A surprise reprieve from regulators has spread relief around banks, asset managers and borrowers that were struggling to figure out how to wean themselves off the tainted and outdated US dollar Libor benchmark.
The rate, which measures the cost of unsecured borrowing between banks, is due for extinction in most currencies at the end of 2021. But embedding an alternative in the US is particularly tricky, given the sheer size of the task. The New York Fed estimates $200tn of derivatives, loans and bond contracts are tied to dollar Libor — far more than for any other currency version.
Reflecting the scale of the challenge, IBA, which compiles and oversees the rate, this week said it planned to publish daily rates for the most widely used dollar benchmarks until the end of June 2023 — 18 months later than originally planned.
The move, supported by global authorities including the Federal Reserve and the UK’s Financial Conduct Authority, formed a marked contrast to the previous hardline stance against shifting the end-2021 deadline.
“I was very surprised by it. I think everybody was. They had been adamant about 2021 being the actual end date,” said Dan Krieter, an analyst at BMO Capital Markets.
Regulators have repeatedly warned the financial sector that Libor, which formed the heart of a trading scandal in 2008, must die. Concerns among banks that flipping to a new rate could cause disruption have largely been swatted away.
In part, that is due to regulators’ frustration with traders who had previously attempted to manipulate Libor to their own advantage. But it also reflects a concern that Libor represents a market that no longer exists. Daily rates are compiled largely by estimates, not real market transactions.
Authorities have left it to banks to figure out how to make the switch without leaving customers short-changed or with contracts they did not want, such as receiving fixed-rate instead of floating-rate payments.
That has left the market needing to change thousands of contracts to use a different lending rate, or add fallback terms including a clearly defined alternative rate after Libor's demise.
US dollar Libor has been particularly problematic. It needs to move to an entirely new rate — such as the Secured Overnight Financing Rate (Sofr) — rather than an enhanced existing rate, which has been the case in other currencies. Take-up has been slow.
The authorities’ leniency on Monday was a “prudent step”, said the Bank Policy Institute, a US financial services lobby group. It was also a shock: hedge funds that had placed bets in short-term lending markets to exploit profitmaking opportunities during the switchover were left scrambling to unwind them.
Many are hoping the extension period will mean most existing Libor contracts simply expire before they need to be converted. Deepak Sitlani, a lawyer at Linklaters in London, called it a “mini-reprieve”.
“The sting in the tail is that it’s only for legacy positions,” he said. “The grey area is: ‘how hard do you want to try to move off US dollar Libor positions?’”
The Federal Reserve said “most” contracts would mature before this kicks in.
Barclays estimated 41 per cent of the $330bn of outstanding US investment grade dollar floating-rate notes mature before the end of next year. The delay would raise the proportion that mature before the deadline to 80 per cent. Of the remaining $66bn in notes that mature after June 2023, nearly 72 per cent include language that provides better fallback language for investors, the bank said.
In the loan market, 90 per cent of existing US leveraged loans have a maturity after 2023, according to the Loan Syndications and Trading Association. The extension gives time for those loans to be refinanced and set against a new interest rate.
“We had concerns that we had tens of thousands of loans that needed to transition from Libor to Sofr in a short period of time,” said Meredith Coffey, executive vice-president of the LSTA. “What we hope now, with this longer window, is that more loans will refinance into Sofr organically.”
A delay buys time. Only 400 out of 2,800 corporate groups had taken up the new derivatives industry protocol that incorporated fallback language into contracts, the Commodity Futures Trading Commission, the US regulator, said last month. Politicians will also have leeway to pass legislation that covers Libor contracts that extend beyond June 2023.
Meanwhile, derivatives of Sofr — crucial to setting its level — remain poorly used. In October less than 10 per cent of US interest rate swaps deals used it, according to data from Isda and ClarusFT, a UK consultancy. In contrast 40 per cent of sterling swaps used an overnight rate, they found.
Andreas Wilgen, an analyst at rating agency Fitch, said the slow take-up reflected a “wait-and-see” approach from some market participants and a recognition that Sofr, being an overnight rate, was fundamentally different to Libor, which combines borrowing costs with a measure of banks’ creditworthiness. An extension would not automatically mean a smooth transition in mid-2023, Mr Wilgen said.
Authorities were keen to stress they did not want market participants to slacken the pace of preparation for the Libor switchover, warning that they would be watching closely for signs banks were embedding Libor in new contracts beyond the end of 2021.
The toughened language “if anything marginally added to the urgency around the transition process”, said Blake Gwinn, head of short-term rates at NatWest Markets.
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