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Publication of LIBOR – the London Interbank Offered Rate – will likely cease at the end of 2021. This is the message UK Financial Conduct Authority (FCA) CEO Andrew Bailey sent in 2017 when he announced that, after 2021, the FCA would no longer compel reluctant banks to respond to the LIBOR survey.
Most financial experts know this. Yet, LIBOR remains by far the most important global benchmark interest rate, forming the basis for an estimated $400 trillion of contracts (as of mid-2018), about one half of which were denominated in US dollars as of end 2016. While the use of alternative reference rates is increasing rapidly, to beat the LIBOR-countdown clock, the pace will have to quicken substantially. In the US, the outstanding notional value of derivatives linked to the alternative secured overnight reference rate (SOFR) remains a small fraction of outstanding dollar-LIBOR-linked instruments.
Before proceeding, let’s take a step back to consider the systemic risk posed by the cessation of LIBOR. Authors see two key issues. The first arises from the legacy contracts referencing LIBOR. When publication of LIBOR stops (or is expected to stop), contracts that lack adequate fallback provisions may plunge in value. To the extent that large, leveraged intermediaries are exposed, the resulting losses could impair their capital, leaving us in the dark about which institutions are healthy and which are not. And, what about the entire system? We know from painful experience that uncertainty about the well-being of key intermediaries, combined with concern about the capitalization of the financial system as a whole, can lead to a freeze in funding markets, diminishing the supply of credit to healthy borrowers. The second issue is whether, when LIBOR ceases, there will be an adequate substitute that allows intermediaries both to fund themselves in a liquid market and to provide credit.
So, where do things stand? First, there remain plenty of dollar LIBOR legacy contracts outstanding and because the latest available data are nearly three years old, and the industry continues to create LIBOR-linked contracts, authors strongly suspect that available numbers understate the challenge.
Second, there is no central repository providing information about what, if any, fallback language exists in these contracts. Without LIBOR, what happens? Inadequate fallback language fosters uncertainty about the value of the assets, and could trigger a wave of lawsuits when the losers (and winners) eventually are revealed.
Third, while the process of creating a satisfactory replacement for dollar LIBOR is well advanced, it is far from complete. After selecting SOFR as its preferred benchmark in 2017, the ARRC has actively and successfully encouraged its use. Historically, reference rates arise through an extended process of trial and error in which counterparties eventually adopt a benchmark that enhances market depth and liquidity. In the current circumstance, in order to ensure that there is a meaningful alternative to LIBOR by the end of 2021, there is little time for such testing.
The good news is that SOFR meets a range of criteria that a robust benchmark must satisfy (IOSCO Board 2013). This includes the key standard that LIBOR lacks: a deep, liquid market.
The ARRC’s “paced transition plan” anticipates the creation of a term SOFR rate by the end of 2021. However, to ensure that the end of LIBOR does not lead to systemic disruption, financial firms and their clients cannot wait for a term SOFR.
So, what to do? Fortunately, regulators in the US and elsewhere are well aware of the risks of delay and are now pushing hard for LIBOR users – especially financial institutions and markets under their supervision – to prepare for a world without LIBOR.
The bottom line: the transition from LIBOR is “an unprecedented global financial engineering project of massive scale that will require extraordinary coordination and cooperation across institutions, markets and jurisdictions” (LIBOR to SOFR Working Group 2019). The excellent work of the ARRC exemplifies what a public-private partnership can achieve. Nevertheless, as the clock on LIBOR runs out, the risk of serious disruptions to the financial system remain.