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Killing Libor proves even harder than global regulators imagined
[NEW YORK] Purging Libor from the financial system is proving no easy task.
For more than three years, regulators have steadfastly maintained that the beleaguered London interbank offered rate would be phased out by the end of 2021. On Monday, they abruptly gave ground and pushed back the date of dollar Libor's anticipated demise by 18 months.
A decision to shift course may have been expected by some, but few anticipated such a long extension. And while officials are adamant that it's only a temporary lifeline, many see the move as a stunning acknowledgment that the task has proven far more daunting than envisaged. At the heart of the delay is the threat to financial stability posed by trillions of dollars of existing contracts and instruments that lack a clear replacement rate. Policymakers have struggled to find a solution to the issue, which stretches across numerous markets.
"Libor dependencies are still entrenched in the DNA of the financial system, which could point to systemic risks if the transition is rushed," said Subadra Rajappa, head of US rates strategy at Societe Generale.
While waiting until 2023 to end key Libor tenors doesn't solve the problem of so-called legacy contracts, a senior Federal Reserve official said it should at least allow for many to expire naturally, especially as policymakers discourage new Libor-linked deals beyond the end of next year.
"This process is just massive because of all the legacy contracts that are hanging out there," said Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings. "There's a huge backlog of them that weren't going to unwind in a very easy fashion."
Monday's decision fuelled a flurry in volume across eurodollar futures as traders adjusted to the new time line.
The delay undoubtedly comes as a welcome reprieve to many of the world's largest banks, which have struggled to transition certain markets to the Secured Overnight Financing Rate (SOFR), the Fed-backed Alternative Reference Rates Committee's preferred Libor replacement.
As the pile of outstanding debt that can't easily be amended to include so-called fallback language looms large, officials and market watchers alike have warned of a potential wave of disruptive litigation should a solution not be found.
"The key takeaway is that the extension will give regulators more time to facilitate an orderly transition away from Libor in cash instruments such as securities and loans," said Scott Buchta, head of fixed-income strategy at Brean Capital. "The big issue here is the lack of uniform fallback language."
Regulators had been vocal in recent months that the transition was still on track, highlighting recent milestones including the shift to by derivative exchanges to SOFR for calculating the value swaps.
More recently, the International Swaps and Derivatives Association unveiled much anticipated legal protocol to help convert Libor-linked contracts to SOFR once the benchmark expires.
Yet despite the progress, measures to shift existing cash instruments - such as floating-rate bonds - away from Libor have proven difficult. Efforts to get lawmakers to support legislation that would impose a fallback benchmark on financial products that lack a viable replacement rate have so far fallen flat.
A senior Fed official made clear on Monday that writing new Libor contracts would be seen as unsafe and unsound banking practice if continued beyond the end of 2021, and that the central bank would supervise such firms accordingly.
The Fed, in a joint statement on Monday with the the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, encouraged banks to cease entering into Libor-referenced securities as soon as practicable.
"It's not like it has been a disaster and nobody has started switching over," said Scott Skyrm, executive vice-president of Curvature Securities. "It's just there's still a lot of work to do. The market is going in the right direction with activity in SOFR picking up, it just needs more time."