Is Libor going away?

Amid widespread expectation that Libor will soon be discontinued, questions are being asked around whether the transitioning towards risk-free rates will prove too onerous to achieve. Christopher Dias, principal, advisory, at KPMG, explores whether the demise of Libor will be as swift as some suggest

Christopher Dias, KPMG

While US and global regulators have been vociferous about the demise of Libor for obvious reasons – it is not underpinned by market transactions, is increasingly subject to expert judgement and is burdened by the weight of past market abuses – the sheer enormity of transitioning this $370 trillion problem with a global reach might cause one to question whether the ‘inevitability’ of Libor going away will actually be achieved any time soon. 

Although the regulators’ message is unwavering, there seems to be recognition – or at least acknowledgement – that the task ahead will be challenging. US Commodity Futures Trading Commission (CFTC) chairman J. Christopher Giancarlo recently echoed comments from UK Financial Conduct Authority chief Andrew Bailey, pronouncing: “The discontinuation of Libor is not a possibility – it is a certainty.” Interestingly, members of the CFTC’s Market Risk Advisory Committee note the outcome as clear, but add that the reality is more nuanced. This would suggest there is more to consider than a simple ‘find and replace’.¹

Despite the efforts of regulatory and industry working groups to facilitate the discontinuation of Libor with road maps and consultations, there remain a number of market participants voicing disbelief, and many – if not all – continue to issue Libor-referenced loans, swaps, debt and derivatives, further exacerbating efforts to effect a smooth and timely transition. 

So why are some market participants reluctant to accept the change to new risk-free rates (RFRs), distinguished by a transparent rate structure and predicated on actual transactions rather than ‘expert judgement’? First and foremost, the size of the project is daunting, involving multiple markets, currencies, regulators and types of participants. The International Swaps and Derivatives Association will expedite the transition for most derivatives contracts; however, there are still trillions of dollars in cash and complex derivatives products that will need to be handled separately via more costly and time-consuming means. 

And, if the size of the effort alone doesn’t emphasise the uncertainty of Libor’s imminent demise, consider some of the hurdles that must be overcome before the transition is complete:

1. Cash products. More and more firms will need to issue new debt and create loan products and securities based on the new RFRs. While some banks have considered loan products, thus far only one supranational, one government-sponsored entity, at least one bank and one insurance company have issued secured overnight financing rate (SOFR) or Sonia-denominated debt.² While the debt parade is promising, it still needs more activity, particularly from non‑financial, non‑government firms.
2. Liquidity. For the transition to be successful, there must be liquidity in RFR-denominated hedging products. Liquidity thus far is scarce – LCH and the CME have established future contracts for SOFR and Sonia, but the transaction volume has yet to achieve a meaningful level and the number of contract maturities is still limited. The success of RFR futures and swaps will also be highly dependent on growth in underlying loans and securities, which are still nascent markets.
3. Infrastructure. A term structure for SOFR has yet to evolve, resulting in contracts being valued in arrears. This concept will likely be anathema to most end‑users, which find the forward-looking term structure of Libor particularly beneficial in terms of forecasting and cashflow management. In addition, legacy contracts will be subject to a basis adjustment to reflect the difference between an RFR and Libor. This is no easy task, and current recommendations have many detractors.
4. Communication. It is generally accepted that communication among most large institutions can be reasonably managed. This is not the case, however, for smaller firms. It is absolutely not the case for most consumers. Adoption of RFRs will need regulators and industry participants to consistently and repeatedly make clear the benefits, need and economics of the impending transition. 

It is a real possibility that some portion of the Libor market will remain in place despite a majority move toward RFRs. Although market participants are developing transition plans to avoid significant disruption, the breadth and depth of the Libor market, combined with the complexity of the changes needed to effect the transition – changes to products, liquidity, infrastructure and communications – suggest not all the trillions of migrating parts will be fully addressed as of a certain date. So, while Libor may go away, it is much more likely to do so gradually, with a few nuances along the way.

 

<sup>1. US Commodity Futures Trading Commission Market Risk Advisory Committee Meeting, July 12, 2018.
2. SOFR, the Secured Overnight Funding Rate, is the alternate RFR selected for USD Libor; Sonia, the Reformed Sterling Overnight Index Rate Average, is the alternate RFR selected for GBP Libor.</sup>

Read more articles from the 2018 Beyond Libor special report

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