How to Bury Libor for Good
It’s time for Britain to lead with a Sonia-linked gilt.
British regulators are worried that financial firms are dragging their feet over dropping Libor from financial contracts. But there's an easy remedy available to promote the benchmark interest rate's successor: the U.K. government should start issuing gilts pegged to the Sterling Overnight Index Average rate, known as Sonia.
The problems with the London Interbank Offered Rates are well-documented. There aren't enough transactions in the wholesale market anymore to generate a credible measure of borrowing costs. And the $10 billion of fines banks have paid for rigging Libor has highlighted how vulnerable the benchmark is to manipulation.
So the Financial Conduct Authority announced a year ago that it will phase out Libor by the end of 2021. But, as FCA Chief Executive Officer Andrew Bailey said on Thursday, about $170 trillion of swap contracts still rely on the suite of rates, and about a third of those mature after the scheduled demise of Libor.
“The biggest obstacle to a smooth transition is inertia, hopes that Libor will continue,” he said. “We should put all of our efforts into transitioning away from it rather than recreating some other version of it.”
The preferred replacement championed by the FCA and the Bank of England is Sonia, which is based on actual transactions – it’s the weighted average rate of all unsecured overnight sterling transactions of 25 million pounds ($33 million) or more between members of the London-based European Venues and Intermediaries Association, formerly known as the Wholesale Market Brokers' Association.
So why not embrace Sonia as the reference for new floating-rate gilts?
Taking the first step to encourage the capital markets to embrace innovation would, in a way, be a trip back to the future. In 1991, the U.K. pulled off a masterstroke that arguably cemented the City of London's role as the financial capital of Europe for the following decades. It sold a 10-year bond denominated in what were known as European currency units, or Ecu.
The Ecu was the synthetic predecessor to the euro. Its value was calculated by taking the 11 currencies of the countries that were then part of the European Exchange Rate Mechanism, a system designed to limit currency fluctuations, and weighting them by gross domestic product and trade.
With the U.K. firmly opposed to joining the single currency project itself, the development of a market in securities denominated in Ecu threatened to drive business to Paris and Frankfurt.
The U.K.'s sale of 2 billion Ecu of benchmark bonds – worth about $2 billion at the time – created the biggest security then available in the virtual currency. Combined with a short-dated Ecu Treasury bill program created by the Bank of England, the bond helped to ensure that the center of gravity for capital markets remained in London even after the euro's introduction in 1999.
By steering some of the 106 billion pounds of this financial year's gross debt issuance into floating-rate gilts referencing Sonia, the U.K. could kickstart the development of a market in bonds that use the new benchmark. It wouldn't solve all of the issues surrounding replacing Libor. But it would underline the U.K.'s commitment to its preferred benchmark.
Last month, the European Investment Bank sold 1 billion pounds of notes linked to Sonia, four times its initial target. It is, so far, the only bond tied to the rate after the central bank improved Sonia's calculation method in April, and came a full eight years after the EIB issued its first Sonia-linked bond.
“We've got to make sure we break that cycle of sitting on the sidelines hoping somebody else will do this and making sure it will happen,” Bailey said at his press conference on Thursday in answer to a question about the EIB initiative.
Replacing Libor is a case where charity should surely begin at home.
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