Twilight for the Libor Era”
A recent overhaul of the Libor regime may prevent further rate rigging scandals, but Libor itself is diminishing in relevance for the financial markets. Treasurers need to be prepared to deal with new industry benchmarks and the wider consequences of a move to a collaterised world, reports Ben Poole.
Over the past 12 months the London Interbank Offered Rate, better known as Libor, has regularly hit the headlines in both the financial and popular press for all of the wrong reasons. A number of banks were implicated in the Libor rate fixing scandal that broke in 2012, leading to highprofile departures from the institutions involved and, more importantly, the Wheatley Review into the benchmark rate in the UK. The Review recommended reform plans for Libor, which were implemented on 1 April 2013, the same day that the UK’s regulators themselves re-launched.
The UK Financial Services Authority (FSA) has given way to two bodies: the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). The recommendations for the new Libor regime itself included having benchmark administrators to corroborate submissions and monitor for suspicious activity. Data submitters will be subject to new systems and controls and a conflict of interest policy, while both groups will be subject to an approved persons regime. As well as these proposals, aimed at preventing rate rigging, it was also recommended that the British Bankers’ Association (BBA) put to tender the role of Libor administration and governance. This potentially leaves the way clear for national central banks to set the reference rate for their relevant domestic currency.
Beyond the rigging scandal made headlines, there were fundamental issues with Libor that are now seeing it contract from being the predominant benchmark in the fixed income interest rate derivatives market. Libor is the rate at which banks say they can borrow from each other, so it is not a market traded number but rather a survey. The fact that Libor does not reflect an actual market price is part of the problem. “I would say that the days of Libor are beginning to come to an end, although it will take a while,” says Kevin Lester, director, risk management and treasury services at Validus Risk Management. “While it is still very much the dominant benchmark in the interest rate market, the winds of change are blowing and it is only a matter of time until Libor diminishes significantly.”
There are three key reasons why the era of Libor is ending:
Libor is an unsecured lending rate: The volume of unsecured interbank lending dropped significantly after
the Lehman crisis. If you have a benchmark that is based on a specific market where the liquidity has dried up, it will quickly become less relevant.
Libor rigging scandals: The most public reason for Libor’s diminishing position, these have undermined confidence in, and the integrity of, the benchmark. A number of banks have admitted to manipulating the Libor rate, either for their own benefit or that of individual traders. This erodes trust in the system, particularly when the number is survey-based rather than traded.
Futurisation of the derivatives space: Derivatives are being moved on to exchange and central clearing, and participants are increasingly collateralising trades. As this trend continues, the relevance of an unsecured lending rate such as Libor is diminished. Market participants want something that better reflects the risks involved in their transactions
The market is now looking for alternatives to fill the role of Libor. What happens here will redefine how the market benchmarks pricing and will have a direct effect on the way that treasurers operate.
Effect on Corporate Treasury
Two main categories are most relevant for corporate treasurers as the significance of Libor decreases. The first can be seen as an operational impact. Treasurers who use Libor benchmarks for loans will have to find new benchmarks – and quickly. Following on from the Wheatley Review some Libor currency rates will disappear, which is happening imminently in certain cases. If you have an Australian dollar or Canadian dollar loan, you won’t have a Libor rate for much longer and will have to find a new rate to use.
The second impact for treasurers to be aware of is that the underlying methodology used to calculate the value of derivatives is changing. In the past, a treasurer valuing a swap would have a single curve, with the main question being what instruments they should use to build that curve. They might choose deposits on the short end, futures in the medium and swaps on the long end of the curve. The new way of doing this, already introduced, is using an Overnight Indexed Swap (OIS) curve.
The OIS rate has become the new market standard for pricing of interest rate derivatives. In simple terms, OIS is a swap between two financial institutions where the floating leg of the swap is based on an overnight rate – such as the Fed Funds Rate or the Euro OverNight Index Average (EONIA) in Europe. It is an actual transacted rate, and so is unlike Libor in that respect. “The liquidity in OIS is pretty good up to two years,” says Validus’ Lester. “Beyond two years it depends on the currency; in the euro you can go a lot longer, whereas with the US dollar you cannot go so long. It is a traded rate that you can use to build a curve and value a swap by it. That change in pricing has happened.”
Valuing a swap the old way, using a Libor and deposit rates, and then the new way with OIS, may produce material differences in the valuation. Within the area of what is possible for a long-term swap this could be 5% or more, potentially producing many knock-on effects. The shift to OIS has already happened on the sell side, so banks are already pricing things this way. It is important for treasurers to incorporate the importance of OIS in asset pricing, or their quoted swap price from a bank may not match their expectations due to the two calculations using different methodologies. This can have an immediate impact; maybe the deal does not get done as a result or the treasurer is reluctant to proceed with it.
General mark-to-market (MTM) calculations will be influenced by this. “Interestingly, in terms of hedge accounting, the expectation is that the US Financial Accounting Standards Board (FASB) will shortly announce that you can use OIS rates as a benchmark for your derivatives for hedge accounting, which isn’t the case currently,” says Validus’ Lester. “This will be a clear confirmation of the trend towards OIS.”
There is potential for unintended consequences from the Libor reforms if corporate treasurers doggedly stick to using this rate as their main benchmark. If the BBA cedes responsibility for setting the reference rate in a particular currency to the country concerned, this could theoretically cause as many problems as it solves. “The rates would then be set by the five biggest banks in the countries concerned,” says Bob Lyddon, central office coordinator at the International Banking (IBOS) Association.
“For example, Canadian dollars would be set in Toronto by Canadian Imperial Bank, Toronto Dominion, CIBC, RBC, ScotiaBank and the Bank of Montreal. Euro Canadian dollars would not drift 2-4% compared to what was on offer in Toronto, but does that then mean that a corporate treasurer based in the UK should actually borrow from a Toronto branch of those banks, rather than from London, to ensure that they do not experience any anomalies?” This, in turn, could throw in to question whether they are able to borrow without all of the problems associated with cross-border lending, such as withholding tax, exchange controls or other anomalies.
Putting the anchor point for each currency back in the country concerned, where market dynamics are geared to what is happening domestically, rather than the concerns of the borrower elsewhere in the world, could well impact on market integration. “For big currencies such as the respective dollars of New Zealand, Canada, Australia, Singapore and Hong Kong – where there is an established market in London and a Libor rate set – to unwind that is like taking a step back 20 years in terms of market integration,” says Lyddon.
This then raises the question of whether treasurers will find themselves facing a policy decision around whether they want to risk having drawings on currencies where they do not know whether the reference rate will be acceptable and there is no alternative. If the choice is in US dollars, euros or pounds then there will be choices, other instruments,
big markets and different players. But outside of these currencies a different approach – as opposed to the general trend towards treasury centralisation – may be required. “Treasurers at the centre could be faced with the reality that rates available to them are not better than those available to their subsidiaries,” says Lyddon. “In order to fulfil requirements such as transparency and being close to the market, the subsidiary treasurer role for specific currencies could become paramount.”
It could also be argued that the move towards collaterised deals could lessen the appeal of centralisation. A major benefit of viewing the corporate financial situation from a global rather than a social basis is the ability to identify where they might obtain cheaper funding. “If a treasurer based in Zurich sees the opportunity for cheaper funding in Japan, for example, they will issue a bond there, do a cross-currency swap and get the cash in euros or another desired currency. In the new world, this will become much more expensive,” says Lester. “When long duration derivatives are to be collateralised, the treasurer can lock in a rate for 10 or 20 years using a cross-currency swap, but the costs of doing this will be going up a lot in the new environment. As a result, it may well be cheaper to borrow locally.”
There is a case for stating that other branches of new or reformed financial regulation are having a similar effect to the new Libor regime when it comes to unwinding. Basel III, the single euro payments area (SEPA), the stress tests of the European Banking Authority (EBA) and reviews of banking systems such as the UK’s Vickers Report all contain elements to that respect.
“These sources are not acting in concert, and the results will likely be loopholes and grey areas,” says Lyddon. “This is the case in Libor where the dogmatic solution to the rigging – not to concentrate responsibility for rate setting in any one
place – causes as many problems and has as many negative impacts as it does positive. It’s all about parochialism really.”
While recent changes to governance of the Libor regime are designed to create more transparency, accountability and security for the benchmark, the bigger picture is that Libor was diminishing as a relevant benchmark even before the rigging scandal broke. The fact that it is an unsecured lending rate rather than a traded figure, together with the futurisation of the derivatives space, have seen alternative rates such as OIS become far more relevant to the markets in the current environment.
For corporate treasurers, these changes in the world of financial benchmark rates need monitoring closely. From an operational standpoint, they may literally find that Libor rates no longer exist for some currencies they are funded in, while the change in methodology behind how the value of derivatives are calculated needs to be understood and implemented in order to avoid surprises in price points when speaking to banks.
Beyond these current impacts, the ‘what if’ spectre of enforced decentralisation lurks in the regulated unwinding of certain markets. To be as prepared as possible for any eventuality, treasurers need to continue to study