Bankers and regulators will be at their screens on New Year’s Eve to see if what was once dubbed the world’s most important number slips quietly into the history books.
The London Interbank Offered Rate, or Libor, is finally being switched off, ending its role pricing derivatives and loans ranging from mortgages and student loans to business funding and credit cards, which totalled $265 trillion globally as of the start of 2021. The rate is being scrapped a decade after banks were caught trying to rig it in what will be the biggest shake-up to markets since the introduction of the euro in 1999.
Its discontinuation on Dec. 31 for new business is being compared by bankers to ‘Y2K’, the computer coding that was forecast to sow chaos in IT systems worldwide in the early hours of the new millennium on Jan. 1, 2000. Banks have spent around $10 billion preparing for Libor’s demise, according to an estimate by consultancy Oliver Wyman.
Y2K in the end saw few major incidents but regulators are taking no chances with Libor, with banks busy testing their systems.
“I am going to be at my desk during the Christmas and New Year holidays and I know there will be other people who are there just in case,” Edwin Schooling Latter, director of markets at Britain’s Financial Conduct Authority (FCA), said.
Many derivatives markets based on Libor have already moved to a new benchmark without major disruption. Watchdogs, however, have warned there may be glitches in some loan markets, especially if the borrowers missed warnings of the switch, and the impact of the change may not be felt fully until later in January.
“If you have a contract that refers to one of those rates, it’s not going to be there when you go and look at the screen in January,” said Schooling Latter, who oversees how Libor is compiled from quotes submitted by banks from a market that has by now largely dried up.
Libor began life in a corner of London’s syndicated loan market in 1969 to help price an $80 million syndicated loan for the Shah of Iran. Its demise was prompted by regulators after banks from across the world were fined billions of dollars for attempting to manipulate the benchmark interest rate to make a profit.
It is being replaced by rates set by central banks including the U.S. Federal Reserve, the Bank of England and the European Central Bank.
The U.S. Fed says its Sofr rate for replacing Libor is based on about $1 trillion in daily transactions, making it far harder to rig.
The complexity of ending Libor is similar to Y2K, said Thomas Wipf, chair of the Alternative Reference Rates Committee (ARRC) convened by the Federal Reserve to end the use of Libor in the United States.
“I think that the need for lots of pre-planning and a lot of preparation are really consistent, and we look forward to the fact that if we’ve over-prepared a little bit, that would be a good thing,” said Wipf, who is also vice chairman of institutional securities at Morgan Stanley.
Libor has 35 permutations across five currencies from the United States to Europe and Japan, making its demise a huge global undertaking for regulators, banks and companies since the FCA fired the starting gun in 2017.
Twenty-four of the 35 permutations disappear completely on Dec. 31, the rest continuing temporarily for outstanding contracts only, not for new business.
Customers who ignore letters from their bank asking to change the interest rate used for a loan could end up in a legal twilight zone if they don’t reply. Getting enough holders of a bond to agree on switching to an alternative rate in time may also be difficult in some cases.
“The really interesting part will be the month of January of 2022, watching what comes out of the London change,” said John Oliver, U.S. Libor transition leader at consultants PwC.
“It’s not going to happen that first day, but the first month’s payments are going to be where things get very interesting,” Oliver said.
OFF TO THE RACES
About 80% of the $265 trillion of outstanding Libor-linked contracts at the start of 2021 were derivatives and swaps that pass through clearing houses, the rest mainly in loans to companies, mortgages and bonds.
Next weekend London Stock Exchange Group’s (LSEG.L) clearing arm LCH will “convert” 200,000 sterling Libor swaps worth a notional $20 trillion to the Bank of England’s Sonia rate. This follows conversion of yen, Swiss franc and euro Libor over-the-counter swaps – derivatives directly negotiated between two parties – worth about $6 trillion earlier this month.
“There was no disruption to the over-the-counter swaps market with those conversions, and all sterling swaps will reference Sonia by Dec. 20,” said Susi de Verdelon, head of LCH’s SwapClear.
Worry over market disruption eased considerably after the Fed said five dollar Libor rates would continue for 18 months until June 2023 for existing but not new contracts.
The FCA has also said six sterling and yen Libor rates will continue in ‘synthetic’ form – Sonia combined with a fixed spread – for a year.
These two measures, which help laggards catch up, along with contracts baking in “fallback” alternative rates, mean that few expect any widespread disruption, though Asia is behind Europe and the United States in switching.
“We have seen a lot more activity in the past two to three months, companies are starting to get a lot more focused on it now,” said Avinash Thakur, head of debt origination for Asia Pacific at Barclays bank.
“The Western nations are the countries which have started off earlier in this process and Asian companies don’t feel it’s as urgent an issue for them, they are less worried about the issue,” Thakur said.
Dollar-denominated Libor accounts for half to two-thirds of outstanding contracts.
“The story is now already shifting to next year with the continued remediation of dollar Libor contracts and the adoption of new contracts of alternative rates,” said Mark Cankett, a partner at Deloitte. “Everybody in the market will want to avoid a cliff-edge at the end of June 2023.”
Banks are pushing hard for the U.S. Congress to approve a bill that would automatically switch ‘tough’ legacy contracts to an alternative rate and avoid legal limbo when dollar Libor ends in June 2023.
“We’re sort of coming into the home stretch, we believe that the tools are available for market participants to get this transition done and we’re hopeful that the legislative path in the U.S. will help solve the tough legacy,” Wipf said.
Others urged U.S. market participants not to wait until mid 2023 but to get a move on by learning from the more advanced switch in Europe.
“People should not solely rely on legislation. Come January 1, I think we’re off to the races,” said Tal Reback, responsible for Libor transition at KKR Credit and member of the Fed’s ARRC.