The Bank of England has warned that the sterling swaps market is not ready for the end of Libor in a year's time, while there are fears that a "synthetic" version for tough legacy contracts could face legal challenges.
Libor, which is used to underpin trillions of dollars of contracts, is due to be phased out at the end of 2021, as the banks that set the rate have agreed with regulators to do so.
Andrew Hauser, executive director for markets at the BoE, said in a speech in December 2020 that sterling markets are reasonably well-positioned to make the transition away from Libor in time for the deadline. However, he warned that in the market for sterling swaps, the primary hedging instrument, there was still some way to go with some companies having some "rapid catching up" to do to be ready.
No more extensions
Jacob Rank-Broadley, head of Libor transition, benchmarks and indexes at Refinitiv US Holdings Inc., said the delay in phasing out publication of the main U.S. dollar Libor rates would be effective. He noted that Sofr, the secured overnight financing rate, which is the U.S. Fed's preferred alternative to Libor, was relatively new and so liquidity in Sofr-referencing derivatives was limited. The U.K. regulator's preferred risk-free rate is the sterling overnight index average rate, or Sonia.
The latest figures from the International Swaps and Derivatives Association Inc. on how much global trading activity is conducted in cleared over-the-counter and exchange-traded interest rate derivatives that reference risk-free rates shows sterling had the highest percentage of risk-free rate-linked interest rate derivatives traded at 33.6% of the sterling market, while 5.6% of U.S. dollar interest-rate derivatives were transacted in Sofr. The total notional size of the market in interest-rate derivatives in November was $108 trillion, ISDA's figures showed.
"We see positive signs of liquidity increasing. In light of many firms continuing their plans targeting a 2021 year-end U.S. dollar Libor cessation we believe it is likely that liquidity will develop in advance of June 2023 and therefore no further extension will be required," said Rank-Broadley via email.
Refinitiv is launching its fully operational commercial version of its forward-looking Term Sonia benchmark on Jan. 11 after creating a prototype of the same rate in July 2020. The forward-looking Sonia rates are designed to provide an alternative to one of Libor's main attractions — that it provides interest rates for months in advance.
Sterling Libor-based loan products maturing beyond 2021-end will cease to be issued at the end of the first quarter of 2021, according to the timetable of the U.K. Working Group on Risk-free Reference Rates, and this will be a key milestone on Libor's final journey, said Andrew Gray, U.K. Libor transition lead at PricewaterhouseCoopers.
"It will be a good indicator of where the markets have got to. Certainly, the Sonia market is growing and we certainly expect to see that trend to continue. It is absolutely clear that most of the major players in the market place are making significant investments in putting in place new arrangements," said Gray.
'Expert judgment'
Libor's intended cessation follows a series of scandals in which banks were fined billions of dollars for attempting to rig the rate in their favor, while the number of actual interbank borrowing transactions used to underpin the rate has also fallen dramatically.
This leaves the panel of banks that have agreed with regulators to continue to set the rate using their "expert judgment." The Financial Stability Board and BoE have each noted that during the pandemic users of Libor became reliant on judgment-based decisions rather than actual market transactions, and said that while central bank rates were being reduced, Libor rates increased.
The Libor panels for sterling, Japanese yen, Swiss franc and euro are due to cease at the end of 2021, said the ICE Benchmark Administration Ltd., which oversees Libor, subject to consultation. One-week and two-month dollar Libor will also cease but publication of the more widely used dollar Libor tenors will be extended until June 2023.
Regulators had been concerned that the sudden end to publication of the main dollar Libor rates would threaten financial stability, so the extension is aimed at allowing the bulk of contracts to simply come to an end.
Synthetic Libor
The Financial Conduct Authority is consulting on changing the way some key Libor rates are calculated to allow continued publication under a new methodology, known as "synthetic" Libor, but only to assist so-called tough legacy contracts, which are those that cannot be amended or transitioned away from Libor. This could be applied to more commonly used sterling Libor settings and the FCA is looking at whether it might also apply to U.S. dollar settings though this depends on progress made in transitioning away from Libor.
"The Treasury has proposed new powers for the FCA to manage the orderly wind-down of Libor, including the power to require a change to a synthetic methodology in the event that the Libor benchmark become unrepresentative," said an FCA spokesman.
The FCA said the U.K.'s risk-free rate working group called for legislative intervention like this to help provide continuity for tough legacy Libor contracts.
Though the method of creating a synthetic Libor is subject to consultation, the FCA has suggested it could be based on a specific Libor risk-free replacement rate plus any recommended fixed credit spread adjustment. It has also said no one should rely on a synthetic Libor being available.
However, PwC's Gray warned that if the FCA did use its powers to produce a synthetic Libor, it could be open to legal challenge, specifically with respect to contracts governed by the laws of jurisdictions outside of the U.K.
"The risk exists because if the underlying contract refers to Libor and you change to something which isn’t Libor but you pretend it is then if a counterparty believes that they have suffered a loss as a result then they would be at liberty to take legal action. There would also be a question mark about how you would actually work out who had lost money and how you could show that in a legally robust way," said Gray.
In response, the FCA said creating synthetic Libor could help Libor users in overseas jurisdictions, though it also cautioned that further action might be needed.
However, Refinitiv's Rank-Broadley said synthetic Libor would be a key tool and expected the industry to welcome its use with tough legacy contracts.
The FCA has said it will be coordinating with other authorities on how it uses its powers and regulators are also working together on the issue under the auspices of the FSB.