(Bloomberg) -- The U.K. Financial Conduct Authority warned traders to speed up their move away from products based on the Libor rate, or risk falling foul of the regulator when the 50-year-old borrowing benchmark disappears.
Financial institutions still hold about $170 trillion in swap contracts based on Libor, or the London interbank offered rate, and about a third of those mature after 2021, when the benchmark rate will disappear, FCA Chief Executive Officer Andrew Bailey will say Thursday in a speech at Bloomberg’s headquarters in London.
“Firms that we supervise will need to be able to demonstrate to FCA supervisors and their Prudential Regulation Authority counterparts that they have plans in place to mitigate the risks and to reduce dependencies on Libor,” Bailey said. "Misplaced confidence is a risk to financial stability as well as to individual firms. The pace of that transition is not yet fast enough."
The FCA is pushing for a quick phase-out of Libor because it’s antiquated, brings too much risk for derivatives and is vulnerable to abuse. While the U.K., U.S., Japan and other regulators have suggested alternatives, the issue remains of how to deal with the legacy of contracts that reference it -- the so-called back book. Alongside the difficulties in changing pacts while they are still in effect, there’s the problem that a new rate will be at a different level to the old one. That will create winners and losers, giving those who miss out an incentive to turn to the courts.
The International Swaps and Derivatives Association, the industry trade body, estimates that about 80 percent of current derivative exposure will expire by the end of 2021. That will reduce the size of the problem only if new contracts don’t rely on it. Given that potential replacements lack the liquidity of Libor, traders are still opening new Libor-based positions, according to ISDA.
“There is substantial consensus that the largest part of the market currently relying on Libor -- that is the bulk of interest rate derivatives -- does not need term rates,” Bailey said, adding that “synthetic solutions” created to replace Libor weren’t viable.
Banks may be happy to see the end of Libor. They’ve been fined more than $10 billion for Libor rigging by traders, according to an April analysis by Bloomberg Intelligence. Several bankers have been found guilty in U.K. and American courts for participating in the rigging schemes. The scandals provided part of the justification for the regulators to do away with the benchmark.
Bailey said last year that from 2021, the FCA will no longer force banks to be on the panels that estimate the various Libor rates. While Intercontinental Exchange Inc., the company that administers Libor, plans to continue publishing the gauge after that date, liquidity in the interbank markets that those estimates are based upon is declining.
“I don’t see a prospect of a reversal in the decline of the market activity that Libor seeks to measure,” Bailey said in a speech in March. “The FCA has not changed its position that it is not going to use powers of compulsion towards submitters” beyond 2021, he said.
If Libor were no longer available, the terms of many bonds that reference it typically would mean the interest rate being fixed at the most recent rate for that issue, according to the International Capital Market Association.
The benchmark is the average rate that a group of 20 banks estimate they’d be able to borrow funds from each other in five different currencies across seven time periods, and is submitted by a panel of lenders every morning. Its administration was overhauled in the wake of the scandal, with Intercontinental Exchange taking over from the then-named British Bankers’ Association with the aim of making the rate more transaction-based.
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