Path dependence

Replacing LIBOR

Publication of LIBOR―the London Interbank Offered Rate―will likely cease at the end of 2021. This is the message U.K. Financial Conduct Authority (FCA) CEO Andrew Bailey sent in 2017 when he announced that, after 2021, the FCA would no longer compel reluctant banks to respond to the LIBOR survey. Given the small number of underlying LIBOR transactions, and the reputational and legal risks banks face when submitting survey responses based largely on their expert judgement, we expect that most banks will then happily retreat. In just over two years, then, the FCA could declare LIBOR rates “unrepresentative” of financial reality and it will vanish (see, for example, here).

Most financial experts know this. Yet, LIBOR remains by far the most important global benchmark interest rate, forming the basis for an estimated $400 trillion of contracts (as of mid-2018; see Schrimpf and Sushko), about one-half of which are denominated in U.S. dollars (as of end-2016; see Table 1 here). While the use of alternative reference rates is increasing rapidly, to beat the LIBOR-countdown clock, the pace will have to quicken substantially. In the United States, the outstanding notional value of derivatives linked to the alternative secured overnight reference rate (SOFR) jumped from less than $100 billion to more than $9 trillion in just the past year (see SIFMA primer). Yet, this amount still represents a small fraction of outstanding dollar-LIBOR-linked instruments.

In this post, we examine the U.S. dollar LIBOR transition process, highlighting both the substantial progress and the major obstacles that still lie ahead. The key goal of the transition is to ensure that the inevitable cessation of LIBOR does not trigger system-wide disruptions. Unfortunately, at this stage, count us among those that remain deeply concerned….

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