Libor’s number is up but a fight is sure to break out to replace it
Authorities say the transition can be done in the next five years. Experts say it could take longer. Businesses fret at the cost. Lawyers lick their chops at all the work it will generate. And some groups might fight a rearguard action to stop it happening at all. But this isn’t Brexit. It’s the transition away from the ubiquitous use of Libor, the financial benchmark.
Regulators would probably be happy if they never had to think about the London Interbank Offered Rate again. Libor is calculated by averaging the interest that a group of large banks would charge to lend to their rivals in various currencies and over various time periods. This formerly obscure benchmark has already caused enough trouble after the discovery that a cabal of traders were routinely manipulating it in order to benefit their portfolios.
Since then, the Financial Conduct Authority has been handed an array of new regulatory powers over financial benchmarks, the responsibility for administering Libor has been removed from the banking trade body that used to do it and it has been awarded instead to Intercontinental Exchange (ICE), which has implemented a series of reforms to the way it is calculated.
This might sound like a job done. Not so. Last week, Andrew Bailey, chief executive of the FCA, announced that, far from being happy with Libor, he believes it is will soon be time for global markets to stop using it altogether. Libor, he said, is no longer a good benchmark for banks and investors to use in pricing $350trillion worth of financial instruments, not because it’s still being manipulated (which it isn’t), but because the market it reflects
– lending by banks to other banks – is in long-term decline.
In other words, Libor is a benchmark for a financial reality that is increasingly irrelevant to the way markets actually operate. The problem is that, like asbestos or lead piping, this thoroughly unsuitable building block of the financial system is built into everything. US mortgages and student loans are priced using it. Interest rate swaps, futures, structured products, commercial loans – name a financial instrument and there’s a high chance that Libor is involved somewhere in its pricing and manufacture. And the reason for that is that Libor is a very useful idea.
Thirty-five Libors are published every day – in five currencies for seven lending periods – so if you want to price a three-month future denominated in yen, Libor is a handy way of accounting for credit risk. It’s also a standardisation tool: if a loan and a derivative both use Libor, it is very easy to use that derivative to hedge risk on the loan. And it means that you can compare and trade products that use Libor interchangeably, creating maximum liquidity.
The problem, which the FCA has finally admitted, is that Libor is made up. It’s meant to reflect the cost of banks’ funding, but it no longer does because, since the financial crisis and resulting regulations, banks no longer fund themselves by borrowing from other banks. In order to keep publishing 35 Libors each day, therefore, ICE has to rely on guesstimates. Every day it asks a group of banks to send in relevant trading data and their guesses for Libor. Then it averages them. Unfortunately, there aren’t nearly enough transactions happening for banks to gather Libor data directly in the market. So it amounts to informed guessing.
The question is, what exactly is in it for the banks. Many of them had to pay big fines after US regulators found that
‘Libor is a benchmark for a financial reality that is increasingly irrelevant to the way markets operate’
their traders were influencing the Libor guesses they sent in each day. The banks have overhauled their procedures to stop that happening again, but the whole process generates a compliance risk to them with absolutely no reward. If they get it right, they don’t directly benefit. The only beneficiaries are the market at large and ICE.
ICE makes money from Libor by licensing it. Every contract that refers to Libor generates a tiny fee for ICE. But the banks, which bear a huge amount of the compliance risk, get no particular benefit beyond the advantage that all market participants gain from being able to use the benchmark. It’s worth pausing to consider this situation. Trillions and trillions of dollars’ worth of financial trades rely on Libor. It is built into their contracts. But the banks whose participation is absolutely vital to its existence have no incentive to keep taking part.
The FCA has the power to compel banks to participate for up to a year, but it doesn’t have the legal power to do so indefinitely. All of which means that a benchmark crucial to the smooth operation of global markets could start to fall apart at any point, whenever Libor banks decide they’ve had enough. Mr Bailey, in his speech last week, finally admitted that this cannot be allowed to continue.
Markets, of course, don’t like the idea of dropping Libor. It’s expensive and annoying. Nor does ICE. One can understand why. ICE bid to take over and administer Libor in order to make money from it. It has invested in reforming it. The authorities made a deliberate decision not to take over Libor’s administration for themselves, despite calls to do so, and instead awarded it to a commercial party.
Now, the FCA has decided that continued reliance on Libor isn’t such a great idea after all. But ICE, and all the users of Libor who can’t be bothered to change, have every incentive to keep the current system going. Or, as Jeff Sprecher, chief executive of ICE, said yesterday (sounding rather like Philip Hammond): “There has to be a long transition period.”
The FCA has named 2021 as the end date for this transition. What we can expect to see, as that draws closer, is a sledge-load of commentary and dire warnings about how it simply cannot be achieved because it involves rewriting millions of contracts. We should remember that “don’t want” is not the same as “can’t”.
Markets haven’t yet come up with enough alternative benchmarks to replace Libor. But financial types are an innovative bunch and it’s simply not tenable to continue with a system that relies on the goodwill of participating banks.
The FCA and its counterparts abroad are right that the system has to change. They will have to stand their ground resolutely, however, because one thing is for sure: to shepherd markets through this change, regulators will have a fight on their hands.