The switch-off of the influential LIBOR benchmark rate, due in 2021, has been described as ‘bigger than Brexit’. Global Insight examines the repeated attempts to rebuild trust in global finance after the rate-rigging scandal emerged a decade ago

LIBOR, the key benchmark interest rate that indicates borrowing costs between banks, is on the way out. Tainted by the rate-rigging scandal that first came to light a decade ago, LIBOR’s days have been numbered for some time. But with banks now lending to each other much less than before, the rate is becoming unsustainable – and vulnerable to continuing abuse.

The move represents one of the most significant changes to financial markets in decades. LIBOR plays a central role in global finance. Used by banks to set financial product prices, it’s a benchmark that underpins trillions of pounds in loans for companies and households worldwide.

It’s not surprising, then, that the Bank for International Settlements, an international financial body owned by central banks, said that switching off LIBOR was ‘akin to surgery on the pumping heart of the financial system’. The treasurer of Deutsche Bank described it as ‘bigger than Brexit’.

The writing has been on the wall since July 2017, when the Chief Executive of the UK’s Financial Conduct Authority (FCA), Andrew Bailey, announced that the regulator would no longer compel the panel of banks that set the LIBOR rate to submit data from 2021 onwards. The FCA followed this last year by stating, along with US regulators, that market players needed to prepare for the end of LIBOR in three years.

In September 2018, the FCA and the Prudential Regulation Authority, a financial services regulator, wrote to around 30 of the UK’s largest firms, giving them a deadline of 14 December last year to submit detailed analysis of their LIBOR-related risks. The regulators insisted that this analysis be approved by their company boards, and that each institution name the senior manager responsible for overseeing it.

‘In our view it’s not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them,’ said Bailey. ‘As well as an inherently greater vulnerability to manipulation when rates are based on judgements rather than the real price of term funding, there are a host of questions about whether and how such reference rates can respond to stressed market conditions.’

Beyond the scandal

When Bailey referred to LIBOR’s ‘vulnerability to manipulation’, everyone knew what he was talking about. In 2012, an international investigation found that bankers at a number of major financial institutions were manipulating LIBOR – falsely inflating or deflating their rate quotations – to profit from trades. As LIBOR is also used to indicate a bank’s health, some banks were able to give the impression that they were more creditworthy than they actually were. Evidence suggested this had been going on since at least 2005.

Regulators in the US, the UK and the European Union have fined banks more than $9bn for their involvement in the scandal. Criminal charges have been brought against individual traders and brokers with mixed success. In 2015, trader Tom Hayes was sentenced to 14 years in prison, subsequently cut to 11 years, for conspiracy to manipulate the LIBOR rate to enhance his trading results. Hayes was found to have acted of his own accord, although he claimed that rate manipulation was common practice at the banks where he worked and that senior managers were aware. In July 2016, four former City traders also received jail terms after being convicted of rigging LIBOR.

The scandal triggered calls for deeper reform of the LIBOR-setting system, along with tougher penalties for offending individuals and financial institutions. But change has been piecemeal so far.

In July 2013, the International Organisation of Securities Commissions produced a set of principles for financial benchmarks that have been the basis for reform and regulation of LIBOR ever since. In addition, Intercontinental Exchange (ICE) Benchmark Administration, which took over the running of LIBOR from the British Bankers’ Association in 2014, has made a number of changes. One of the most important is the ‘waterfall’ methodology for formulating LIBOR submissions. This is designed to ensure that panel banks use transactions from a wide pool of funding sources and make submissions based on objective data. It’s meant to minimise the use of subjective judgement – and potential manipulation.

In April 2019, ICE said all LIBOR panel banks had transitioned to this methodology. In addition, LIBOR panel banks must now have designated senior managers who have personal liability, as well as annual external audits.

Caroline Phillips is a partner at Slaughter and May in London and Chair of the IBA International Financial Law Reform Subcommittee. She says Andrew Bailey’s announcement in 2017 effectively sounded the ‘death knell’ for LIBOR. ‘There’s still an element of judgement in LIBOR because it’s not sufficiently liquid,’ she says. ‘That does make it prone to abuse, so it was already on its way out. That process has been accelerated by Bailey’s speech.’

Even without the scandal, it was difficult to envision a long-term future for the rate. ‘LIBOR was always ripe for reform, given its flaws,’ says Jason Lawrance, a partner at Osborne Clarke in London. ‘The high-profile nature of the various rigging scandals pushed it up the regulators’ agenda and made it necessary that they take action now.’

But suspicions linger that LIBOR is still not entirely trustworthy and remains open to potential abuse. These suspicions hardened after a number of class actions were filed in the US in the years following the scandal, accusing a string of major banks of rigging LIBOR. A number of banks have settled private US antitrust legislation.

A changing market

The LIBOR scandal was probably the trigger to find an alternative rate, says Rein van Helden, a partner at Stibbe in Amsterdam and Vice-Chair of the IBA Banking Regulation Subcommittee. Since the global financial crisis and the European Central Bank’s quantitative easing programme, there’s no interbank lending any more. ‘If there is, it may be overnight, but that’s about it. Any three-week, three-month or six-month LIBOR [rate...] doesn’t happen,’ he says.

However, he believes that any concerns about manipulation have now ‘completely gone’ because of the scandal. ‘A thing like that won’t happen again because it’s closely monitored by regulators now,’ he says.

Phillips adds that ‘the market is more focused on the 2021 deadline and the point at which LIBOR becomes so illiquid that it ceases to be a rate at all. That could be an earlier date.’

Changes to the financial markets have become the main driver for the LIBOR switch-off, says Kathrine Meloni, a special adviser at Slaughter and May in London. ‘The rate has existed for 30 years – when it was invented, there was an interbank market and that was how banks funded themselves. That’s no longer the case – banks’ funding models have completely changed,’ she says.

‘With LIBOR, the number of transactions, even in the most frequently traded LIBOR maturities, on most days is tiny,’ adds Meloni, who co-chaired a panel session on LIBOR at the 36th IBA International Financial Law Conference (IFLC) in Berlin in May.

Jim Ho, a partner at Cleary Gottlieb in London – one of the panellists on the IFLC session – also highlights this problem. ‘Ultimately, there’s simply not enough depth of transactions that feeds into LIBOR submissions,’ he tells Global Insight. ‘Since 2012, steps have been taken to fix LIBOR by improving governance and oversight. And yet, unsecured borrowing transactions between banks have dropped, reducing the size of the underlying market underpinning the rate.’ He gives the example, of the underlying daily transactions for the three-month US dollar LIBOR being less than $500m, when there are $200tn of loans, bonds, derivatives, mortgages and other financial products referencing LIBOR.

Risk-free alternatives

The end of LIBOR may be in sight, but what’s less clear is what should replace it. Risk-free reference rates (RFRs) could offer the best solution. These rates are considered harder to manipulate as they are based on actual market transactions, as opposed to the quotes that panel banks submit to compile LIBOR.

‘The change to risk-free rates is the next step in the process of moving away from a rate that has very little basis in terms of underlying trades,’ says Stephen Powell, a partner at Slaughter and May in London, who is on the IBA Banking Law Committee’s Advisory Board. ‘The sheer number of people thinking about this initially at financial institutions and now also at corporates is quite amazing.’

The Bank of England-backed Working Group on Sterling Risk-Free Reference Rates – a group of major dealers active in sterling interest rate swap markets – has backed the Sterling Overnight Index Average (SONIA) as the best alternative. SONIA is a measure of the price at which banks and building societies lend to each other.

New bonds referencing SONIA have started to emerge. Lloyds offered the first in September 2018, followed by Santander and the Royal Bank of Canada. ICE and CurveGlobal, a venue owned by investment banks and the London Stock Exchange Group, have begun trading SONIA futures to establish market pricing.

In the US, the Alternative Reference Rates Committee has chosen the Secured Overnight Financing Rate (SOFR), a Treasuries-based repo rate that will reflect the cost of borrowing cash secured against US government debt. A repo, or repurchase agreement, is a secured loan; one party sells a security to another party and agrees to repurchase it later at a set date and price. As repos are a key source of short-term funding in the financial system, a rate based on these transactions is seen as a good candidate for an alternative reference rate.

‘Both of these benchmarks have the benefit of being anchored in significantly more active markets than term LIBOR,’ said the FCA’s Chief Executive Andrew Bailey. ‘Neither involves expert judgement. In both cases, issues about fairness with regard to who is on or is not on panels fall away, as transaction data are collected from all relevant market participants by the relevant central banks. The Euro OverNight Index Average (EONIA), Switzerland’s Swiss Average Rate Overnight (SARON) and Japan’s Tokyo Overnight Average Rate (TONAR) also benefit from being anchored in overnight markets.’

The RFRs will have a greater set of observable transactions and will provide a more robust and measurable benchmark, says Ho. ‘For example, SOFR has volumes of in excess of $700bn on a daily basis.’

However, a recent study by the International Swaps and Derivatives Association shows that the interest rate derivatives market continues to rely on the old benchmark. Just 2.5 per cent of the $70tn of contracts traded in the first quarter of 2019 were tied to LIBOR’s potential replacements such as SONIA and SOFR.

The financial markets are currently working out how to construct a fallback rate, derived from the RFRs, which is economically equivalent to LIBOR for legacy contracts.

‘An RFR is a different animal to LIBOR, both operationally and economically,’ says Meloni. ‘RFRs are generally backward-looking overnight rates. They are not available like LIBOR over a range of maturities, and importantly, they do not include the same measure of bank credit risk premium. LIBOR was designed to represent banks’ funding costs in the London interbank market. An RFR represents a theoretical rate of return an investor would expect from an entirely risk-free investment over a specified period of time.’

The LIBOR legacy

According to Ho, in certain pockets of the market, there’s still limited understanding of the need to prepare for a post-LIBOR world. ‘Market participants aware of the issue are still nervous about moving too quickly too soon,’ he says. ‘We’re at the stage where we have figured out, for the most part, the known unknowns. Steps can be taken incrementally, like getting organised and identifying key risk areas in the first instance. You don’t want to wait until it’s too late.’

The level of preparedness depends on the particular financial market, adds Lawrance. ‘In the loan markets, the process of preparation is ongoing because a term LIBOR replacement rate has yet to be adopted. The derivatives market appears to be further advanced given its familiarity with SONIA, which is likely to form the basis of any LIBOR substitute.’

Moving away from a rate referenced in so many financial instruments around the world will inevitably be a long and complex process. This prompts the question of whether it’s useful to be talking in terms of deadlines.

‘There are challenges ahead of us, ranging from concerns about value transfers to how we deal with legacy contracts,’ says Ho. ‘Some cash market participants are also finding it difficult to adapt to an overnight rate. But do we really need a forward-looking term rate, or is it just something we are used to? Change is scary, but it’s not insurmountable. This is an opportunity for all of us to rethink how we use the benchmarks.’

Without a deadline, it’s possible that preparations for the post-LIBOR era would never have started. In Switzerland, for example, it was clear for some time that the TOIS reference rate wouldn’t survive. But only once a date was agreed for its termination – 29 December 2017 – did serious work on the move to SARON begin.

‘The due diligence exercise for each market participant is so enormous… if there wasn’t a deadline, I don’t think they would ever get to the end of it,’ says Meloni. ‘There would be a temptation to let LIBOR exposures run off and that would mean you might end up supporting LIBOR for the purposes of legacy exposures for 20, 30 or even 50 years.’

The legacy of LIBOR may extend beyond 2021, adds Lawrance. ‘If there’s a material transfer in value between the parties as a result of the substitution of LIBOR for another rate, or if one of the parties sees it as an opportunity to re-trade an existing deal, it’s not too much of a leap to see how this will lead to litigation,’ he says.