Life after LIBOR
The London Interbank Offered Rate (LIBOR) is dead. Or so we thought. The Fed’s choice to use the much maligned benchmark for its Main Street Lending Program illustrates that despite the 13 year process to phase out, or at least significantly change, the rate has not been seriously considered by policymakers.
LIBOR will live beyond its planned death in 2021 though this does not mean it is no longer at death’s door. In fact, the Fed seems even more determined to kill the rate judging by recent statements. Like the Euro Short Term Rate (ESTR), LIBOR will be completely replaced. Nonetheless, the pause on the global economy must be used to give serious thought to what form LIBOR’s successor will take.
The Overnight Indexed Swap (OIS) is the main contender for the throne. It is noteworthy 1 month and 3 month rates for this benchmark are not yet mainstream which has numerous implications for derivatives markets. If central banks and regulators fail to ensure the creation of shorter schedules for OIS and, assuming it becomes the only game in town, this would seriously tighten liquidity in global markets. Despite what the detractors of derivatives, however exotic, say they play a crucial role in adding depth to capital markets and sturdiness to bank balance sheets once traded responsibly.
OIS is administered by the New York based Commodity Futures Trading Commission. Location is key here, NYSE Euronext added LIBOR to its domain following the British Bankers Association’s failure to address LIBOR’s flaws. Hence, Fed and not Bank of England sentiment regarding benchmark rates is key to envisaging life after LIBOR.
According to the more optimistic epidemiologists, COVID will be resolved in a 3-year period which would presumably coincide with the end of LIBOR. Once again, central banks will have to return to the drawing board and figure out how to reach base rate normality. This correspondent believes the end of Quantitative Easing (QE) in Europe will highlight fundamental problems in how the programme was implemented. The ECB bought billions of assets from banks with practically no regard for their health and these assets will start to cause problems supposing the rates reach the 1-2% range. For instance, how will the recently bailed out Banca Monte dei Pasci di Siena cope in a normal rate environment? Presumably not too good considering it almost collapsed when rates were negative in real terms. There will be more such banks when rate ratcheting returns.
The LIBOR-OIS spread was a remarkably useful measure for credit risk and volatility in 2007-08 and markets participants will have to find a replacement. The Ester-OIS spread is the most intuitive for monitoring the Eurozone and navigating the next Euro crisis though Ester is not forward looking. However, assuming globalization continues to steamroll ahead post-COVID, a single benchmark, as LIBOR has been, would be most useful. However, this desire is likely to go unmet.
The US is opting for the Secured Overnight Financing Rate (SOFR), the UK with the Sterling Overnight Index Average (SONIA) and Japan has chosen the Tokyo Overnight Average Rate (TONAR). Like Ester, these are not forward looking so they are practically useless from a corporate banking perspective. As a consequence, LIBOR’s replacements seem a little worse even considering all of the drama and scandals associated with the original interbank rate.
Perhaps the biggest problem in life after LIBOR will be the litigation resulting from the re-pricing of LIBOR linked contracts running beyond the rate’s end. There appear to be quite a few considering the $300tn worth of contracts associated with the rate, among them thousands of long-term contracts particularly in the merchant banking space. Banks will be under no obligation to give LIBOR quotes once it is phased out. Central banks have provided no guidance on this issue so when they step out of the fold, lawyers will step in and make global banking more convoluted at a time when that is exactly the opposite of what is required. In other words, life after LIBOR will be little better than life during COVID.
By Robert Tolan