Bank of England Warns On Libor Transition
The Bank of England has warned that firms are continuing to write new Libor contracts even though the benchmark interest rate is expected to be discontinued after the end of 2021.
The UK central bank said in research published this week that many new contracts maturing beyond 2021 continue to reference Libor. The Financial Conduct Authority said two years ago that it will not compel panel banks to submit to Libor beyond 2021.
With Libor expected to be discontinued after end-2021, the use of alternative interest rate benchmarks is steadily increasing. But use of Libor remains widespread, and this poses risks to market stability. https://t.co/8KgzL9XzKL #BankOverground pic.twitter.com/PDH5uRy8X3
— Bank of England (@bankofengland) September 30, 2019
“Despite the progress in establishing alternative reference rates and in building these new markets, much more work is needed to complete the transition,” added the study.
After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates based on transactions, so they are harder to manipulate and more representative of the market.
The Bank of England highlighted the loan markets, which is still dominated by Libor-linked lending, and many new long-dated derivative contracts which are referencing Libor.
“Firms now need to focus on shifting new business from Libor to alternative rates, and should put in place a clear transition plan to mitigate their legacy risk from older contracts,” said the Bank of England. “In June 2019, the Prudential Regulation Authority and the Financial Conduct Authority published guidance for firms on the issues they need to consider when making a transition plan.”
The UK has chosen the sterling overnight index average, Sonia, as its new risk-free rate. The European Central Bank started publishing a new benchmark rate this week.
The euro short-term rate (€STR), a new benchmark interest rate, has been published for the first time. The rate reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. The €STR is available here https://t.co/BUp2OidOjS #EuroSTR pic.twitter.com/b14OFa6YHP
— European Central Bank (@ecb) October 2, 2019
The US has adopted the secured overnight financing rate, SOFR, as its risk-free rate to replace US dollar Libor.
CME Group announced last month that it plans to introduce options on three-month SOFR futures.
— CME Group (@CMEGroup) September 4, 2019
Agha Mirza, global head of interest rate products at CME Group, said in a statement: “Offering options on futures builds on our ever-growing SOFR ecosystem and deep expertise in listed interest rate options, and provides clients with another solution for managing exposure to interest rate price risk around the world.”
The exchange said that since SOFR futures debuted in May last year, more than 195 global market participants have traded over 6.3 million contracts at CME Group.
“A record 120 large open interest holders held open positions in SOFR futures as of Aug. 27, 2019,” added CME. “Additionally, open interest surpassed a record 283,000 contracts on Aug. 30, 2019.”
— CME Group (@CMEGroup) September 5, 2019
Deloitte Financial Services UK highlighted in a blog that the as markets transition from IBORs, there are likely to be recurrences of market and customer misconduct – although they are likely to manifest differently.
“This being the case, risks of misleading clients, market abuse (including insider dealing and market manipulation), anti-competitive practices, both during and after transition (such as collusion and information sharing) and risks arising from conflicts of interest, are all likely to reappear,” said Deloitte.
Therefore firms should ensure that they robustly identify and mitigate conduct risks arising during the transition.
“As the famous statesman Edmund Burke once said, “those who don’t know history are destined to repeat it”,” added Deloitte. “There is plenty of historical information available to firms about potential conduct pitfalls.”