Interbank lending rates are used throughout capital markets and the real economy. LIBOR, the London Inter Bank Offered Rate, is the most well-known and was at the centre of a scandal where traders manipulated the rates.
Each currency has interbank lending rates (or benchmarks), which are unsecured and typically set daily, covering various terms from overnight, weekly, monthly and up to one year, at the rate banks are prepared to lend to each other. A whole range of securities from Interest rate swaps (IRS) and other capital market instruments already reference these, and their use extends to trade finance, corporate loans, mortgages and other types of credit.
The government and central bank policy response to the scandal was to request discontinuation of LIBOR, and request the market lead the creation and use of alternative reference rates (ARR) based upon real transactions (backward looking data) rather than based upon consensus views (more like a forward estimate), with the aim of making it less susceptible to manipulation. In order for this transition, all newly traded contracts (including their ISDA agreements) would need to reference the ARR (as they become available and when they are expected to be sufficiently liquid), with the “backbook” of existing, live, legacy contracts requiring remediation to ensure they have the right “fallback” language (to reference new ARR), and are agreeable, and importantly are enforceable. Every area from legal, pricing, trading, risk management through to operations, settlements, treasury and finance are affected (as well as loans, mortgage products and syndication). This is the most far-reaching change to the global finance industry, being a market solution led change rather than purely a regulatory compliance issue. Inaction is not an option, with regulators recently reminding us that rules are part of their toolkit, and may be introduced if the market does not find and act upon a solution.
Understanding the technical and operational flows within each business line and asset class, is critical in preparing for this change. Norton Edge provides the clarity of thought and depth of experience required in order to help analyse impact and map current operational models.
Part 2 of IBOR 101 will provide insight as to what courses of action the institutions should take – based upon what is already known, and despite the uncertainty as to which of the IBOR replacement scenarios will play out.