Benchmark Reform Is Big Industry Challenge

Shanny Basar

Scott O’Malia, chief executive of derivatives trade association ISDA, stressed that benchmark reform is the biggest task for the financial industry.

Scott O’Malia, ISDA

“In fact, I can’t think of any other event past or present that even comes close in terms of scale and impact,” he said at ISDA’s regional conference in London yesterday.

There have been a series of scandals about investment banks manipulating Libor, and other interest rates, for their own benefit, which resulted in regulatory penalties of $10bn (€8.5bn). As a result, regulators have been looking to move away from Libor and other interest rates submitted by a panel of banks and moving to risk-free rates based on actual transactions.

O’Malia explained that financial markets have total exposure of more than $370 trillion from derivatives, loans, mortgages and deposits to Libor and other benchmark rates so the transition will be felt by virtually everyone. The move will take time due to the difficulty of changing existing contracts, for example, a change in the terms of a bond requires the consent of a majority of investors.

In addition the transition is taking place under a short timeframe. The UK FCA will not require Libor panel banks to make submissions after the end of 2021 and the transition period for compliance with the EU Benchmarks Regulation is due to expire at the end of next year.

ISDA published a survey and report on benchmark reform in June and O’Malia said there has been some progress.  Cash bonds, futures products and clearing services for swaps linked to the US and UK rates. The US is adopting SOFR, the secured overnight financing rate, while the UK will be using Sonia, the sterling overnight index average. The World Bank Group this week sold a record £1.25bn Sonia bond

In the European Union the European Central Bank’s working group has recommended Ester, the euro short-term rate, as the new risk-free rate to replace the existing EONIA, the euro overnight index average.

The ECB said in a statement: “This is because the EONIA as it stands will no longer meet the criteria of the EU Benchmarks Regulation and will therefore see its use restricted as of 1 January 2020.”

The European Commission’s Tilman Lüder, told the ISDA conference that he had high hopes for Ester but was concerned about the transition from the Euribor term rate.

Lüder said: “It is unlikely that any of the IBORs will be very reliable so the industry needS to work out how to structure term rates from reliable sources. The aim should be to construct term rates based on overnight data.”

Vladimir Tsonchev, expert, DG market operations, money market and liquidity division at the European Central Bank, added on the panel that Ester is intended to launch by October 2019 at the latest. However this leaves only a short time before EONIA stops being published in 2020.

Nick Saggers, managing director, business support executive at Bank of America Merrill Lynch, said on the panel: “This is a challenge for new products. Not many swaps have used SOFR although the rate has been published since April and clearing is available.”

David Horner, head of risk for rates derivatives at LCH, the clearing house owned by the London Stock Exchange Group, explained on the panel that the US is allowing three years between the launch of a risk-free rate, the creation of a term structure and full transition.

The UK and US have made more progress on the transition, but more work still needs to be done.

Edwin Schooling Latter, FCA

Edwin Schooling Latter, head of markets policy at the Financial Conduct Authority, said on a panel at the conference that there is no guarantee that Libor will survive until 2021, as the underlying market is shrinking, and there will then be a period of acute uncertainty.

“Libor panels could contract or the rate may become unrepresentative of the market,” he added. “We would then need to construct a synthetic rate and how will this be done ? It is better for the market to move away from Libor before this happens.”

Horner said the industry is in the foothills of the transition to risk-free rates.

“A lot of financial market infrastructure has been built and is in use and working,” Horner added. “The next challenge is to introduce incentives that nudge volumes.”

Katherine Darras, general counsel at ISDA, said on the panel that the association launched a consultation in July regarding implement fallbacks for derivatives contracts referenced to certain IBORs. Comments are due by October 12.

O’Malia said: “However, if a fallback rate takes effect, it’s important that it occurs with the minimum amount of disruption.”

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