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COMMENTARY: Last Libor bank standing

Imagine you’re an executive at one of the banks on the panel that sets Libor rates. Perhaps even the executive responsible for your bank’s Libor submissions.

You and your colleagues may be feeling a little uncomfortable. After all, Libor is a word synonymous with unsavoury concepts such as manipulation, fraud even. It carries with it a degree of reputational risk.

But stop: your bank already struck a deal with the Financial Conduct Authority, Libor’s regulator, to continue submitting quotes to the panel to ensure the benchmark survives until the end of 2021, giving the markets some breathing space to be able to engineer a suitable replacement.

In that respect, your employer is doing the financial markets a great service in maintaining crucial stability at a delicate juncture.

Now, however, the time has come for the benchmark that underpins trillions of dollars of financial products to fade gently into oblivion. As banks on the Libor panel begin to drop out – as is their right from the start of 2022 – there will come a point where the benchmark no longer reflects the underlying markets it purports to represent.

There are 16 banks on the panel that sets sterling Libor and US dollar Libor. Let’s suppose regulators and/or the benchmark administrator decide in advance that six is the minimum number of participants in the panel for the rate to remain representative.

Now let’s suppose a series of banks quit the panel, leaving your firm as one of the six remaining Libor-setting firms. The existence of Libor hangs by a thread. Imagine your dilemma: if your firm informs the regulator of its intention to resign from the panel, Libor will immediately die, triggering a mass fallback exercise as the benchmark transitions to alternative risk-free rates. Whisper it quietly, but your firm could position itself to benefit from this transition and make some quick cash.

The regulator and administrator are aware of this awkward scenario. And so the exact number of panel banks that would constitute an unrepresentative rate remains cloaked in mystery.

That very opacity is causing problems for dealers and other Libor users. Some are calling for ‘pre-cessation’ triggers to be inserted into derivatives contracts to switch instruments to a fallback rate if Libor is no longer deemed representative but before it finally dies. Others argue these triggers are not required.

This is one of many areas of controversy and confusion besetting Libor. Debate will continue as the benchmark’s end-2021 day of destiny draws closer.

STAT OF THE WEEK

Implied volatility on three-month EUR/USD options was at 4.7 at the start of December, down more than a third since the start of the year and just over half the level at the start of 2017. Low volatility has sapped impetus from the forex options market in recent months.

QUOTE OF THE WEEK

“I would say the political risk is becoming worse and worse, so this is kind of a probability recalibration” – risk manager at a Chinese bank, on the heightened chances of the Hong Kong dollar de-pegging from the US dollar.