The end of Libor?

On June 30, British bank NatWest sent out an arcane-sounding press release - bus operator National Express had become the first company to take out a loan based on Sonia, a replacement for scandal-hit interest rate benchmark Libor.

It was billed as the first switch of thousands that British firms would make by end-2021, when the benchmark is set to be decommissioned. Four months on, NatWest's trailblazing Sonia switch has been followed by only one other loan, when the bank struck a deal with utility South West Water on October 2.

The slow progress highlights the challenge banks and borrowers face as regulators attempt to end the use of Libor, a benchmark embedded in as much as $340 trillion financial contracts worldwide from home loans to complicated derivatives.

Libor, once dubbed the world's most important number, was discredited after the 2008 financial crisis when authorities in the United States and Britain found traders had manipulated it to make a profit.

But replacing Libor is proving expensive and tricky with concerns that, if mishandled, it could trigger credit market confusion and waves of lawsuits, finance industry sources said.

With no obvious alternative, some countries are adopting their own benchmarks. The United States is leading the way with a booming trade in derivatives linked to its new Sofr rate, while the European Central Bank started publishing Estr, its new interest rate benchmark, earlier this month.

In Britain, professional investors such as hedge funds and pension insurance clients are also already writing and trading derivatives contracts linked to Sonia. But companies which make up the so-called Libor "cash" market of sterling-denominated loans are dragging their feet or are even not aware of the shift.

At least two banks in Britain have shifted staff from teams preparing for Brexit to specialist Libor taskforces in the past quarter as the issue becomes more pressing, industry sources said.

"Part of the market is very educated and smart on this and part of the market is not even aware that Libor is going," said Phil Lloyd, head of market structure & regulatory customer engagement at NatWest Markets.

Lloyd said banks like NatWest are battling to allay concerns among corporate borrowers that the Sonia benchmark will make it harder for them to know how much interest they owe because the rate is backward looking.

Sonia, the sterling overnight index average, is based on the average of interest rates banks pay to borrow sterling from one another outside market hours, and is published at 9:00 am local time (0800 GMT) daily, after the transactions have been vetted by the Bank of England.

Borrowers taking out Sonia loans will in effect not know exactly how much interest they owe until they are required to pay.

In contrast, loans linked to Libor can have forward-looking term rates, meaning borrowers have greater certainty over their future liabilities and can manage cash flows more easily.

Bankers and consultants said the market was exploring a forward-looking Sonia term rate by mid-2020 to appease borrowers but not everyone is in favour.

The overnight Sonia rate, based on actual transactions, is seen as more robust and less vulnerable to the kind of manipulation that affected Libor, which was based on rates submitted by banks.

The Libor rigging scandal saw billions of dollars in fines levied on major banks and jail sentences for traders convicted of manipulating the benchmark for profit.

Some banks and lawyers fear the creation of a Sonia term rate, which would likely be based on forward-looking estimates from banks as opposed to past transactions, could undermine the security of the benchmark and even spawn legal dangers for banks.

Murray Longton, a consultant at Capco who advises financial firms on Libor transition, said banks were fearful of lawsuits, as the proliferation of alternative Sonia term rates offered by different lenders could spark allegations of mis-selling.

"If you get this wrong, this is PPI for investment banking- if you haven't communicated properly and you move a customer (on to Sonia) and benefit, there could be a case where this gets reviewed and you owe your client a lot," he said.

The Payment Protection Insurance (PPI) mis-selling scandal in Britain has cost banks more than 43 billion pounds in compensation after the contracts were retrospectively deemed to have been mis-sold.

"A lot of the corporate market are waiting for a few things of which one is a term rate. And if they never get a term rate, then waiting will lead to them still executing Libor, and not being ready for Sonia. The clock is ticking," Lloyd said.

"And the other point about having a term rate is you're starting to get back into a world where you are really recreating a new version of Libor."

But the reluctance of corporate borrowers to buy into Sonia is not the only reason for the slow progress.

Banks face large costs for adapting systems and educating thousands of relationship managers on the merits of Sonia over Libor.

Fourteen of the world's top banks expect to spend more than $1.2 billion on the Libor transition, data from Oliver Wyman show, with the costs for the finance industry as a whole set to be several multiples of that sum.

Much of this cost is linked to the arduous task of changing the terms of contracts tied to Libor whose duration extend beyond the 2021 deadline. Progress has been held up not only by nervous borrowers but also by banks in loan syndicates which may not always agree on the new wording required to adapt existing loan agreements to the new benchmark.

"You need unanimous agreement to change the baseline product, so what are the chances if you've got 10-15 participants (in a syndicate) that they will all agree on the same thing?," Capco's Longton said.

Some corporate borrowers are also playing a wait-and-see game to see whether they can benefit financially from Libor's slow death spiral. But this could have costly consequences, depending on the so-called "fallback" language in contracts for their existing loans.

These fallbacks - originally designed to kick in if Libor was temporarily unavailable - usually stipulate alternative rates, such as calling other banks for a quote or using the last published Libor rate. But the fallback clauses were not designed to cope with Libor ceasing to exist indefinitely.

That could create big risks for borrowers, for example, by potentially converting a "floating rate" loan, tied to the fluctuations of Libor into a fixed-rate one.

Serge Gwynne, a partner at consultant Oliver Wyman, said regulators could do more to help banks manage the transition away from Libor, starting with much harder deadlines on when it would formally cease to exist.

"Libor is embedded everywhere in the plumbing of the financial world, that's why this is such a big challenge," said Longton.

"You are changing a product that has been used to create markets for a long time. You are not just taking one thing out and putting one thing in but changing the whole dynamic of how this works."