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Libor, not quite obsolete, is getting an upgrade

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Libor may not be around for much longer, but it’s still getting an update.

After a year of development and testing, the ICE Benchmark Association is changing how major global banks submit quotes used to derive the interest rates used to benchmark everything from mortgages to derivatives contracts.

Over the next few weeks, there will be a “gradual” transition to submissions of interest rates on actual wholesale financial transactions, rather than solely in-house opinions, in reporting the rates they would agree to borrow funds from other banks.

ICE said the transition should be completed over the next year.

The new methodology is part of a broader effort to reform Libor, formally the London interbank offered rate, which was tarnished by a rate-rigging scandal in 2012, and is considered anachronistic now that most financial institutions abandoned overnight repo markets for funding after the financial crisis.

(The international rate-rigging scandal involved multiple global banks illegally manipulating the rates reported to the British Bankers' Association, which led to the U.K.’s Financial Conduct Authority to reassign Libor administration to ICE.)

A more robust methodology could also help further ICE’s goal of preserving the benchmark past 2021, when global banks will no longer be required by the U.K.’s FCA to submit estimates.

“This next stage of enhancing the methodology supports the objective of developing a robust and sustainable Libor that can continue on a voluntary basis beyond 2021,” said Tim Bowler, ICE’s president.

The so-called “waterfall” method of deriving Libor estimates will involve banks using average rates available from wholesale, unsecured funding transactions between banks as well as issuance or trading of debt instruments in the primary and secondary markets. Expert judgment estimates would still be permitted if banks have an “insufficient” volume of transactions, according to ICE.

Currently, Libor is determined by 11 to 16 panel bank opinions on what they would have to pay to borrow from other banks on various terms (overnight; one week; one, two, three or six months; or one year). The banks offer the term quotes across five currencies, the U.S. dollar, euro, sterling British pound, Japanese yen and Swiss franc.

The infrastructure and systems needed to submit waterfall data was developed between ICE and panel banks in 2016-17, and went through production testing in the fourth quarter when panel banks made parallel Libor submissions using waterfall and the existing estimate methods. These daily test Libor rates gathered over three months were published March 17 alongside Libor rates on the existing submission standard.

Currently, some US$350 trillion in outstanding financial instruments around the world, including derivatives, futures, bonds and corporate loans pay rates of interest linked to Libor.

The New York Federal Reserve is working on developing a replacement rate for dollar-denominated assets that would be derived from its recently launched Secured Overnight Financing Rate (SOFR). While that rate is considered a fit for the derivatives and swaps markets, the Fed’s Alternative Rate Reference Committee (ARRC) has yet to produce longer-term rate that would be suitable for corporate and consumer loan products. The lack of progress by ARRC has encouraged ICE and its client institutions to seek a voluntary extension of Libor past 2021.

In an October 2017 survey by Bank of America Merrill Lynch, nearly 80% of institutions favored keeping Libor as a reference rate after 2021.

In a statement released Wednesday, the Loan Syndications and Trading Association said it was pleased that ICE “is continuing its work to strengthen Libor. At the same time, though, we believe it is prudent for the loan market to be prepared to function in case" Libor "ceases.”

The LSTA is a member of the AARC working group.

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SOFR ICE Benchmark Administration Loan Syndications & Trading Association