The UK’s FCA is to phase out the Libor rate, or London Interbank Offered Rate. Libor has been around for nearly 50 years. It is a measurement, updated daily, of the average estimated lending rate of a group of 20 banks in seven currencies. It is submitted by a panel of lenders every morning. It underpins literally hundreds of trillions of dollars of securities transactions, investment products and derivatives. Many investment funds use Libor as a benchmark.
However, Libor has also been plagued by scandals in recent years. It has been abused by bankers, resulting in over $9 billion in fines and several jail terms for those responsible. Since then the Intercontinental Exchange has taken over the calculation of the rate, relying more on actual transactions rather than a small coterie of bankers, but the FCA thinks it is time for a new approach.
The FCA has stressed that its actions have less to do with the scandals, and more to do with the fact that Libor has become outdated, and is not sufficiently reflective of actual money markets.
“The absence of active underlying markets raises a serious question about the sustainability of the Libor benchmarks that are based on these markets,” says Andrew Bailey, Chief Executive of the FCA. “If an active market does not exist, how can even the best run benchmark measure it?”
The outcome of the change will be to inject a great degree of uncertainty into Libor-based swap rates, for starters. Bailey says that it is apparent that for many of the contracts which term Libor is used as the reference rate, “there is not a real need to capture in the reference rate a measure of term or bank credit risk premia.”
Interestingly, Bailey also said he could not discount the risk of a costly and messy transition, particularly if the panel banks tasked with setting Libor try to exit from the process before 2021. The FCA has the powers to compel them not to, but at the same time, Bailey seems to be admitting there might be a bit of a bumpy ride.
What does this mean in practice?
It is not going to be an easy task. Some way of continuing to support the underlying rate used by the many, many investment products that will still be current post-2021 will need to be devised. Some of that onus is likely to fall on the ICE Benchmark Administration, which is currently overseeing the setting of the rate.
Many investment contracts, between investors and product providers, will need to be re-written. But for so many of these, Libor is a key constituent. Replace it with something else, and are you not breaking the contract. City of London lawyers will be rubbing their hands with glee. Investors, on the other hand, will likely see product providers asking them to opt in to new terms once a new benchmark is determined.
“It remains to be seen how the markets will address these issues,” says Max Hinxsman, a banking partner with Fieldfisher in London. “Given the number of contracts that will be affected, we would not be surprised if the derivatives markets were to adopt the familiar protocol solution.”
By this, Hinxsman reckons different solutions will be applied depending on the product – for example,loan contracts may make use of ad hoc solutions, while with swap documents the market may instead opt for a ‘big bang’ switch over.
It is best that consumers check your terms and conditions for individual contracts and ask your product provider. If you have trading contracts that rely on Libor rates, again, check with your broker or counterparty. For short term positions, this is less likely to be an issue.