In this post, the first of a series of posts addressing the end of Libor and her relatives, we look at where Libor came from, why it grew to such ubiquity, and where its flaws impact the stability of the whole global financial system. In future posts we’ll discuss what’s happening to these benchmark rates, and how this will impact financial markets.
In essence, we try to understand what’s likely to happen to an icon of modern finance.
The foundations of LIBOR
The most common interest rate benchmark used worldwide for loans from mortgages to credit cards, LIBOR was formalized by the British Bankers Association (BBA) back in 1986. LIBOR stands for London Inter-Bank Offered Rate and was intended to represent the interest rate that major banks can borrow from one another, unsecured for maturities up to one year in five major currencies (USD, EUR GBP, YEN, and SFC). Since reforms in 2013, these maturity points are limited to seven active dates, including overnight, with another eight inactive. For each maturity, a rate is calculated by averaging (with cut offs) the up to 20 submissions from “panel members” before 11am each morning, to generate “fixings”. Importantly, LIBOR is an unsecured interest rate, where no collateral is exchanged, calculated from the surveying of panel members’ voluntary rate estimates.
The “ibor diaspora” – LIBOR, TIBOR & EURIBOR et al.
Once upon a time, interbank lending formed the basis for global finance. The onset of the offshore Euro-dollar market in the 1980s propelled London as a convenient center of global finance, and LIBOR as THE benchmark interest rate upon which much of this finance was based. By the 90’s, as other financial centers grew to compete with London, so too did the diaspora of inter-bank benchmark rates (ibors), with descendants in Tokyo (TIBOR), Honk Kong (HIBOR), and Shanghai (SHIBOR) to name a few. In 1999 the birth of the Euro currency fostered the creation of a European competitor, EURIBOR, the off spring of the union between Paris’s PIBOR and Helsinki’s HELIBOR. It’s important to note that these are NOT directly related to LIBOR, but instead distant cousins, each with their own regulators. Each face their own reform (separate from LIBOR) and in some cases, (e.g. EURIBOR) have grown to become more important than the comparable (EUR-LIBOR) market. As such, we have tried to distinguish the LIBOR reform, and its impact on markets, from any comparable reform process in one of the “descendants”. In some cases, for example in Europe, LIBOR reforms will have a minor impact of the local financing markets, relative to EURIBOR reforms. And in others (e.g. Switzerland) non-LIBOR reform processes might pave the way for successful LIBOR reform.
In the exhibits in this post (Appendix 2), we’ve combined the markets within a currency regime (e.g. in Euros, EURIBOR and EUR-LIBOR) and provided estimates of their share relative to LIBOR.
LIBOR’s troubled past
The fundamental problem with LIBOR is the lack of transactions used to validate the rate-submissions upon which the official fixing rates are based. Even in its heyday, there were few inter-bank unsecured transactions, but this weakness was really highlighted during the crisis. Since then there has been only a handful of transactions per year – the “I” in LIBOR is missing in action – and the rates were considered to lack “transactional validity”. Consequently, larger banks could collude in fixing the rates to favor their own LIBOR-linked portfolios. However, given the submissions are supposed to reflect where banks would “bid between one another for unsecured funds” there is an element of “credit assessment” built into the rates. If a bank is struggling for funds, and its LIBOR submissions reflected that, it could trigger a run on the bank. This was the consideration during the 2008 crisis when it was felt that some banks held their submissions down to deflect credit concerns, and after the crisis, an investigation into this practice unearthed broad collusion. The result was large fines for many US and European banks, and jail terms for individuals. LIBOR had indeed become “LIEBOR”. These scandals continue to tarnish LIBOR and damaged any reform attempts, and on August 17th, the US FDIC filed a fresh lawsuit against a number of European and UK banks, resurrecting the scandals.
Can’t we just forgive and forget, and move on with LIBOR?
In 2013 governing bodies began to attempt reforming LIBOR with the aim of increasing transactions. The plan, employing new globally agreed principles, was too optimistic and failed, forcing the FCA’s hand. Unfortunately, replacing LIBOR will be no easy task. The FCA have set a target date of end-2021, only just over 4yrs away, by which time any remaining players will be on their own, losing the official backing of the FCA. Without it, rational actors are likely to have moved onto a fresh benchmark.
Currently LIBOR is everywhere, estimated by some to be the basis for more than $350 trillion in securities and liabilities. It is the basis for estimating funding, and therefore the valuation, of the majority of debt securities, either explicitly (interest paid tied to LIBOR) or implicitly (using LIBOR to determine the financing of non-LIBOR-related securities). More conservatively, using largely 2012 data as analyzed by Duffie and Stein in 2015 the direct exposure to USD LIBOR was estimated to be around $152 trillion.The details across markets are somewhat illuminating, take for example in the US$ LIBOR markets (Exhibit 1 table below). The underlying industry report they use also estimated the average roll-off periods for the various asset classes, which may give one an idea of how much of this exposure will have naturally rolled off before the proposed end date for LIBOR. For example, exhibit 1 (below) shows that 90% of syndicated loans were expected to roll off within 5yrs of 2012. Therefore, we can expect a large portion of syndicated loans to be “naturally” renegotiated before the 2021 date, perhaps to a new benchmark rate, were one to exist. Conservatively, we can estimate that 76% of the US$152trn will have rolled off within 5 years, and as such, can be renegotiated naturally within the 2021 deadline. Similarly, taking FCA’s lead, local regulators could (though under no requirement to do so) initiate capital penalties which penalize LIBOR-related transactions in favor of those related to other benchmarks, providing “moral suasion” to migrate.
While some in the financial markets have promised to “eat their hat” if LIBOR ever disappears, we can see no clear evidence that we shouldn’t take the FCA at their word. Therefore, perhaps it’s best to expect that sometime around 2021, perhaps with a short delay, LIBOR will have retired
How could such a flawed instrument have become so ubiquitous?
The fact that the air might be bad always makes way for the aversion to suffocation, as inhabitants of several countries will testify. As LIBOR lending markets grew in the 1980s and 1990s, so too did financial sophistication and hedging practices, fueling a boom in interest rate derivatives. Much of the products were LIBOR-linked, and the growth in volumes ensured that LIBOR-linked products were where the liquidity was. It was arguably these derivative transactions that provided the transactional validity that LIBOR progressively came to lack. And in doing so, ensured the success of such a flawed instrument.
In each subsector of the US$ market, LIBOR grew in importance, helped by this derivatives boom. For example, the 3-month Eurodollar interest rate futures markets are directly linked to US$ LIBOR and became the main hedging vehicle for shorter-dated dollar liabilities. The FX market used LIBOR term rates to calculate the hedge costs in the forward markets. And the interest rate swap market, the biggest in the World, was generally related to LIBOR. To that end, one swapped between a fixed rate cash flow and a LIBOR-related cash flow. The open interest and volumes traded in each of these markets swamp by many times, that of any other similar market, with the exception of EURIBOR, to which we’ll return shortly. The recent problems with LIBOR have propelled the growth in other markets, particularly the Overnight Indexed Swap (OIS)-related swap markets, and some funding has already switched to these forms. But LIBOR-related derivatives remain the principal form of hedging, sustaining the LIBOR dominance.
EURIBOR has long been the biggest competing benchmark to LIBOR, the market where Eurozone banks offer to lend unsecured EURO funds to other banks in the interbank market. It is outside the FCA regulatory remit, instead administered by the European Money Markets Institute (EMMI) and is now large, having successfully absorbed the Euro-LIBOR market which has largely disappeared. Comparable numbers for the exposure to EURIBOR benchmarks was around USD 220 Trillion in 2012 (Appendix 2). EURIBOR, being an unsecured benchmark, has also suffered from minimal transactions and panel bank defections. To that end, it is equally flawed. In May 2017, the EMMI announced their previous attempt to move to transactions-based pricing had failed and they would seek “hybrid” solutions. Part of that hybrid will no doubt include the newly announced ECB-published euro unsecured overnight interest rate. This benchmark rate is targeted to appear in 2020 after up to two years of market consultation and based upon data they already collect. However, with so few unsecured transactions taking place such that the EMMI’s reform of EURIBOR has stalled, it’s uncertain this new ECB rate will attract enough liquidity to take over. In sum, we could end up with three (EURIBOR, EONIA and ECB) weak and ineffective benchmarks. In sum, the EURIBOR reforms may be floundering too. We discuss EURIBOR and the new ECB rate in greater detail amongst the market impacts section below.
So, in addition to the LIBOR challenges, we find EURIBOR in disarray. Together, it’s estimated that the LIBOR and EURIBOR markets impact between USD360-600 Trillion of securities. This remarkable number embodies the size of the challenge faced by the World’s regulators and the financial markets they serve.
Exhibit 1- Source -Adapted from Market Participants Group on Reforming Interest Rate Benchmarks 2014 Note – Syndicated and Corp Business Loans overlap.
|Exhibit 1: USD LIBOR Market Footprint by Asset Class
|Volume (USD Bill)
As of 2012
|% of LIBOR-related||Estimated exposure to LIBOR||Percent Roll-off after 5-years|
|Corporate business loans||1,650||30-50%||660|
|Non-corporate business loans||1,252||30-50%||501|
|Commercial real estate/Commercial Mortgages||3,583||30-50%||1,433|
|Floating / variable rate notes||1,470||84%||1,235||73%|
|Forward Rate Agreements (FRAs)||29,044||65%||18,879||100%|