Financial markets should start accelerating efforts to ditch Libor in favour of the Bank of England's revamped interest rate benchmark being launched next week, a senior BoE official said. Banks have been fined around $9 billion for trying to rig Libor, or London Interbank Offered Rate, prompting the BoE and other central banks to come up with their own "risk free" substitutes that are more difficult to manipulate.
Last year, banks and other market participants in London backed the daily Sonia or Sterling Overnight Index Average as a substitute for sterling-denominated Libor to price trillions of pounds in swaps and derivatives contracts. Sonia was run by a trade body in the past but from Monday it will be calculated and published by the BoE and based on transactions that represent about 90 percent of the market.
Sonia is based on actual transactions rather than quotes made by banks, which were open to manipulation. It will be draw on about 50 billion pounds ($70.91 billion) worth of daily funding transactions between lenders and customers, three times the amount of transactions that underpin Sonia at present. "This has been a long time coming," Sarah John, head of the BoE's sterling markets division, told Reuters.
Market participants have been waiting for the BoE to make Sonia more robust before ditching Libor and shifting trillions of pounds in liquidity. "That's why it was an absolutely critical milestone to get Sonia reformed because until that was in place, a lot of the rest of the work that was needed could not really start in earnest," John said.
The New York Federal Reserve began publishing its dollar Libor replacement, the Secured Overnight Financing Rate or SOFR, on April 2, but has suffered calculation hiccups. John said data gathering for the revised Sonia has been tested with a "shadow" benchmark produced in recent weeks. "Some of the issues that happened in the US shouldn't happen to us," John said. Britain's Financial Conduct Authority has effectively set an end 2021 deadline for migrating from Libor to Sonia, warning that Libor may not be around after then.
In September 2016, Sonia was used to price 7.7 trillion pounds of derivatives, but this is dwarfed by 40 trillion pounds of derivatives based on Libor. John expects new products will help to build up Sonia liquidity, including loan and bond market products that currently reference Libor. The Intercontinental Exchange and London Stock Exchange are launching rival three-month futures contracts based on Sonia.
John sees little excuse not to switch to Sonia when it comes to new business but legacy Libor contracts present a challenge. Libor comes in variants that stretch out many years, even if regulators question their robustness, while Sonia is a purely overnight rate. John said it was difficult to devise a Sonia rate stretching out months into the future as there is no real market to underpin it and she wants to avoid benchmarks based on quotes or estimates rather than actual transactions.
"I don't think I would say it's my expectation that nothing can be done here, but I am saying it's something we need to work through carefully and fully understand the risks before landing on a way forward," John said. Libor is compiled by a division of ICE, and Stuart Williams, president of ICE Futures Europe, said that for now Sonia will not be able to replace all Libor usage because it lacks forward versions. Not all legacy contracts will migrate to Sonia. Libor itself is being reformed and could still live on in some form.
"While the FCA have announced they are not going to be forcing or mandating contributions to Libor post 2021, that doesn't prevent contribution by choice," Williams said. John said the jury was still out as to how much of the migration of legacy Libor to Sonia would be feasible. "Inevitably there will be a very small proportion of the market that will find it difficult to make the transition." But in the meantime people should start thinking about what it means to them if there is no Libor rate after 2021, she said.
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