For the last eight weeks, policy formation has ground to a halt on a broad range of issues as governments pivoted hard and fast to respond to the accelerating COVID-19 pandemic. However, policymakers continued to make progress on a number of key policy issues despite the pandemic.
Every day this week, this Disruption and Data blog will feature details of major policy initiatives that have not been derailed by the pandemic. Mostly, these developments have been lost in the noise in the news cycle. But our PolicyScope platform users and our daily COVID19 Report readers have watched the incremental forward progress on each of these important issues.
Let’s start with the transition away from the London Interbank Offer Rate (LIBOR) and towards market-based benchmarks. For non-specialist readers, the end of this blogpost provides a summary of LIBOR’s history, why it matters, and why policymakers now require a transition.
Activity Levels Remain Trend-Consistent, Despite the Pandemic
As the chart below illustrates, policymaker activity regarding the transition away from LIBOR has barely slowed throughout the pandemic:
While the volume of activity is relatively low compared with COVID-19 policy initiatives, the stunning part of the policy trajectory is that every single item contributing to the activity levels showed continued work on the LIBOR transition without any change.
Let that sink in for a minute. While central banks and policymakers globally were creating massive liquidity lifelines, delaying Basel III implementation, relaxing accounting standards and loan loss recognition standards…..while markets were experiencing dramatic, unprecedented volatility….the policy juggernaut regarding the mechanism used to price financial contracts continued forward without a deviation in direction.
Highlights from March and April globally included:
· March 19: The UK government consults on the tax implications from moving away from LIBOR (NOTE: the commentary period ends on 28 May 2020).
· March 28: The Bank of England releases the minutes from the monthly stakeholder group meeting that occurred on 26 February. They note that the 31 January 2020 final decision by the UK government to proceed with withdrawal from the European Union did not impact market functioning.
· April 8: Australian regulators release publicly and jointly the feedback they received from financial institutions regarding the transition away from LIBOR. Among other things, financial institutions report that low liquidity in the replacement benchmark rates means that firms continue to underwrite contracts using LIBOR as their benchmark. Moreover, aggregate notional exposure at present to LIBOR contracts is approximately A$10 trillion. Levels of preparedness were uneven in Australia, as in other parts of the world. Policymakers were unmoved, indicating that “prompt action is imperative” and that failing to act now to transition legacy contracts creates “significant reputational operational and legal risks….risking disruptions in financial markets.”
· April 10: The Prudential Regulation Authority in the UK publishes its 2020/21 Business Plan in which it indicates that it “has considered further potential supervisory tools that authorities could use to encourage the reduction on the stock of legacy LIBOR contracts to an absolute minimum before the end of 2021, and will keep the use of such tools under review in light of progress made by firms on the transition. The Bank, the PRA and the FCA will step up engagement with firms on LIBOR transition through our regular supervisory relationship, reviewing management information and collecting data from firms to assess progress.”
· April 14: The Financial Stability Board letter to the Group of 20 Finance Ministers and Central Bank Governors makes clear that despite the considerable pandemic response work underway and despite considerable pandemic-related market volatility/financial stability issues, the FSB views continued work to transition away from LIBOR to be a policy priority.
· April 15: In a highly unusual move, the Secretary General of the Financial Stability Board held a conference call with all major financial trade associations and released his statement at the start of the call. The statement reiterates the message that the FSB maintains LIBOR transition as a priority for work during 2020.
Despite these moves, the ECB is still using LIBOR-OIS spreads as one of the reference rates for monetary policy.
The only reason why U.S. securities regulators have not been active in this area so far in 2020 is because at the end of 2019, they issued no-action letters that efforts to transition existing swaps contracts away from LIBOR would not constitute a “material” amendment that would recharacterize the contracts as “new” and, thus, would not trigger regulatory requirements regarding clearing, portfolio reconciliation, trade execution. However, mandatory recertification of “eligible counterparty status” will still be required alongside regulatory reporting requirements.
What Comes Next: A few inflection points remain on the horizon in 2020 during which policymakers could still shift course. The most important of these are:
(i) the July FSB report to the G20 regarding supervisory measures and “remaining challenges” to implementing the LIBOR transition by year-end 2021; and
(ii) the 3Q2020 deadline for London-based market participants to cease underwriting LIBOR-based contracts.
Under normal circumstances, nothing would derail this policy train. But we do not live in normal times. If major economies remain relatively locked down in June and the economic damage from the shuttered supply chains is significant, policymakers could conclude that delaying the LIBOR transition by one year is warranted.
To date, the LIBOR transition has occurred within an effectively benign low rate environment supplemented particularly in Europe with significant central bank asset purchases that impact the supply and demand curve for safe assets to underpin bank funding strategies. Shifts in interest rates and/or shifts in the shape of volatility for key overnight rights in repo markets and in overnight interest rate swap markets may generate less-smooth transitions that will trigger more rapid reaction functions from policymakers. Substantial shifts between GPB and EUR money markets throughout the now-combined Brexit transition process (which has June inflection points pending) and pandemic responses may yet generate additional market and policy volatility to an already difficult and technical transition process.
For decades, risk-based pricing in financial contracts (particularly derivatives) occurred in relation to a “risk-free” rate. The rate in question was not actually a rate that represented zero risk. Instead, financial market participants agreed to use a common standard benchmark for pricing risk. The idea was that all risk would be assessed and priced based on how much riskier an exposure was expected to be compared with the risk free rate.
The agreed nominal “risk free rate” was the London Interbank Offer Rate. Every afternoon, bankers in London would compare the offer rate for credit. The average of all bank offer rates would be published as LIBOR. LIBOR rates were quoted in multiple reserve currencies.
During the Great Financial Crisis, it became clear that the traditional mechanism for setting the risk-free rate was subject to political pressure and potential manipulation from the central bank. A series of controversial phone calls from the Bank of England suggested efforts to moderate the LIBOR rate in order to mitigate the impact of the financial crisis.
After the dust settled, policymakers decided to shift away from the potentially subjective LIBOR rate to rates that were more objective and transparent. Shifting to market-based benchmarks required a parallel shift to more localized benchmarks. Benchmark rates will no longer be quoted from London. Instead, benchmarks will be set in geographically disparate locations corresponding to the reserve currency in question. Sterling benchmarks will still be set in London, but USD benchmarks will be set in New York, JPY in Tokyo and EUR in Frankfurt. Central banks are managing the transition process in regular consultation with market participants
Migrating all current financial contracts and all risk measurement modeling systems was always going to be a challenge. A major inflection point looms in the third quarter of 2020, when the Bank of England has requested that market participants cease writing new contracts using LIBOR as the reference rate.
BCMstrategy, Inc. is a start-up company using patented technology to automatically measure and analyze global public policy developments. The company began tracking daily global COVID19 activity in late February 2020, which means the company has captured in its time series the full global reaction cycle for this issue as it occurs. For more information and to get started using the next generation of policy intelligence tools, please visit www.policyscope.io.