Post-LIBOR Framework Materializes, Looking to Spark a Transition

While still some years away, working groups and regulators are laying the groundwork for a replacement of LIBOR.

Several years after a multi-billion dollar scandal rocked the financial services industry, UK officials and regulatory authorities are now charting a course for the replacement of LIBOR. While still some years away from an outright replacement, the wheels are already in motion for an heir apparent to the London Interbank Offered Rate (LIBOR), per a Reuters report.

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In its simplest form, LIBOR represents the average of the estimated interest rates of loans between leading banks. However, past vulnerability with this framework and a propensity for scandal and abuse has prompted a push to replace this structure with an improved iteration.

This would represent a herculean effort; the system has been in place since 1984. Even optimistic estimates do not see any replacement of LIBOR before 2021, though this could be initiatied as early as this year.

How did we get here?

LIBOR has been effectively marred for years, and a breaking point was reached in 2012 when many of the world’s leading lenders were shown to have engaged in widespread fraud. The consequent scandal enveloped the financial services industry, leading to billions in fines.

Of greater importance however was whether history would simply repeat itself given the inherently vulnerable structure of LIBOR. Still, for its flaws, the institution has remained remarkably resilient, even five years after the global scandal. Moreover, the idea of scrapping LIBOR or even transitioning to a more polished model seems tenuous at best, and with skepticism abounds.

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New steps

Beginning as early as next year however, some tangible steps may be taken to actually signal the start of a transition from LIBOR. This entails a more central effort by the clearing arm of the London Stock Exchange, which already covers clearing of short-dated Sterling Overnight Indexed Average swaps (SONIA).

In particular, these products are used to hedge against adverse moves in rates or currencies. Citing the recent report, the clearing unit was even exploring a plan to begin clear several swaps covered by LIBOR. In parallel to this effort, an industry group composed of members from the sixteen top dealers of swaps and other derivatives were also looking to create SONIA futures contracts.

This tone was echoed by Francois Jourdain, the acting chair of a working group installed by the Bank of England (BoE) to promote the adoption of SONIA: “It will happen. It may be difficult, it may happen on a different time frame depending on different levels of difficulty, but it will happen.”

Indeed, this move would certainly go a long way towards heralding a broader replacement of LIBOR. The logistics of supplanting LIBOR remain tremendous, with the prospect of an IT overhaul and other expensive contingency plans looming as sizable headwinds. This phenomenon is exacerbated across specific sectors as well, many of which face legal quandaries over a switch.

Sparking a transition

Regardless of the scope of the challenge ahead, the efforts of working groups and other venues seems to have gained traction for a transition. Ultimately however, a wide adoption of futures contracts referencing SONIA would place the onus on exchanges themselves, which could facilitate or stifle the initiative.

One thing working towards this aim is the competitiveness of SONIA futures. As exchange traded futures are cheaper and more transparent relative to other market instruments, they can ultimately accrue liquidity fast, thereby boosting confidence to make the switch.

Once initiated, the process could also materialize faster than realized, though the working group and others do not see any wider movement occurring before next year. Many exchanges are reticent to hasten the fall of LIBOR given that a shakeup of the status quo could lead to them losing business to rivals. Time will tell regarding the timetable and scope of a transition effort. For now many forces appear to be actively working to phase out LIBOR.

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