Why US dollar Libor spreads may be mispriced

When Ice Benchmark Administration said on November 30 that it expected to continue publishing the most widely used US dollar Libor tenors until at least mid-2023, the market reaction was swift. Short-term US dollar Libor spreads collapsed nearly 30% as traders priced in the delay. Hedge funds and dealers that had bet on an earlier end to Libor are said to have suffered losses of up $2 billion as a result. 

But the market may have gotten ahead of itself.

The spread move implied IBA’s announcement would also delay the so-called pre-cessation announcement from Libor’s regulator, the UK Financial Conduct Authority (FCA). This statement – designed to give the market as much time as possible to prepare for the benchmark’s demise – will confirm the future date at which publication is going to stop.

The date of the announcement has its own significance. The point at which the regulator pre-announces Libor’s cessation becomes the anchor for a five-year lookback period used to calculate a spread between Libor and its successor – this spread will be added to the successor rates when the old benchmark dies, avoiding a dramatic step-change. The longer the market has to wait for the announcement, the narrower that spread will be, because a greater share of the lookback will be drawn from the recent period of rock-bottom rates.

Will the pre-cessation announcement for US dollar slip along with the end-date envisaged in the IBA consultation, though? Not necessarily. 

Speaking on a December 4 webinar, Edwin Schooling Latter, the FCA’s director of markets and wholesale policy, reminded listeners that the regulator could trigger the calculation of fallback spreads for all Libor currencies and tenors at the same time, even if some benchmarks outlive others.

Cross-currency markets in particular could see significant disruption if fallback spreads for opposing legs of a transaction are fixed at different times

There are good reasons for doing so. Staggering the pre-cessation announcements could create dislocations in the market. This can be seen in the so-called 3s/6s basis, a widely traded proxy for the final fallback spreads. As of January 11, the spread between three- and six-month US dollar Libor was 7.9 basis points, compared with 12.6bp for sterling Libor. Before IBA’s announcement, the 3s/6s basis in both currencies was trading between 11bp and 12bp. Delaying the pre-cessation announcement for most US dollar Libor tenors by 18 months would lock in this discrepancy over the life of outstanding derivatives contracts. Cross-currency markets in particular could see significant disruption if fallback spreads for opposing legs of a transaction are fixed at different times.  

The FCA seems to have no appetite for that. The regulator has maintained it will make announcements about Libor’s future soon after IBA finishes consulting the market on its proposed end-dates. That consultation – which covers all currencies and tenors, not just those scheduled to cease publishing at the end of 2021 – was launched on December 4 and is expected to be completed by the end of January.

“This should make it possible to determine and make announcements on the future path for all five currencies simultaneously, even if the proposed cessation date is different – end-Dec 2021 for four currencies, and end-June 2023 for some US dollar settings,” Schooling Latter said on the webinar. 

He went on to stress that the FCA wanted “to provide clarity to the market on all 35 settings as soon as practicable”.

If Schooling Latter’s comments are anything to go by, US dollar Libor spreads may be due another re-pricing.