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A crucial interest-rate benchmark faces a murky future

EVERY working day, shortly before noon, British time, the London Interbank Offered Rate, or LIBOR, is published. For five currencies and seven maturities, from overnight to 12 months, it is the average, trimmed of outliers, of up to 20 banks’ estimates of the interest rate at which they can borrow from other banks. It is also the benchmark for financial contracts reckoned to be worth $350trn. Derivatives depend on it most. But plenty of asset-management products, as well as corporate loans and mortgages, are based on LIBOR and similar rates, notably EURIBOR, an interbank rate for euros.

Yet LIBOR’s days may be numbered. Regulators are promoting other benchmarks. On July 27th Andrew Bailey, the head of Britain’s Financial Conduct Authority, said that the FCA had spoken to banks about sustaining LIBOR until the end of 2021, but no longer. In April a working group set up by the Bank of England concluded that SONIA (the Sterling Overnight Interbank Average Rate), which the central bank administers, was its preferred alternative. In June a committee convened by the Federal Reserve proposed a broad Treasury repurchase or repo rate, to be published by the New York Fed, as a replacement for dollar LIBOR. Rival rates are also being pushed in Japan and Switzerland.

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Outside the financial world, LIBOR is best known for scandal: in 2012 it emerged that banks had been manipulating their reported borrowing costs for years. In 2015 and 2016 five traders were jailed for conspiracy. Until 2013, when the FCA started overseeing the market, LIBOR was not even regulated. In 2014 ICE Benchmark Administration (IBA), a subsidiary of Intercontinental Exchange (which owns the New York Stock Exchange, among other marketplaces), took over the running of LIBOR from the BBA, a British bankers’ trade body. IBA’s boss, Finbarr Hutcheson, says that surveillance, using clever software, has been stepped up. Banks and regulators have also sharpened their act.

But regulators’ enthusiasm for alternatives is founded on technical rather than moral concerns. LIBOR’s underlying markets have worn thin. Although the shortest dollar, sterling and euro rates are based largely on actual loans, others rely on banks’ “expert judgment”—ie, informed guesses. In one currency-term combination, Mr Bailey noted, banks on the LIBOR panel mustered just 15 transactions in all of 2016. Another worry is that LIBOR implicitly includes banks’ own credit risk. Something closer to a risk-free rate would be a better benchmark for some markets, especially in derivatives.

Hence the push for alternatives based, like SONIA and the American broad repo rate, on transactions. (Efforts to rebase EURIBOR on transactions have stumbled.) Such benchmarks should also be hard to manipulate—and thus immune to the rigging that befell LIBOR.

The alternatives also have their flaws. Joshua Roberts of JCRA, a financial-risk consultancy, agrees that LIBOR is likely to be replaced by transaction-based rates. But he points out that SONIA, for example, being an overnight rate fixed daily, does not reflect the dependence of rates on the term of a loan. A borrower pegged to three-month LIBOR knows his interest payments for the next quarter. With SONIA, he won’t.

Even if LIBOR survives for several more years, some contracts based on it will outlive the benchmark. For that reason, says the International Swaps and Derivatives Association, a trade body, substitutes (possibly the new benchmarks) will have to be written in. It may anyway be too soon to write off LIBOR. Mr Hutcheson at IBA welcomes the competition, but argues that LIBOR will continue to suit multinational corporate borrowers, among others. “I feel very confident”, he says, “that LIBOR will be here for a long, long time to come.” Let’s see in four years.

Source: economist
A crucial interest-rate benchmark faces a murky future

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