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Pimco warns that misstep on Libor alternative could be costly
[NEW YORK] Pacific Investment Management Co says there will be consequences from being too complacent during the phasing out of Libor, the global borrowing benchmark that underpins more than US$350 trillion of financial products.
"We strongly argue that a viable alternative needs to be entrenched before Libor is phased out, and that investors should consider there is a marginal risk that Libor ceases abruptly and unexpectedly," Pimco's William De Leon and Courtney Walker wrote in a note published Wednesday. "Our greatest concern is that a transition that is not well-scripted and fails to consider the potential impacts on all securities types threatens to favor certain market participants over others."
Market participants have been uneasy since a British regulator, the Financial Conduct Authority, last month said that at the end of 2021 it will no longer force banks to help set the scandal-plagued benchmark rate. The London interbank offered rate, or Libor, has become so deeply entrenched in financial markets that even after it was rigged and manipulated, there's no consensus yet on what could effectively replace it.
Libor's demise isn't so much a result of the corruption cases that generated some US$9 billion of banking fines. Rather, it has more to do with the fact that the data used to calculate it isn't really there anymore as firms have gravitated toward secured funding, which is backed by collateral, over unsecured funding.
"It is reasonable for investors to be concerned that banks might cease to voluntarily report Libor unexpectedly in the future," wrote Mr De Leon, Pimco's global head of portfolio risk management, and Ms Walker, a portfolio risk manager. "However, given the considerable scope of Libor and its characteristic as a public good, we expect that banks will voluntarily administer the benchmark until an alternative is firmly in place and do so even though they will no longer be compelled."
The UK's Libor-replacement effort is part of a global push to reform benchmark rates discredited by manipulation and false reporting. In 2014, the Financial Stability Board set out a road map to overhaul rates including Libor and develop viable risk-free alternatives. The Bank of England unveiled the Sterling Overnight Index Average, or Sonia, in April as a near risk-free alternative to Libor for use in sterling derivatives and other relevant financial contracts.
The Alternative Reference Rates Committee, a Federal Reserve-sponsored group, recommended replacing Libor with a new, broad Treasury repurchase agreement, or repo, rate, based on the cost of overnight loans that use US government debt as collateral. The rate known as Broad Treasury Financing Rate, or BTFR, is based on about US$660 billion in daily transactions.
ICE Benchmark Administration, which runs Libor, could even continue to produce the benchmark with banks on the rate-setting panel after 2021.
"With alternatives to Libor selected in certain markets, the focus has now moved to how best ensure a fair and orderly transition," Mr De Leon and Ms Walker said.
"Pimco believes that because such a transition would be so complex and potentially involve significant participation within the financial industry to implement, the transition may require a regulatory mandate to ensure a coordinated and smooth move away from Libor and to the new benchmark."