Life after Libor: be prepared or risk financial meltdown, ASIC warns

The Australian 12:00am May 10, 2019

Richard Gluyas

ASIC has warned chief executives of a possible financial meltdown unless they adequately prepare for the likely demise of the global benchmark interest rate Libor in 2021.

In an alert reminiscent of the Y2K information technology scare that ultimately failed to ­materialise, the watchdog has written to CEOs of the nation’s top financial institutions to seek an assurance that they understand the risks associated with a global move to new benchmarks that were less vulnerable to ­manipulation.

“The transition away from Libor may have significant implications for the entities’ risk management, operational processes and information technology infrastructure,” the letter said.

“Insufficient preparations for the transition could have a negative impact on the entities’ business, clients and the markets in which they operate.” The letter, which was strongly supported by the Reserve Bank and prudential regulator APRA, said ASIC expected major Australian financial institutions to undertake a comprehensive risk assessment of the potential impact of the Libor transition.

Libor, or London Interbank Offered Rate, is an indicator of borrowing costs between banks.

It is referenced in financial contracts worth trillions of dollars that extend beyond 2021, including derivatives, bonds and loans. This is then used to price everything through the financial system from mortgages to credit cards.

Since the global financial crisis, regulators have embarked on an ongoing program of benchmark interest-rate reform, after several rates were subjected to attempted manipulation by market participants.

ASIC negotiated settlements with Australia’s four major banks last year over attempted manipulation of the bank bill swap rate, with massive fines also paid by global banks in relation to rigging of Libor.

Cathie Armour, an ASIC commissioner, told a conference in Hong Kong last month that the widespread manipulation had a “far-reaching” impact on market sectors, including organisations that provided key services to meet the needs of communities.

As a result, global regulators had been working with markets to strengthen interbank offered rates, identify alternative risk-free rates (RFRs), and ensure contracts referencing current interbank ­offered rates included robust fallback provisions.

Last year, the resilience of the BBSW was strengthened, with the benchmark directly calculated from market transactions during a longer rate-set window with a larger number of participants.

Ms Armour said ASIC was confident that the work done to strengthen the BBSW would ensure it remained a key benchmark.

“But part of the effort to deliver sound financial benchmarks is to ensure that, even for those interest rate benchmarks that are robust, appropriate fallback provisions are included in contracts to ensure that potential future disruptions are minimised,” Ms Armour told the International Swaps and Derivatives Association conference.

Libor, she said, was deeply embedded in financial markets, and in the plumbing of businesses around the world, including Australia.

ISDA had therefore been working on mechanisms and the language of fallback provisions to significantly reduce the risk of “widespread disorder” in derivatives markets when Libor ended.

Ms Armour urged companies to adopt the mechanisms for new and legacy contracts in preparation for a smooth transition.

Reserve Bank deputy governor Guy Debelle told the same Hong Kong conference that there were insufficient transactions in the short-term interbank market to underpin Libor.

He said the banks that made the submissions that were used to calculate the benchmarks were uncomfortable about continuing to do this as they mainly relied on their “expert judgment” rather than actual transactions.

To prevent Libor from abruptly ceasing to exist, the UK Financial Conduct Authority had received assurances from banks on the Libor panel that they would continue to submit bids until the end of 2021.

Dr Debelle said the transition from Libor to alternative RFRs was accelerating internationally.

A year ago, the US Federal Reserve started publishing SOFR (the Secured Overnight Financing Rate), with the Bank of England implementing reforms to SONIA (Sterling Overnight Index Average).

These rates, according to Dr Debelle, were more robust than Libor because they were anchored in active and liquid underlying markets.