The UK Financial Conduct Authority (FCA) announced on 27 July that it would not sustain the London Interbank Offered Rate (Libor) – the key (and controversial) benchmark for hundreds of trillions of derivatives contracts – after 2021. While the problems with Libor that emerged during the global financial crisis are well known and talks of phasing it out are nothing new, the FCA caught the market somewhat by surprise by attaching a definitive timeline to the discussion. The question now becomes how the markets will respond to the FCA’s actions and what it will mean for investors.
RIP Libor? Not so fast
We at PIMCO do not think Libor will simply disappear after 2021. Given the sheer volume of derivatives contracts and debt currently tied to Libor, removing it from the landscape will be a complex exercise and is unlikely to happen by 2021. What we’re watching is how Libor may evolve over the next few years.
We believe Libor may persist after 2021 even without FCA support, possibly through oversight by a new regulatory body or by member banks. We do, however, expect trading of derivatives keyed off other benchmarks, such as overnight index swap (OIS) rates and the federal funds rate in the U.S., will continue to increase.
Investors: Stay informed
Issuers, hedgers and investors alike will need to adapt to Libor’s declining prominence and stay tuned to the dialogue as “transactable” benchmarks like the repurchase (repo) rate and other prospective Libor replacements evolve and gain traction. The Alternative Reference Rates Committee (ARRC), for instance, recently announced its endorsement of the Broad Treasuries Financing Rate (BTFR), but we see a long road ahead before the BTFR will be fully deployed and widely used.
Becoming educated about alternative benchmarks, especially the underappreciated repo markets, will be critical for market participants to successfully navigate the changing landscape over the next few years. In the near term, we believe uncertainty about the unwinding of Libor could increase spread volatility and create opportunities in products indexed to short-term rates as the market evolves.
For more of our views on rates and markets, see “Putting Markets in Perspective.”
Rick Chan is a PIMCO portfolio manager focused on interest rate derivatives. Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the PIMCO Blog.