The demise of Libor is not a done deal for markets
Moving more than $350tn of derivatives pegged to benchmark will take longer than five years
by: Alexandra Scaggs
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© FT montage
Reports of the death of Libor may be exaggerated, particularly in US markets.
The UK markets regulator, the Financial Conduct Authority, has set a rough timeline for banks to prepare for a transition away from the floating interest rate benchmark that is crucial to world markets. By the end of 2021, it will no longer require banks to contribute to its calculation for rates in sterling, it said.
Yet that may not signal the passing of a number that over the last 30 years emerged as one of the pillars of global finance and, more recently, a symbol of its decay.
Libor’s administrator, the US’s Intercontinental Exchange, will still be able to publish the dollar rate after that point, and analysts and trading executives say it may still be necessary.
Five years is not long enough for banks to overhaul the $350tn of outstanding derivatives, loans and mortgages tied to the key reference rate, they say.
Banks, companies, insurers, pension funds and consumers are among a multitude of participants that have swaps and debt that is regularly affected by changes in short-term interest rates in the money market. Libor for a term of one month and, more often, three months maturity are the cornerstones of the floating interest rate market for the broader economy and users of derivatives.
The question now is, how many banks will be willing to contribute to the benchmark after 2021, and for how long?
“It’s certainly possible that they’ll continue to publish the rate,” says Mark Cabana, a strategist with Bank of America Merrill Lynch. “But it’d be something banks do because they recognise how pivotal Libor is in the financial system, and not because of anything related to their bottom line.”
Libor has already created headaches for market participants. Banks and interdealer brokers racked up $9bn in penalties because their employees tried to manipulate the rate, and authorities demanded a wholesale review of Libor, passing administration from the industry to ICE, a regulated Exchange.
Global regulators envisaged the rate would be based on transactions, rather than the survey structure that left it vulnerable to price fixing. But the underlying market — unsecured short-term lending between banks — is not exactly vibrant.
In the second quarter of 2017, less than half of all currencies’ Libor submissions for terms of a week or longer were based on actual transactions, according to data from ICE. That introduces some legal risk, since flawed submissions could be subject to regulator scrutiny.
Substitutes for libor are planned. In June, the Alternative Reference Rates Committee (ARRC), a dealer-led industry group backed by regulators, announced a US replacement called the Broad Treasury Financing Rate (BTFR). It is expected to be running in the first half of next year. Last week CME Group, ICE’s derivatives exchange rival, said it would develop futures and options on the new benchmark.
But the rate is not published yet and, crucially, the BTFR measures the cost of overnight repurchase agreements (repo) secured by Treasuries, whereas Libor reflects unsecured money market-based borrowing between banks.
Another issue is building out longer-term reference rates, particularly for one or three months, from the overnight rate in the event of a permanent Libor demise. Dollar Libor is quoted across a range of monthly maturities out to 12 months.
The dollar-denominated swaps market has about 65 per cent of its more than $100tn in notional outstanding value tied to Libor, according to the ARRC. A swap contract involves the exchange of fixed and floating rate cash flows over a term that can run to 30 years or longer. Such contracts generally rely on three-month dollar Libor as the benchmark floating rate.
“US dollar Libor has to live longer, because the replacement is going to take a while to roll out,” says Jason Williams, a strategist with Citi Research.
ICE’s policy is to publish Libor as long as it receives five or more submissions for a particular currency. But if enough banks decide to stop contributing to the Libor panel, others may follow. And broadly, a five-bank panel is likely not enough to sustain a rate over the long term.
The market is exploring options if ICE were to stop publishing Libor before all the relevant contracts are updated. Regulators, banks and investors could agree on a fixed spread over their region’s chosen short-term reference rate, and work out a term structure.
But as Mr Cabana notes, the option “obviously would raise some concerns around what spread to be chosen, the term structure of the fixed spread . . . but these, in our view, would be easier challenges to address than renegotiating and re-hedging existing contracts”.
ISDA, the derivatives industry’s main trade association, is also working on details of potential fallback provisions to be used if Libor is no longer published. Commercial rivals are also interested. Meanwhile, the CME eyes it as a chance to exploit futures contracts that would be tied to new reference rates.
“We are working very closely with ISDA on potential fallback,” Sean Tully, global head of financial and OTC products at CME, told investors on Tuesday.
But executives and analysts acknowledge none of these new benchmarks have as wide of a reach as Libor.
“In the end, we see the most likely scenario as involving a fractured derivatives market with multiple underlying benchmarks across different countries developing,” says Mr Cabana.
Even the fact that the move was largely on the shoulders of Apple’s jump higher after it released great earnings news shouldn’t make much of a difference. The trend is the trend, and it is still to the upside.
The real problem is that a few of the positive developments I’ve presented here in recent weeks have started to peel away. That does not mean this bull market is over, but it does put us on notice for the sometimes critical month of August.
Why is August critical? Not for the fireworks of, say, October. It is often a slower month in terms of turnover as summer vacations take hold. And as we approach Labor Day, volume can get quite low, creating a market where even the slightest change in mood can move the price needle quite a bit. Heavy volume provides buffers. Lower volume allows one side—either bull or bear—to dominate.
For example, the so-called flash crash of 2015, when the Dow Jones Industrial Average dropped roughly 1,100 points in the first five minutes of trading, and exchange-traded funds nearly collapsed due to panic selling. That happened on Aug. 24.
Of course, that’s an oversimplification, and there were many other reasons why prices moved so much. I contend that if the markets had been their usual robust selves, the whole incident would have been more modest.
That sets up this month for a surprise, although I cannot say definitively it will be a negative one. Yet given the recent negative action in some of the sectors and indexes whose technical breakouts I cheered on, it does seem that more caution is warranted.
Monday, I wrote here that the Dow Jones Transportation Average fell off a small cliff. The short-term condition still looked vulnerable, but the long-term trendline from the start of this leg of the rally remained intact.
I warned that the trucking subsector was already sitting on its own trendline, and in Tuesday’s session it fell below it.
It’s not the death knell for the broader market, just something to keep in mind. But now, the small-cap Russell 2000 index has fallen back into its prior trading range, and that is yet more evidence for the bears (see Chart).
Chart
Should the index drop below that short-term support, I would have to concede that the important upside breakout failed—and down goes another bullish argument.
Finally, recent weakness in big technology stocks has also scared the bulls. On July 27, many of the big names scored bearish reversal patterns by jumping higher early in the day and closing with significant losses. Amazon.com’s (ticker: AMZN) earnings miss played a large role, but the Dow industrials still managed to close at a fresh record high. New highs are not bearish.
Even Amazon is not truly bearish, as it remains above the major trendline drawn from the start of this rally leg in February 2016. Further, the NYSE advance-decline line, which measures full market breadth on the New York Stock Exchange, reached another all-time high of its own on Tuesday.
Because market breadth remains strong, even as a few sector indexes weaken, it is very hard to think the market is about to break. Three of my four key sectors—financials, home building, and tech—remain very close to multiyear highs. Only retail is floundering.
The caveat is that as August activity starts to thin, even small bits of bad news can cause a stampede to the exit doors. Of course, a little more good news could cause a stampede to higher prices, so the conclusion is to hold a bullish point of view but not mortgage the house to do it.
Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.
