Libor battles aren’t over, but the war is won

Transition will shift into new phase next year, leaving systemic threats behind

Over the past four-and-a-bit years, the interest rate market has been labouring towards the common goal of safely decommissioning its most widely used benchmark, before it could either blow up or melt down.

It’s too soon to say there will be no damage, no distress after panels for the first four Libor currencies are disbanded on December 31, but it’s not too soon to say the industry has achieved its main aims. Libor looks set to power down in an orderly fashion, thanks to widespread adoption of the protocols that will re-hitch today’s contracts to new risk-free rates (RFRs) after Libor’s death, and to growing liquidity in those RFRs.

There have been plenty of bumps in the road, and the market has sometimes diverged from the course urged by regulators. History will still record it as an unprecedented challenge, and a major success.

Those involved in the effort are starting to acknowledge this.

Speaking at a Risk.net event on December 8, Edwin Schooling Latter, director for markets and wholesale policy at Libor’s regulator, the UK Financial Conduct Authority (FCA), reeled off a string of numbers “better than I would have dared to predict a year ago”, in a no-tears farewell to euro, sterling, Swiss franc and Japanese yen Libor.

“What could have been a complete disaster in the main seems to be landing pretty smoothly,” says the head of Libor transition at one major bank.

Even the Federal Reserve Bank of New York seems full of confidence, posting a meme on LinkedIn of the actress Tina Fey high-fiving herself at the thought of “2022 without Libor”.

What could have been a complete disaster in the main seems to be landing pretty smoothly

Head of Libor transition at a major bank

The story isn’t over yet. While market participants will be free to enjoy the New Year celebrations, there will be work to do when they return to their desks. While January 2022 marks the end of most Libor currencies, it is also the beginning of a new phase in the transition as fallbacks kick in for non-cleared contracts and a clean-up operation gets under way.

Because Libor rates published up to and on December 31 will remain valid for the duration of their term, fallbacks for over-the-counter contracts will be triggered over a period of time, as they hit their reset dates. These contracts will also have different interest periods and payment dates to cleared instruments. The fallbacks devised by the International Swaps and Derivatives Association maintain the original coupon dates and push the interest period back by two business days – a so-called ‘observation shift’ – to allow time for payment. Trades converted by clearing houses will retain the original observation period with a two-day payment delay. This will create a slew of mismatches and basis risks to deal with after the initial switch.

Less vanilla parts of the markets will also need further attention. It remains to be seen whether fallbacks for swaptions, which were released late and without a standard protocol for adoption, have been inserted into contracts in a consistent manner. Cross-currency swaps with a US dollar leg are another potential pothole. These could, in theory, reference Libor on the US dollar leg and an RFR on the other, creating a new basis risk in the market.

Then there’s the rump of loans and bonds relying on synthetic Libor – a safety net created by the FCA for contracts that cannot transition to new benchmarks. These instruments will also be exposed to basis risk when derivatives hedges flip to RFRs, but they face an even bigger threat. The FCA will review the need for synthetic Libor annually and has warned the market not to count on the safety net being there for long.

But these challenges are a world away from those that would have followed an unmanaged, disorderly end to Libor. There may be dents and dings in the New Year; there should not be a disaster.