Here's what will happen after the death of the magical number underpinning $350 trillion in trades

day of the dead hat

  • Libor, linked to about $350 trillion worth of financial
    products, will be replaced by an alternate pricing benchmark for
    everything from mortgages to credit cards. 
  • Replacing Libor will be lengthy and problematic, and is
    one of the key themes to look out for in 2019 as financial services
    and asset managers start transferring to new
    systems. 
  • Thousands of existing contracts will need to be
    renegotiated causing a huge operational and financial burden that
    will consume legal teams for months. 

Libor, the rate that banks agree on when lending to each other,
was problematic from the beginning. Unsurprisingly, it turned out
to be widely rigged, and some of the biggest and most notorious
banks had gotten tangled up in the Libor rigging scandal. Some
criminal charges were brought against low-level traders, and huge
fines were levied against some of the banks.

Another big thing that came out of the scandal was the
realization that Libor, crucial to the credit-based economy and to
hundreds of trillions of dollars in derivatives, had to go. It is
due to die by the end of 2021.

“This is a material change in one of the most important numbers
in finance,” said Sandie O’Connor, chief regulatory affairs officer
at JPMorgan Chase in New York.

Short for the London Interbank Offered Rate, Libor underpins
everything from credit card loans to mortgages to the more arcane
derivatives and syndicated loan contracts. Millions of financial
products use the benchmark. 

Upending Libor has become
key
in 2019, meaning that this is the year to start worrying
about the thousands of contracts that need to be renegotiated as
the financial world shifts to new systems. 

“Operationally, the amount of work needed to make changes is
tremendous,” said Kevin McPartland, head of market structure at
Greenwich Associates. 

The new benchmarks 

Enter new alternate benchmarks — SOFR (the secured overnight
financing rate) will be introduced in the US and will be secured
against US Treasuries. Europeans will be served by Sonia/Eonia
(Sterling/Euro overnight index average) instead.

Where Libor relied on a system of individual banks submitting
their figures for lending costs each day — making it ripe for

manipulation
— SOFR will be calculated using real
transactional data. Banks paid $9 billion in fines following the
rigging scandal, with new rates introduced to reduce human error,
and even outright fraud. 

Referring to SOFR, JPMorgan’s O’Connor said: “We need to
leverage financial infrastructure to get people trading on this
benchmark, because just having a rate does not make a market.”

It’s complicated

There’s another catch for replacing a 35-year old system. Libor
and SOFR represent different levels of risk, so swapping out one
system for the other will be a lengthy, and potentially costly,
process for some contracts. 

Similarly, SOFR needs significant trading volume in order to
build up enough data to determine value for one month, three month,
and six month rates.

From a documentation and interest rate perspective, things get
more complicated still. In June, The Bank of England pointed out
that in the previous 12 months the stock of Libor-linked sterling
derivatives stretching beyond 2021 had grown.

Significant runway is needed

Market structure experts cite the need to amend existing
contracts to include “fallback” clauses which which specify what
happens when Libor disappears.

This is comparatively easy for loans, but for derivatives,
swaps, and options, amending existing contracts could potentially
lead to legal battles. 

That’s why 2019 is a crucial year.

“Loan documents, systems and practices will need to evolve to
accommodate SOFR,” said Meredith Coffey, executive vice president
of the Loan Syndications and Trading Association. “Significant
runway is needed to restructure, given the magnitude of the issue
and the thousands of deals that will need to be converted.”

London is behind

Some companies haven’t got their act together quite yet. A
survey conducted by JCRA, an independent financial risk management
consultancy, and Travers Smith, a London law firm, has found that a
large majority of firms with exposure to Libor are yet to start
making preparations for its discontinuation. 

Beyond that, prospectuses and technology will need to be changed
and new futures contracts will need to be drawn up. CME has
launched SOFR
futures
, ICE did the
same
last October, LCH (The London Stock Exchange’s clearing
unit)
cleared
its first SOFR swap contract last July and CME
followed
a few months later.

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Source: FS – All – Economy – News
Here's what will happen after the death of the magical number underpinning 0 trillion in trades