistance from Edward Bolingbroke, Stephen Spratt and Liz Capo McCormick.

Top Photo: Commuters cross London Bridge in view of skyscrapers in the City of London skyline in London, U.K., on Thursday, Oct. 15, 2020. Photographer: Simon Dawson/Bloomberg.

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