Confidence in the reliability of the London Interbank Offered Rate (LIBOR) was eroded after the financial crisis by well-documented cases of attempted manipulation and false reporting. Although significant improvements have been made to the methodology and governance of LIBOR since April 2013, its long-term future is now in doubt. Chris Salmon, executive director for markets at the Bank of England, explains the reasons for this and how regulators are working with market participants to promote transition to alternative benchmarks.

How did LIBOR work and why is it being phased out?
LIBOR is the predominant reference rate for short-term interest rates and is used as a benchmark for a broad range of contracts in the global financial system. It was originally designed to measure the offered rate on unsecured interbank deposits, but is now used in many applications as a proxy for the general level of interest rates.
 
However, it has become increasingly clear that the absence of active underlying bank deposit markets raises a serious question about the long-term sustainability of LIBOR. The disruption to financial stability were LIBOR to become unavailable could be large, so work must begin in earnest on planning the transition to alternative, near risk-free rates (RFR) that are based firmly on transactions.

What types of transactions use LIBOR as a reference?
Use of term LIBOR — the three-month and six-month tenors – is widespread, especially in sterling and US dollar markets, but also in Japanese yen and Swiss franc.

The greatest concentration of financial contracts referencing LIBOR is in derivatives markets — in sterling, more than £30tn of ‘over-the-counter’ derivatives and £4tn of exchange-traded reference LIBOR. US dollar LIBOR derivatives probably run to the hundreds of trillions. The economic purposes of these contracts include hedging or gaining exposure to: outright interest rate risk; basis risk; cross currency risk; and interest rate volatility. Banks, pension funds, insurers and hedge funds are all heavy users of LIBOR derivatives.

LIBOR is also important for the real economy, providing a reference for more than £200bn of small and medium-sized enterprises and corporate loans, around £125bn of Floating Rate Notes, and £200bn of structured debt. LIBOR typically provides a transparent and widely accepted reference point for the floating interest payments on these instruments. 

The widespread use of LIBOR might be taken as evidence of the overwhelming need for LIBOR-linked financial contracts. However, I do not believe this is the case. In practice the dominance of LIBOR reflects a combination of convention, inertia, and what economists call ‘network effects’. LIBOR derivatives are liquid because they are widely used, and they are widely used because they are liquid. But near risk-free benchmarks are more suitable in many applications.

What action are regulators taking to ensure there will be no market disruption?
The responsibility to plan for a future without LIBOR lies primarily with market participants. However, the Bank and FCA are committed to working with the market to minimise risks to financial stability and market integrity. The authorities are taking action in three key areas.  

First, the FCA has been working with panel banks to ensure their support for LIBOR until the end of 2021 to create a smooth transition to alternative reference rates.

Second, the Bank and FCA have established the Working Group on Sterling Risk-Free Reference Rates to develop and implement alternatives to sterling LIBOR. The Working Group has identified the Sterling Overnight Index Average (SONIA) as its preferred alternative. The Bank has taken over the administration of SONIA and is reforming the benchmark to make it more robust. Those reforms take effect on 23 April 2018. 

Third, authorities internationally have tasked the International Swaps and Derivatives Association to work with market participants to develop fallbacks for LIBOR in derivatives contracts. The presence of fallbacks can help to mitigate market disruption if LIBOR were to fail unexpectedly. 

What happens to legacy contracts that still reference LIBOR after end-2021?
As of today, that is highly uncertain. Given that uncertainty, my advice to legacy contract holders is to start considering early, and definitely well before 2021, whether and how those contracts should be converted to reference alternative benchmarks.

There is no doubt that a substantial effort will be required by market participants to achieve this before 2021. The Working Group will propose an approach to voluntary conversion in both derivatives and cash markets. 
Ask the expert



Chris Salmon is the Bank of England's executive director for markets. He is responsible for all bank operations in financial markets; management of the Bank’s balance sheet and the UK's official foreign exchange reserves on behalf of HMT; and delivering market intelligence for monetary and financial stability.

He was previously executive director, banking & chief cashier (2011–2014) and private secretary to then governor, Sir Mervyn King (2006–2009).

For remaining contracts, fallbacks can help to ensure contract continuity in the event LIBOR fails. Where no fallbacks exist, market participants should carefully consider contingency plans in the event that LIBOR is discontinued. 

What are the differences between LIBOR and SONIA?
SONIA reflects rates on unsecured bank deposits, as does LIBOR. So SONIA is conceptually similar to LIBOR. But there are three critical differences:
 
1. LIBOR relies on bank submissions while SONIA is derived only from transactions.
2. LIBOR is published in several tenors out to one year, with 3s and 6s being most popular, while SONIA is only an overnight rate. 
3. Term LIBOR rates contain a bank credit risk component, which is not reflected in a simple or geometric average of overnight SONIA rates. 
 
SONIA is considered an RFR precisely because it does not include the term bank credit component. For many applications in which LIBOR is currently used, a term bank credit risk component is neither necessary nor appropriate. RFRs provide a better proxy for the general level of interest rates.
 
However, some market participants have expressed a preference for term benchmarks with the interest rate set in advance for the full payment period. As SONIA cannot provide this, a market-led working group is working on the development of term SONIA reference rates.

What other plans are underway to reform SONIA to make it a better tool?
The Bank is improving the robustness of SONIA by capturing a broader base of transactions. Reformed SONIA will be based on some £50bn of transactions each day, covering overnight unsecured deposits in the brokered and bilateral markets. SONIA currently captures only brokered transaction totalling around £15bn per day on average.
 
To enable the broad adoption of SONIA, the Working Group will help develop market infrastructure around SONIA. Futures contracts referencing SONIA have already been announced and the Working Group will help develop documentation to enable the use of SONIA in cash markets. 

Seen a blog, news story or discussion online that you think might interest CISI members? Email eila.madden@wardour.co.uk.