For markets to continue to rely on benchmarks that were widely rigged is pretty clearly a bad idea. But coming up with a good replacement can be hard. That’s been the case in a number of countries looking to phase out Libor as an interest-rate benchmark in the wake of rate-manipulation scandals. But the stakes are especially high in Switzerland, whose central bank has been using a Libor rate as its main monetary policy target.
1. What’s the plan in Switzerland?
Swiss franc-Libor rates underpin about $6.5 trillion of financial products and are used to price about 80 percent of Swiss banks’ loans. The Swiss Average Rate Overnight, known as SARON, is Libor’s designated replacement for setting interest rates on items like loans and mortgages. SARON is based on overnight transactions between financial institutions in what’s known as the repo market. It’s been in place for a decade and is administered by the stock market operator SIX.
2. What went wrong with Libor?
For decades, the London Interbank Offered Rate provided a way to determine the cost of everything from student loans and mortgages to complex derivatives. It’s compiled from a daily survey of about 20 large banks that estimate how much it would cost to borrow from each other without putting up collateral. This self-regulated system proved open to abuse, as did other benchmarks used in currency trading and other markets. Banks began manipulating their Libor submissions either to appear healthier than they were or to profit from trades based on small movements in the rates. Banks eventually paid close to $10 billion in penalties.
3. Is the new system ready?
Up to a point. Banks are preparing to use it for products like syndicated loans or mortgages, but several key questions still need to be resolved. Unlike Libor, the figures reported for SARON represent real trades, amounting to an average of 4.9 billion francs. But for some products, including futures and three-month swaps, there’s very little trading activity. The most liquid product is the compounded three-month SARON, with an average daily volume of 292 billion francs. The SNB had been guiding monetary policy by targeting a range for three-month Swiss franc-Libor. But simply replacing it with three-month SARON poses complications.
4. What’s the problem?
Libor could easily come in many maturities, because it represents what rate banks thought they would charge for different tenors, or lengths for loans. But SARON reflects overnight borrowing only. To come up with a three-month figure requires adding up each overnight payment for the 63 trading days that period covers -- which can be only done after the three months are over. That means it conveys a picture of what traders thought in the recent past, making SARON a clunky tool for guiding rates in the near future.
5. What are the central bank’s options?
It’s possible that the demise of Libor might require a bigger re-think of the way the Swiss conduct monetary policy. One option could be to do what the Bank of England does and make the policy benchmark be the rate of interest paid on the money commercial banks hold with the central bank. Another might be to take the U.S. Federal Reserve’s approach and target the interest rate banks use to lend reserve balances to one another overnight, what’s known as the fed funds rate.
6. Couldn’t the SNB just stick with Libor?
Theoretically, they might be able to. While Britain’s Financial Conduct Authority won’t force banks to contribute past 2021, Intercontinental Exchange Inc., which administers Libor, plans to continue publishing the rates, with lenders contributing voluntarily. The question is whether a central bank would want to use a policy benchmark that no longer has official backing and potentially a dwindling number of participants.
7. What does dropping Libor mean for the rest of the market?
Investors will need to figure out what to do about already agreed-upon contracts that run past Libor’s end date of 2021. They must also prepare the paperwork for new deals. For derivatives, these are typically standardized agreements based on U.K. law. For mortgages and syndicated loans, Swiss law applies. Most Libor-linked mortgages and debt instruments have relatively short maturities in Switzerland. Swaps and futures are more likely to be the instruments to need their pricing revised, according to the national working group studying the matter.
The Reference Shelf
- A Bloomberg story detailing the unfolding of the Libor scandal.
- A QuickTake overview explaining global efforts to find a replacement for Libor.
- A QuickTake on scandals involving a range of benchmarks.
- A New York Fed report on alternative reference rates.
- Zurich stock market operator SIX’s factsheet on SARON.
— With assistance by Richard Jones