Libor, linked to about $350 trillion worth of financial products, will be replaced by an alternate pricing benchmark for everything from mortgages to credit cards.
Replacing Libor will be lengthy and problematic, and is one of the key themes to look out for in 2019 as financial services and asset managers start transferring to new systems.
Thousands of existing contracts will need to be renegotiated causing a huge operational and financial burden that will consume legal teams for months.
Libor, the rate that banks agree on when lending to each other, was problematic from the beginning. Unsurprisingly, it turned out to be widely rigged, and some of the biggest and most notorious banks had gotten tangled up in the Libor rigging scandal. Some criminal charges were brought against low-level traders, and huge fines were levied against some of the banks.
Another big thing that came out of the scandal was the realization that Libor, crucial to the credit-based economy and to hundreds of trillions of dollars in derivatives, had to go. It is due to die by the end of 2021.
“This is a material change in one of the most important numbers in finance,” said Sandie O’Connor, chief regulatory affairs officer at JPMorgan Chase in New York.
Short for the London Interbank Offered Rate, Libor underpins everything from credit card loans to mortgages to the more arcane derivatives and syndicated loan contracts. Millions of financial products use the benchmark.
Upending Libor has become key in 2019, meaning that this is the year to start worrying about the thousands of contracts that need to be renegotiated as the financial world shifts to new systems.
“Operationally, the amount of work needed to make changes is tremendous,” said Kevin McPartland, head of market structure at Greenwich Associates.
The new benchmarks
Enter new alternate benchmarks — SOFR (the secured overnight financing rate) will be introduced in the US and will be secured against US Treasuries. Europeans will be served by Sonia/Eonia (Sterling/Euro overnight index average) instead.
Where Libor relied on a system of individual banks submitting their figures for lending costs each day — making it ripe for manipulation — SOFR will be calculated using real transactional data. Banks paid $9 billion in fines following the rigging scandal, with new rates introduced to reduce human error, and even outright fraud.
Referring to SOFR, JPMorgan’s O’Connor said: “We need to leverage financial infrastructure to get people trading on this benchmark, because just having a rate does not make a market.”
There’s another catch for replacing a 35-year old system. Libor and SOFR represent different levels of risk, so swapping out one system for the other will be a lengthy, and potentially costly, process for some contracts.
Similarly, SOFR needs significant trading volume in order to build up enough data to determine value for one month, three month, and six month rates.
From a documentation and interest rate perspective, things get more complicated still. In June, The Bank of England pointed out that in the previous 12 months …read more
Source:: Business Insider