Life After LIBOR
“Libor is like the ivy that has grown through the house- ripping it out could crash the financial system. Removing it requires planning…’— Thomas Wipf, Chair of the Alternative Reference Rates Committee
The London Inter-Bank Offered Rate (LIBOR) underpins various financial products- from traditional term loans like mortgages to complex derivatives such as interest-rate swaps. Although widely used in the 1970s, it was standardized as an officially produced rate by the British Bankers’ Association in 1986. Since then it has grown considerably and at one point became the reference rate for about $350 trillion worth of financial instruments.
The rate is produced for five different currencies: the US dollar, British pound sterling, the Swiss France, the Euro and the Japanese Yen. It is calculated using an average of submissions from members of seventeen panel banks, each situated in the world’s major financial centers in the UK, USA, France, Japan and Switzerland. It also comprises submissions on rates for seven short-term maturities, from 1-day to 12-month contracts. The widespread use reflected the fact that a substantial proportion of banks’ funding came in the form of unsecured lending from other banks. Naturally the rate at which banks make loans and sell derivatives to customers should at least equal their cost of funding. The Libor rate submission system was an attempt by banks to predict the future cost of funding based on previous rates and other macro-economic conditions that could influence future rates. But the rate-rigging scandal that unraveled between 2008 and 2012 undermined the trust once placed in the system.
LIBOR’s FALL FROM GRACE
Allegations that major banks were understating their borrowing costs were first made by a Wall Street Journal article in May 2008. The anomaly discovered was that the weakness of banks’ balance sheets during the financial crisis was not reflected in the low rates at which they were able to borrow. But attentions were gripped by the great ructions in the wider financial system during the crisis, and the US Department of Justice and Serious Fraud Office in the UK only launched investigations in 2012. The WSJ article’s allegations were verified to some extent. There was a rate rigging scandal on a much wider scale than initially suggested. It involved both under and over-reporting rates and, in many cases, pre-submission collusion between bankers and traders. This enabled the parties involved to benefit from spreads on the derivatives being traded and allowed bankers to boost their bonuses.
This scandal was arguably the last straw, rather than the sole reason, for the turn away from LIBOR as a major reference rate. The use of LIBOR to reflect the cost of funds for banks presumed that banks obtained funding from other banks. A series of regulations designed to strengthen banks’ capital position however reduced the importance of inter-bank lending as a source of funds to large banks. In the years following the 2008 crisis the Federal Reserve introduced the Liquidity Coverage Ratio rule, which requires that large, internationally active banks hold a specific level of High-Quality Liquid Assets (HQLAs) on their balance sheets at any point in time. This limited banks’ willingness to engage in inter-bank trading to comply with capital ratios. It also vastly increased banks’ holdings of US treasuries (the nearest cash equivalents given the high liquidity of US treasury markets), a development which has significantly changed the way in which large banks obtain funds from each other.
The reduced inter-bank activity undermined the rationale for the use of LIBOR as a reference rate for loans and financial products, as LIBOR can no longer reflect banks’ cost of funds. Most large banks have shifted their activity to overnight repurchase (repo) markets, where they can borrow money from other large banks by using treasuries as collateral https://www.frbatlanta.org/research/publications/wp/2018/13-can-the-us-interbank-market-be-revived-2018-11-26. The increased holdings of treasuries and other safe assets made the secured lending market more viable because it is subject to less credit risk and allows banks to put excess treasury holdings to good use. Much inter-bank lending now involves smaller banks and non-bank financial institutions, who are exempt from the high capital requirements imposed on banks and in any case do not have sufficiently high treasury holdings to engage in secured lending on a large scale.
AN UNCERTAIN TRANSITION
Amid the chorus of calls for a transition away from LIBOR, the Secured Overnight Financing Rate has emerged as its likely successor in the US. On its face, this seems perfectly logical—systemically important banks rely on funding from repo markets to far more than they rely on unsecured lending. SOFR is a value-weighted calculation that incorporates a wide variety of both bi-party and tri-party repo transactions calculated over 30, 90 and 180-day averages. In addition, SOFR’s transaction volume of between $2 and $4 trillion has significantly eclipsed US LIBOR’s (although LIBOR remains a more popular reference rate for derivatives and loans) .This degree of market depth increases immunity to manipulation or influence by participants.
Yet there are major pitfalls. Perhaps the most glaring is that SOFR is not a forward-looking rate. It is based entirely on past average rates, and though these may indicate what the future rate could be, potential inaccuracy cannot be ruled out. This problem was demonstrated by the volatility that gripped repo markets in September 2019, when rates rose to as high as 10%. In the present low interest rate environment, such an abrupt increase would not be reflected in the daily averages used to set the SOFR.
It may, of course be argued that this is not a problem that can be overcome by the use of LIBOR because bouts of volatility are inherently unforeseeable. This, however, ignores the fact that a confluence of factors influenced the repo spike in September 2019: the earlier reversal of the Federal Reserve’s quantitative easing program, the corporate tax payments due that quarter and payments due for US government bond auctions. Indeed, repo rates generally rise towards the end of the year; in December 2018, the rate rose from 2.56% to 6.125%. Banks tend to be unwilling to lend towards the end of the year to maintain their balance sheets for regulatory checks. Libor presumed that bankers on the panel can best determine how the convergence of these varying factors could influence rates, and thus banks’ cost of funding. SOFR’s weakness is that it provides no mechanism by which future rates can be predicted.
SOFR’s reliance on an average is unlikely to be a defence against even short-term market volatility. In September 2019 SOFR spiked from 2.43% to 5.25%. The Federal Reserve’s $75 billion daily injections eventually calmed the market turmoil. The problem may therefore be less pronounced in our current low-interest rate environment, where the Federal Reserve has an interest in keeping rates low and thus stable. But the assumption that interest rates will hover above the zero-lower-bound forever is at best unwise. If interest rates rise and interest risk becomes a more prominent concern for financial institutions, some method of incorporating future rate predictions may need to be factored into SOFR.
Emeka Nduka-Eze is an LLM Student at NYU, having graduated with an LLB degree from the University of Durham in 2019. He spent summers working in Law firms in London, and maintains strong interest in Corporate Law and Financial Markets. He will sit for the New York Bar Exam in July 2021