Market participants expect a migration away from the use of LIBOR as a key derivatives benchmark but have said the shift will be gradual due to the complexities involved in switching existing contracts to new standards.
Martin Wheatley, CEO-designate of the Financial Conduct Authority, one of two new bodies that will replace UK regulator the Financial Services Authority from next year, completed a review of LIBOR at the end of last month. He stopped short of suggesting LIBOR should be replaced completed, opting instead for a series of measures that would increase transparency and accountability.
“If we move to a different benchmark that revolves around derivatives and off-balance sheet items, agreements that underpin LIBOR-based instruments – especially those relating to funding – could face litigation, which is not desirable,” said David Clark, chairman at the Wholesale Markets Brokers’ Association, a trade body that represents interdealer brokers. “The industry is keen to move on as quickly as possible, and substantially in the form we have at the moment.”
Market participants are unlikely to move existing contracts to a new benchmark because of the complex legal changes it will require to the agreements that govern derivatives positions. But there is a chance for index providers and other firms to market new benchmarks that could be more suitable than LIBOR.
In the US, the New York Stock Exchange has been touting its DTCC GCF repo index, which lists the daily interest rates for the general collateral finance repurchase agreements market, as an alternative to LIBOR.
Wheatley proposed a code of conduct for those banks involved in setting LIBOR, the publication of banks’ submissions after three months and the removal of the British Bankers Association as the administrators of LIBOR. He also called for the cessation of a multitude of tenors and currencies that are not backed by sufficient trade data, which would reduce the number of LIBOR benchmarks published daily from 150 to 20.
The recommendations follow allegations that banks colluded to manipulate the benchmark to benefit their own positions and improve the perceived health of the interbank lending market during the credit crunch.
The UK’s Barclays Bank is so far the only firm to face action, opting for a US$450 million settlement with US and European regulators, but more of the 17 other banks that are involved in setting LIBOR are also under investigation.
“The Wheatley review had a neat balance between anonymity at the point of submission and transparency later down the line, which is good for confidence,” said Guy Sears, director of wholesale at the UK’s Investment Management Association. “It was important that any change to LIBOR didn't endanger the viability of existing contracts but whether people readily write contracts on LIBOR going forward is another matter. It’s useful as an uncollateralised benchmark, but the transactions that LIBOR underpins are invariably collateralised.”
While LIBOR has been a long-established benchmark for interest rate swaps, FX options and forward rate agreements, Clark asserts the market has become more sophisticated since its initial introduction in the 1980s.
“You could rightly question whether LIBOR was the right benchmark to use for sub-prime property debt in Florida – which it clearly wasn't,” he said. “In the absence of a properly functioning interbank unsecured cash market, is LIBOR the right way to value off-balance sheet items? The answer is probably no.”
However, Clark added that if banks were incentivised to become more active in the interbank cash market LIBOR would remain a realistic funding benchmark.
For the pricing of off-balance sheet products – i.e. benchmarks used to price assets and liabilities that are not recorded on a firm’s balance sheet – Clark believes LIBOR can be appropriate if the basis risk between unsecured cash markets can be measured to provide reliable pricing in off-balance sheet markets.
“The realistic alternative is to have a separate composite off-balance sheet curve which would operate alongside LIBOR and which would not be distorted by credit factors,” he added.