How prepared are markets for the end of Libor?

The purpose of Bank Overground is to share our internal analysis. Each bite-sized post summarises a piece of analysis that supported a policy or operational decision.
Published on 30 September 2019
With Libor expected to be discontinued after end-2021, the use of alternative interest rate benchmarks is steadily increasing. But use of Libor remains widespread, and this poses risks to market stability.

Libor, one of the main interest rate benchmarks used in global financial markets, is a measure of the average rate at which banks are willing to borrow wholesale, unsecured funds. It underpins financial contracts worth trillions of pounds, including derivatives, bonds and loans.

But the way banks fund themselves has changed, leaving very few transactions in the underlying market Libor measures. This means Libor is not a reliable benchmark for interest rates and is expected to be discontinued after end-2021.  

Users of Libor need to prepare by transitioning to alternative, more robust benchmarks, such as overnight risk-free rates.

In sterling markets, the primary alternative is SONIA, which is published by the Bank of England and based on an average of over £40 billion of transactions each day.  This supports a well-established and growing derivatives market, and has rapidly become the benchmark of choice for floating rate bonds over the last year.

Despite the progress in establishing alternative reference rates and in building these new markets, much more work is needed to complete the transition.  Many new contracts maturing beyond 2021 continue to reference Libor. 

In particular, in loan markets, Libor-linked lending continues to dominate. And many new long-dated derivative contracts also continue to reference Libor, with steady growth in the stock of cleared sterling Libor swap contracts maturing beyond 2021 (Chart A). 

Chart A

Firms continue to write new Libor contracts despite clear risks to its existence after end-2021

Total value of contracts referencing GBP Libor cleared through LCH(a)

Chart A - How prepared are markets for the end of Libor?
  • Source: LCH.

    (a) Includes gross notional outstanding of all interest rate derivatives with a GBP Libor linked floating leg cleared at LCH Ltd, excluding inflation swaps.

    April 2018 and Aug 2019 refer to observation dates for roll off profile. The chart presumes no new trades are transacted after the observation dates.

    Maturity date calculated based on residual maturity of trades at dates specified.

    Previously published data revised due to methodology improvements since the July 2019 FSR.

Firms now need to focus on shifting new business from Libor to alternative rates, and should put in place a clear transition plan to mitigate their legacy risk from older contracts. In June 2019, the Prudential Regulation Authority and the Financial Conduct Authority published guidance for firms on the issues they need to consider when making a transition plan.

Firms must be able to run their business without Libor from the end of 2021, so it is not in their interests to continue to increase exposures to Libor, or to have a large stock of legacy contracts that will become subject to significant legal uncertainty beyond that point.

This post has been prepared with the help of Stefania Spiga, Peter Balint, Tom Horn, Lyndsey Pereira-Brereton and Amber Evans.

This analysis was presented to the FPC in June 2019.

Share your thoughts with us at BankOverground@bankofengland.co.uk

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