07.13.2018

FCA: Reliance On Libor Should Stop By End-2021

Speech by Andrew Bailey, Chief Executive of the FCA, at Bloomberg, London – on transitioning from LIBOR to alternative interest rate benchmarks.

Highlights
Why firms need to end their reliance on LIBOR by end-2021.
Why overnight risk-free rates (RFRs) are the right foundation for interest rate markets.
The progress made on transition to these overnight risk-free rates and the work that remains to be done.

Introduction

When I spoke about LIBOR in July last year, I made clear the need to transition away from LIBOR before end-2021. The importance of doing so has not changed.

Andrew Bailey, FCA

Andrew Bailey, FCA

Today, one year closer to that end-2021 date, I would like to talk about what the world of interest rate benchmarks after LIBOR will look like. The Financial Stability Board, drawing on work done by its Official Sector Steering Group (OSSG), which I have the honour of co-chairing with Jay Powell of the Federal Reserve, has today published a statement(link is external) on the future roles for overnight RFRs and term rates. I will set out some of the progress made on the transition to that future world. I will cover what has been achieved in the year that has passed, and what remains to be done.

I hope it is already clear that the discontinuation of LIBOR should not be considered a remote probability ‘black swan’ event. Firms should treat it is as something that will happen and which they must be prepared for. Ensuring that the transition from LIBOR to alternative interest rate benchmarks is orderly will contribute to financial stability. Misplaced confidence in LIBOR’s survival will do the opposite, by discouraging transition.

There is some good news to report on the important steps taken towards transition. But the pace of that transition is not yet fast enough. There is much further to go.

The case to replace LIBOR

One might consider that the likelihood that this rate will stop would be incentive enough, but I want to begin by setting out the case, indeed the need, to move away from LIBOR. LIBOR, or the London Interbank Offered Rate to give its previous full name, is intended to measure the rate at which banks could borrow funds in the wholesale markets. It was the rate structure for the eurocurrency markets when such things existed as distinct parts of the overall system. There are a number of reasons why LIBOR has become a problem.

First, financial markets have changed, and LIBOR has not been able to keep up with that change. The international interbank market has dwindled substantially. There are several reasons for this. In the shorter-term – post the financial crisis – bank funding has switched away from this interbank market.

Second, the longer-term reason is that the eurocurrency markets no longer exist as a distinct entity. There is a very important point here. The so-called euromarkets lived in an era where it was assumed that they were separate from domestic financial markets. The latter were where domestic monetary policy was set, central banks operated, and were the home of government bond markets. So, naturally, risk-free rates which are rooted in the credit standing and policy institutions of the domestic state, were a feature of domestic financial markets and not the euromarkets. LIBOR was not a risk-free rate, rather, it became a proxy for risk-free rates plus a measure of bank risk. From that, concepts like the TED spread, the US Treasury to Eurodollar spread, emerged as proxies of banking system risk. A problem which resulted – and it is striking with the benefit of hindsight to think how long and to what an extent this has gone on – is that LIBOR came to be used to price much of the interest rate derivatives market, even as that derivatives market expanded far beyond hedges for the euromarkets. Logically a risk-free rate should have been used. I say this because an important reason for reform is to correct this situation.

The third and fourth reasons that LIBOR has become a problem are powerful but shorter to describe. The third is that since banks do not lend to each other much these days on an unsecured basis, and the market is not returning, LIBOR is measuring the rate at which banks are not borrowing from one another. To do this, the system relies on the so-called expert judgement of the panel banks. It is esoteric to say the least to ask and answer the question, were I to borrow, which I am not doing, what might the interest rate be? But, more fundamentally, what is such a rate representative of? And that is critical because to continue in the now regulated world of benchmarks, LIBOR has to be representative. I struggle to see the case for this judgement.

The fourth problem is that since the system for quoting rates and thus constructing LIBOR is fragile, it is more vulnerable to misconduct. But let me be clear, I do not believe there is misconduct today. My point is that the system is more vulnerable to it. This is the case for acting to replace LIBOR.

Read the rest of the speech here.

Chairman of the US CFTC said :

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