By Mitul Patel
On July 27, the head of UK's Financial Conduct Authority (FCA) said that LIBOR, the benchmark London Interbank Offered Rate, is no longer sustainable as a reference rate given that the market providing the data is no longer "sufficiently active," calling on banks to replace it by the end of 2021.
Andrew Bailey, Chief Executive of the FCA, announced today the intention to phase out LIBOR by the end of 2021. Although various regulatory bodies have attempted to reform the reference rate over recent years, the lack of sufficient transactions has led the FCA to believe that LIBOR is no longer tenable as a benchmark rate.
The Bank of England has already looked at alternative reference rates and determined that the overnight unsecured lending rate known as Sonia* would be the best alternative to LIBOR and has now begun the process of transitioning to a new benchmark.
Although interest rate swaps based on Sonia are tradeable, they have not been as liquid across the yield curve as LIBOR-based swaps. And while derivatives based on expected 3-month LIBOR rates at different quarters are traded in high volumes daily, there are no exchange-traded derivatives on Sonia rates. Furthermore, Sonia-based interest rate swaps compound daily, rather than semi-annually as is the convention for LIBOR-based swaps. Questions will also arise over what to do about legacy instruments and contracts that reference LIBOR.
The UK is not alone in looking for a replacement for the scandal-prone benchmark used globally as a reference for trillions of dollars of financial contracts. In the U.S., the Alternative Reference Rates Committee, an industry body set up by the U.S. government, recommended a new, broad, U.S. Treasurys repo rate in June 2017, which will reflect the cost of borrowing cash secured against U.S. government debt as a replacement for LIBOR. In Europe, concerns have also been growing over Euribor, as banks have been pulling out of the rate-setting panel of 20.
While the panel banks may continue to set LIBOR daily, they will no longer be compelled to by the FCA. One possible solution touted is producing a one-off set of term credit spreads to add to the dynamic base of risk-free rates like Sonia.
Although several questions need to be answered, one thing is clear: LIBOR, tarnished by the credit crunch and a byword for corruption, is on its way out. In the UK, Sonia is likely to become the new benchmark rate, and although the transition will be lengthy and difficult, it now appears inevitable.
*Sonia, the Sterling Overnight Index Average, was introduced in March 1997. It reflects bank and building societies' overnight funding rates in the sterling unsecured market. The Bank of England is currently taking steps to reform the Sonia benchmark, which is anticipated to move to a new basis by April 2018.
Euribor (Euro Interbank Offered Rate) rates are based on the average interest rates at which a large panel of European banks borrow funds from one another. There are different maturities, ranging from one week to one year.
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