Life without Libor

Pakistani authorities are reportedly planning to float ‘Panda’ bonds in the Chinese market. Given that the London Interbank Offered Rate (Libor) – which has been the benchmark for most previous Pakistani bonds floated abroad – has fell out of favour among central banks and is apparently on the way out, it will be interesting to see which near-risk-free-rate benchmark the Pakistani government picks up for this issue.

For more than three decades, Libor has remained global interest-rate-setting benchmark. It is derived from cost-of-funds expectations, as reported by selected prime banks, for inter-bank, short-term, unsecured lending. This benchmark, which offers multiple currency-tenor pairings suitable to a variety of instruments, markets and geographies, managed to survive a rate-fixing scandal that emerged during the 2008 financial crisis, leaving in its wake hefty fines on some banks and prison-time on a few bankers.

But while the markets continued their Libor love affair – underwriting trillions more in financial contracts using the peg – the 2008 rigging scandal, which enriched greedy traders/bankers at the expense of public, had tainted its reputation among Western central banks. The Inter-Continental Exchange (ICE) – the mega conglomerate which now administers Libor after its original custodians, the British Bankers Association exited the scene circa 2014 – has pledged reforms to bring Libor in line more with real-time transactions/data and away from banker expectations.

But the leading central banks in the West are having none of it. Both the United States and the United Kingdom have come up with alternatives which they hope will replace Libor over time. Early in April this year, the US Fed introduced the Secured Overnight Financing Rate (Sofr). Sofr is different from Libor in two key aspects: i) it tracks actual, overnight cost-of-funds cash transactions, and ii) it is secured against US treasury securities. Both those aspects make Sofr a close proxy for what happens in the real market.
Later that same month, the UK’s Financial Conduct Authority (FCA) introduced a reformed version of the two-decade old ‘Sterling Overnight Interbank Average Rate’ (Sonia). The Sonia rate is the Sofr-equivalent for the UK, but specific to Sterling-based cash repo transactions. Having made it clear that it will not legally bind the financial institutions to report their Libor rates beyond 2021, the FCA is encouraging financial institutions there to move towards Sonia.

Both benchmarks, Sofr and Sonia, made the waves this year after institutions like Credit Suisse, Lloyds, Fannie Mae, World Bank and the Asian Development Bank raised funds using either of these rates. But adoption is slower. One recent Financial Times estimate noted that $370 trillion worth of financial products were still using Libor and Euribor (Euro Interbank Offer Rate). Another estimate put Libor alternatives like Sofr & Sonia having less than 5 percent market share in loan and derivatives contracts.

Why is Libor not dying, even though it is being shown the door? One view is that even though it is a flawed benchmark – on account of (i) its methodology (there is banker discretion involved) and (ii) its usage cases (the lending rate captured in Libor is projected to all kinds of non-lending financial products), Libor is still about the only benchmark that is deeply ingrained in and acceptable to the global financial system. Meanwhile, suggested reforms by ICE, especially the Waterfall Methodology, are expected to make Libor reflect the real market activity instead of a few bankers’ vested interests.

But the constant push by progressive central banks to replace Libor must make countries like Pakistan to prepare for the eventuality: a life without Libor. After all, Libor will no longer have official sanction by the end of 2021, after which it will be competing with the likes of Sofr and Sonia. Better, then, for Pakistan to contract new bonds and loans with a different interest-rate benchmark. (There are Shanghai and Hong Kong Inter-Bank Offered Rates, too, by the way).

What, then, of the outstanding bonds and commercial loans contracted in Libor? Better let them mature over time and re-contract the rolling ones with a non-Libor benchmark. Though it looks like Libor will likely be around in the 2020s; but should it die sooner, the old contracts will need to be carefully rewritten and replaced with a non-Libor rate. That may not be a catastrophic event, though it will exact some legal fees.

On a concluding note, given the reforms going on abroad, perhaps the Pakistani central bank also needs to commission a review on whether the current Kibor (Karachi Interbank Offered Rate) mechanism is rigorous enough to reflect the market realities.