Central banks ready to break swap market's Libor habit

Policy-makers are not content to leave the interest rate derivatives market anchored to Libor and its family of benchmarks, preferring the idea of a multi-rate world. But getting from here to there will require the market to be pushed, and could also fragment liquidity. Joe Rennison reports

Federal Reserve

Libor is bad for you. Market participants know it, but lack the willpower to do anything about a reference rate that anchors roughly 60% of over-the-counter interest rate derivatives, so central banks and supervisors are going to help users kick the habit. And they don't care how unpleasant the withdrawal symptoms are.

That, in a nutshell, is the message of a July report prepared for the Financial Stability Board by 21 high-ranking officials from 11 countries – the Official Sector Steering Group (OSSG). The report lists a series of potential drawbacks involved in breaking away from Libor – higher costs, less liquidity, the need for a new family of basis swaps to help manage the exposures that will appear in a multi-benchmark world – but sticks to its guns. In short, the OTC and listed interest rate derivatives markets can no longer be allowed to rely on the far smaller volume of trades seen in interbank lending, the OSSG insists, and participants should instead be helped to migrate to a reformed Libor benchmark and a variety of others that are closer to risk-free.

"It is important this happens," says one OSSG member. "The reputation risk inherent to Libor is too great. The real economic damage of recent scandals is not the point. Should another scandal hit, who knows what will happen? It would be terrible. We have to hedge for this possibility."

Selecting and implementing the hedge will be the trick. In sections dealing with each of the OTC market's five major currencies, the relevant authorities first suggest suitable risk-free rates – a total of 16 are mentioned, ranging from central bank rates to repo and overnight indexed swap rates (OIS) – and then outline the powers they have to push the market in this direction. For both sterling and yen, the phrase ‘moral suasion' is used; the UK authorities say they will "consider whether it is feasible to issue recommendations to UK-regulated firms to move derivatives to a risk-free rate". Jerome Powell, member of the Board of Governors of the Federal Reserve System and co-chair of the OSSG, tells Risk the central bank "will help" banks understand the current situation is not good for them (see box, Fed's Powell: "we will help them understand").

Some ideas are more radical. US authorities hold out the possibility of using "official sector influence" on central counterparties (CCPs) to ensure higher margin requirements where trades do not use benchmarks that meet standards laid out by the International Organization of Securities Commissions. Risk understands CCPs were not consulted on this proposal before the report was published. "That's crazy. That's not what margin is for," says one head of OTC clearing at a European bank.

We have no reason to think they will resist this and drag their feet

Whatever tools are used, there is a conviction that the market cannot be expected to migrate naturally to a multiple-rate world – Libor may be flawed, but it offers unrivalled liquidity, and many of the mooted alternatives are either immature, untested or in some cases non-existent. The OSSG report repeatedly refers to a companion study prepared by a mixed group of derivatives users – the market participants group (MPG) – which also concludes a multiple-rate world is the way to go and endorses the idea that central banks and supervisors may have to push and steer this transition.

"We agreed that while there is already an attraction for alternative benchmarks for market participants, there probably is not enough attraction to move liquidity over until it is already there. So official sector support may be needed to get the things moving," says Darrell Duffie, professor of finance at Stanford Graduate School of Business and co-chair of the MPG.

A variety of alternative reference rates for derivatives products already exist, however, including constant maturity swap (CMS) and constant maturity treasury (CMT) rates, as well as Eonia, the Federal funds effective rate, Sonia and other OIS rates. Some of these are healthy markets, but none have the scale associated with Libor – according to the OSSG report, roughly 65% of the $171 trillion notional of US dollar OTC interest rate derivatives are linked to Libor, along with 92% of the $32.9 trillion in listed derivatives.

That prompts some sceptics to ask whether regulatory intervention can work if the alternative benchmarks have already been tried, tested and have ultimately not taken off.

"If you come in as a regulator and try to install something artificially, then people will wonder why. I do not think an imposed benchmark can possibly succeed. There has to be a desire for it," says Robert Emerson, head of fixed income and interest rates at software vendor SuperDerivatives. "And we already have a number of indexes. We have Libor, CMS, people still even trade CMT. There's Eonia, Sonia, base rate swaps. There are OIS swaps that are quite liquid – you can trade any size of Fed funds OIS swap out to five years. There are many benchmarks already."

The Fed's Powell is not expecting outright opposition, arguing the dealers in particular understand the need to change: "We have every reason to think they want to move to a new rate and so we have no reason to think they will resist this and drag their feet," he says.

A second group of problems arises at this point, however. Assuming derivatives users move to a multiple-rate world, liquidity will end up being split across a variety of benchmarks. This has a number of consequences. First, not only will a liquid market need to exist in each of the new benchmarks, but dealers and other market participants will in some cases need to hedge the basis that exists between them – so swaps will need to be called into existence that allow a floating Libor rate to be exchanged for a floating repo reference rate, for example. This could be a particular challenge for smaller jurisdictions.

It is an issue the Mexican central bank is already considering, says Julio Santaella, director of operations support at the Banco de México and member of the OSSG. As things stand, peso-denominated swaps reference the tasa de interés interbancaria de equilibrio (TIIE) – a Libor-like composite of bank quotes. The rate is based on executable quotes submitted to the central bank by 15 institutions, with seven of those chosen at random. If the difference between the highest and lowest quote exceeds a certain threshold, then the central bank will execute a loan with one of the outlier banks and a deposit with the other – a mechanism designed to keep the system honest.

"Our local reference rate is robust, but we are also reviewing the possibility of having at least two reference rates, as the FSB is recommending. Maybe that would be better," says Santaella.

A basis market already exists between TIIE and US dollar Libor. If new rates are introduced in both the US and Mexico, a total of six basis swaps may be needed – four to connect each of the two US dollar and peso rates, as well as one to connect the peso benchmarks, and another for the US dollar benchmarks. As new benchmarks are added in other currencies, the same kind of proliferation would, in theory, occur.

"There is some concern about this, but the OSSG recognised the issue and we think these markets can develop. We have been surprised to see the TIIE markets grow exponentially, so we wouldn't be surprised if we can develop the basis markets in one or two years," says Santaella.

This process will further sap liquidity from Libor products. "That's the hope," says Stanford University's Duffie. Some corporates worry this will drive up hedging costs, but Duffie does not buy it. "We have several hundred trillion dollars in Libor-linked trades. If you cut that down to even just 100 trillion, say, I still don't think corporates are going to struggle to get large trades through. I think the risk is that we don't pare it down enough rather than paring it down too much."

That might be true for liquid tenors in major currencies, but for less-liquid tenors or less-liquid currencies, the OSSG recognises participants may end up trapped in markets with rapidly dwindling liquidity, and rapidly rising trading costs. "Some participants may not have the ability to change their contracts. As benchmark use moves to alternatives, those participants may suffer from reduced liquidity and transparency and increased hedging costs," says the report.

Despite its support for a multi-rate approach, the MPG also highlights potential "reluctance among market participants across regions to move to an entirely new benchmark", over fears that the costs would outweigh the potential benefits.

This is borne out by the patchy adoption of OIS as the correct discounting rate for cash-collateralised trades. While the biggest dealers and buy-side firms switched away from Libor from 2008 onwards, many firms have not followed suit. A recent derivatives survey published by actuarial and consulting firm Milliman found roughly half of the 67 insurance company respondents were not planning to do so.

"Look at how much confusion switching from Libor to OIS is causing for discounting," says Ram Kelkar, principal and managing director of the capital markets group at Milliman in Chicago. "As our survey findings indicate, many insurers are not yet valuing swaps using OIS, which you would think would be the norm. My concern is that if it is taking so long to gain industry acceptance for a relatively well-understood rate, then how is this move to non-OIS benchmarks for the UK and US going to help meet the stated goals of achieving reliable and robust benchmark interest rates?"

Prosaic concerns about the back office, and systems upheaval, will add practical complexity to the FSB's aims. Some feel these costs can be limited by getting widespread buy-in for changes from larger buy-side participants and dealer banks, allowing smaller derivatives users to continue to function in much the same way as they do now. Banco de México's Santaella reiterates the FSB's commitment to ensuring costs do not become excessive and that time is given for the market to adapt.

Despite the potential drawbacks listed in the report, the OSSG does not flinch. The number of banks participating in the Euribor process has fallen from 41 to 26 in less than three years, according to one member of the OSSG. For Santaella, it's indicative of the potential risk of inaction.

"The material impact of Libor manipulation may not be that large, but the potential loss of reputation and the escalation of losses could in principle be so high. People continued to trade Libor because they had no alternatives, and now regulators are required to instill confidence in the governance of interest rate benchmarks once more," he says. "That is why reform is so important."

BOX: Fed's Powell: "we will help them understand"
Of the five currencies on which the Financial Stability Board (FSB) report focuses, authorities in the US were singled out as having "a stronger willingness to intervene to facilitate a solution" – meaning they are more prepared to push derivatives markets away from Libor.

The notional volume of outstanding financial contracts linked to US dollar Libor – including over-the-counter and listed derivatives as well as loans and other products – is estimated at up to $160 trillion, making it the largest market for Libor-benchmarked products.

So what is the Fed planning to do? Jerome Powell, one of five current members of the Board of Governors of the Federal Reserve System, co-chaired the official sector steering group (OSSG) that compiled the final FSB report. Despite the report's strong language, Powell does not envisage an uphill battle to convince market participants of the need to move towards alternative reference rates.

"We think market participants, particularly the dealers, understand – and we will help them understand – that the current situation is not a good one for them," he says. "The underlying incentive structure is that the volumes of derivatives written on Libor are much greater than the volumes in the interbank funding market, so that creates incentives to manipulate the funding market. That is not good. And we think the firms get that. We have every reason to think they want to move to a new rate, so we have no reason to think they will resist this and drag their feet."

But the market will not move away from Libor by itself. More than anything else, that requires co-ordination, says Powell. "Who will write the first contract? How liquid is that going to be? The co-ordination problem will be to ensure there is adequate liquidity for the new rate. We intend to play a role in making sure that happens. We need to get to a place where a significant number of derivatives are written on the risk-free rate," he says.

The surprise contender for the risk-free rate – or rather, more risk-free than Libor – is one based on general collateral repo markets. This blindsided some market participants, who assumed the Federal funds effective rate (FFER) would be the frontrunner. FFER is the overnight rate paid by banks to trade balances held at the Fed, and is already used in the overnight indexed swap (OIS) market, or when discounting US dollar cash-collateralised trades. The accompanying report from the market participants' group (MPG), though, says it would "hesitate to recommend" the rate because it is based on a relatively narrow set of transactions – and it even warns the OIS market may need to look for a different overnight rate if concerns about its robustness "cannot be eliminated".

A decision about the best risk-free rate will be made on the basis of the Federal Reserve's ‘2420' collection of transaction data. The central bank began collecting data in April this year and is expected to have enough information for a preliminary assessment by mid-2015. The process will also enable the Fed to consider whether Libor can be moved away from panel-based quotes, to a rate based purely on transaction data.

"We need to look at how it behaves at various times of the year, in times of stress and no stress," says Powell. "If we push for a purely transactions-based dollar Libor, it has to work. It is very important this is done right rather than superfast. We will live with this decision for a long time. I expect the answer to be that we can do this - but can dollar Libor be a fully transaction-based, non-panel-based rate? That is not assured, but that is what we are shooting for."

Basing Libor on actual transactions is likely to make the reference rate more volatile – a point recognised by both the MPG and the OSSG. That volatility has caused some concern among corporates, which fear a significant rate change could bring unintended tax issues (see box, Libor reform: the tax angle). Corporates, along with other market participants, are also concerned that a rate change may lead to contract disputes with counterparties and the need to renegotiate legacy contracts. The FSB report emphasises that a smooth reform of Libor must avoid the need for swaths of contract revisions - a point re-iterated by Powell. "We really don't want to have corporates amending contracts," he says. "They are worried about that. We want to note that no-one is going to be dragging contracts out the drawer to amend them."

BOX: Libor reform: the tax angle
Corporates are concerned that without regulatory intervention, changes to the way Libor is calculated could result in a jump in their tax bills.

Under US federal income tax regulations, if the reference rate for a product is changed by more than a de minimis amount, companies have to mark their positions to market, with any gains or losses recognised for income tax purposes.

If the calculation mechanism for Libor changes to one that is based on transactions rather than bank estimates, then rates are not only likely to be more volatile in future, but could also jump at the point of the changeover.

"There are various provisions in a loan agreement which, if they are changed more than a de minimis amount, would fall outside a tax safe harbour, and could lead to a remeasurement of that loan. It's effectively a redemption and a new loan," says Tom Deas, vice-president and treasurer at Philadelphia-based chemicals manufacturer, FMC Corporation.

The specific rule is Treasury regulation 1000.1-3, which defines the de minimis threshold for changes to a debt instrument's interest rate at 25 basis points or 5% of the yield.

"For a move this big, we are expecting all the authorities will provide some relief here. The next phase in this process is to have national tax authorities and accounting authorities assess the implications of changes to existing benchmark rates and to accommodate it to the degree they are able," says Deas.

The market participants group contribution to the benchmark reform project noted that "corporates are not yet convinced that wholesale change" of Libor is necessary. "The main requirements of corporates with regard to reference rates are transparency, availability (daily, while remaining durable in turbulent markets), supervision, a large number of contributors and the continuity of contracts. "‘Transaction-based' is not a top criterion," the report adds.

Officials recognise this. "We acknowledge there are also continuity concerns arising from the fact that, for tax purposes, replacing one Libor pricing source with another pricing source may be viewed as extinguishing an old contract and replacing it with a new one. We are consulting with the US Treasury Department to see if such tax effects could be avoided," says the Financial Stability Board report.

 

BOX: Key messages from the FSB report

On the need to move away from a Libor-dominated derivatives market:
From a systemic perspective, having such a large stock of contracts settle on a rate based on a relatively small market creates undesirable incentive problems, and the MPG acknowledges this adds to the risk of manipulation. Hence, shifting a material proportion of derivative transactions to a risk-free rate would reduce the incentive to manipulate rates that include bank credit risk and would reduce the risks to bank safety and soundness and to overall financial stability.

On the need for regulatory intervention:
Without official sector leadership, there may well be no action by market participants, despite their desire for a greater range of reference rates.

On the benefits of concentration in one benchmark rate:
Benefits from the current system of a single dominant benchmark include lower frictional hedging risks and costs, risk transfer synergies amongst a wide range of markets, simpler back office operations, valuation consistency for risk, capital and tax purposes and improved transparency.

On fragmentation:
Basis markets between the different rates would also need to be developed in order to allow market participants to hedge risks incurred as their assets and liabilities may reference different rates.

On the costs to end-users:
The costs (and benefits) of the multiple-rate approach may also differ across participants. Although the market as a whole may benefit from a multiple-rate approach, some participants may not be willing to migrate their contracts to another alternative if their transition costs are too high or the new alternative is not appropriate for their needs.

On "moral suasion":
The UK authorities, in association with others, should then consider using moral suasion with the G14 dealers that hold a majority of the derivatives legacy books to facilitate a voluntary transition once sufficient traction has been gained and shorter-run contracts have expired.

On US regulatory involvement:
On the policy front, the Federal Reserve and the CFTC will continue to examine the range of official sector powers to effect change toward greater use of risk-free reference rates in US dollar derivatives markets [including] official sector influence on CCPs encouraging higher margins for contracts tied to non-Iosco-compliant rates.