The London interbank offered rate may survive more than a year longer than investors were told, as the financial industry continues to grapple with the challenge of transitioning away from a crucial but troubled benchmark and toward a regulator-backed replacement.
(ticker: ICE), whose ICE Benchmark Administration collects submissions for the interest rate, said Monday that it would speak with market participants about continuing to publish all but two maturities of U.S. dollar Libor until June 30, 2023. Global banking regulators had originally targeted the end of 2021 for the end of Libor.
The five Libor maturities that may survive beyond 2021: overnight, one-month, three-month, six-month, and 12-month.
The IBA said it still plans to halt the publication of one-week and two-month Libor, tenors that are less commonly used as benchmarks, after Dec. 31, 2021. The administrator said it still plans to cease other currencies’ Libor publications at the end of next year.
Libor’s fate matters because it has been for decades a crucial input into the interest rates of financial products as diverse as floating-rate business loans, preferred share payouts, floating-rate corporate bonds, and commercial mortgages.
Libor, which was found to have been manipulated leading up to the financial crisis, has been the subject of a yearslong effort by regulators to shore up the integrity of the global financial system. More recently, experts have noted low transaction volumes in the market underlying the benchmark.
U.S. banking regulators published a joint statement on Monday encouraging banks to stop using Libor in new contracts “as soon as practicable” starting at the end of next year, and said that if banks continue to underwrite contracts with the benchmark as usual after that time it “would create safety and soundness risks.”
But they also said that continuing to publish Libor until mid-2023 “would allow most legacy [U.S.] Libor contracts to mature before [the benchmark] experiences disruption.”
That highlights one of the major challenges of replacing Libor: Many of the outstanding contracts behind bonds and loans that use Libor aren’t standardized. And while industry groups for business-loan and derivatives markets have come up with alternatives and replacements, there are some contracts that don’t have an easy alternative.
In fact, legislation may be required for those contracts, according to strategists at TD Securities. “Some contracts referencing USD Libor will remain even after June 2023 and for those contracts legislation is the only solution,” they wrote in a Nov. 30 note.
There are other reasons the timing of the switch matters in the U.S., the strategists say. A quicker transition could temporarily boost interest rates that issuers have to pay (and investors receive) on existing derivatives contracts tied to Libor, they point out in a recent note.
That’s because of an adjustment regulators need to make to the “fallback” rate (or the replacement rate) to make it more comparable to the old one. Libor is supposed to include compensation for the risk of a bank defaulting, while the new benchmark, called the Secured Overnight Financing Rate or SOFR, is not. So regulators and industry associations have suggested adding an adjustment to outstanding contracts—basically adding an extra yield cushion for credit risk.
Financial industry groups and regulators recommend the following adjustment: Measure the median gap between Libor and SOFR over the past five years, and then add that amount to the SOFR benchmark rate.
But if the industry starts using that adjustment rate now or over the coming year, it will reflect a jump in Libor that occurred in 2016 for technical reasons.
TD Securities’ strategists lay out the difference that would make in their Nov. 30 note. If outstanding derivatives contracts start using the benchmark for 6-month Libor at the end of this year, the rate’s adjustment spread will be more than 40 basis points (hundredths of a percentage point). If it occurs at the end of 2021, it will be closer to 30 basis points. And by midway through 2023, it falls below 30 basis points.
Between the legislation needs and the extra costs, “given regulators’ insistence that the Libor transition must proceed, the [time] extension may be viewed as helping to smooth the transition,” the strategists wrote.
Write to Alexandra Scaggs at [email protected]