ICE Benchmark Administration has published their expected “Roadmap for ICE LIBOR.” An alternate title would have been “How We Can Publish a Credible Benchmark Without Getting Our Faces Ripped Off By An Angry Mob.” This is an important document in the evolution of LIBOR and for financial markets in general. Our analysis tackles the tricky question of how ICE Benchmark will incorporate market transactions (ie, repo) in the benchmark going forward.
ICE Benchmark Administration (IBA) has defined their mission statement as:
- IBA will implement a uniform submission methodology for LIBOR panel banks based on parameters defined by IBA and the LIBOR Oversight Committee
- IBA will publish a single, clear, comprehensive and robust LIBOR definition
- Submissions will be non-subjective and fully transaction-based wherever feasible.
Watch out for that last step! As LIBOR watchers know, the great downfall of LIBOR in the last ten years is that it is based on a dwindling number of real observations. Currently, its just triangulation – what people think is the best rate. Even leaving aside LIBOR fixing scandals, letting people make up a number just isn’t a good idea when over US$450 trillion in OTC derivatives are based on that figure. Also, in the wacky world of observed vs. made-up index numbers, LIBOR (unsecured debt) is now less expensive than repo (secured debt) in most major jurisdictions. That’s like if credit card debt would be less expensive than mortgage debt. (For more on this, see our recent research report, “The Repo/LIBOR Flip: What It Means for the Markets.”
LIBOR can not make a switch to repo all at once – that would cause havoc. Instead, IBA is taking a middle ground position in adjusting the benchmark: “In order to anchor LIBOR to the greatest extent possible in transactions, as well as reflect changes in banks’ funding models, IBA has designed a waterfall of submission methodologies to ensure that LIBOR panel banks use funding transactions where available.” The waterfall that IBA has designed is:
So first there is repo, then there are transactions that are based on LIBOR in some way, then there is the made up number. The Expert Judgement piece is still a little dicey, but at least IBA promises transparency is how much of each waterfall is going into the final numbers: IBA will publish a regular retrospective statement showing the ratio of respective inputs (i.e. transactions, transaction-derived data and Expert Judgement).
IBA has made another big change by expanding the number of eligible counterparties that a bank can consider when making its LIBOR decision. It used to be just bank-to-bank transactions, but the expansion is really a big broadening of the types and range of transactions that will be captured. The new list includes transactions with:
- Banks
- Central Banks
- Corporations as counterparties to a bank’s funding transactions but only for maturities greater than 35 calendar days
- Government entities (including local /quasi-governmental organisations)
- Multilateral Development Banks
- Non-Bank Financial Institutions, including Money Market Managers and Insurers
- Sovereign Wealth Funds, and
- Supranational Corporations.
So will LIBOR change? Absolutely. By implementing these reforms and basing submissions off of a waterfall that starts with observed transactions, IBA is taking the huge step of modernizing LIBOR for a world where a) the index is based on where actual market participants will trade and b) banks are not the center of the funding universe. There will be some very unhappy customers as the rates adjust, and some transactions are going to be cost a lot of money very suddenly, but IBA has taken the right step forward.
The full IBA paper can be found here.