U.K. regulators' decision toabandon the Libor benchmark by the end of 2021 threatens to sowconfusion in the market as the industry races to replace thescandal-plagued rate that underpins more than $350 trillion offinancial products.

“It's going to be a feast for financial lawyers,” said BillBlain, head of capital markets and alternative assets at brokerageMint Partners in London. “Libor is part of the financialinfrastructure that supports the swap, loan and floating-rate bondindustry. Everyone now will need to check what contracts say,and it's going to be a headache for anyone with a Libor-basedcontract.”

Andrew Bailey, head of the Financial Conduct Authority, saidThursday in London that Libor isn't sustainable because of a lackof transactions providing data. Industry and regulators need tostep up planning for a transition to “alternative reference ratesthat are based firmly on transactions,” he said. Bailey outlinedthe factors involved in the move away from Libor, withoutadvocating any specific candidate to replace it.

The London interbank offered rate, or Libor, is behindsecurities including student loans and mortgages. The benchmark isthe average rate a group of 20 banks estimate they'd be able toborrow funds from each other in five different currencies acrossseven time periods, submitted by a panel of lenders every morning.Its administration was overhauled in the wake of the scandal, withIntercontinental Exchange Inc. taking over from the then-namedBritish Bankers' Association with the aim of making the rate moretransaction-based.

The U.K.'s Libor-replacement effort is part of an ongoing globalpush to reform benchmark rates discredited by manipulation andfalse reporting. In 2014, the Financial Stability Board set out aroad map to overhaul rates including Libor and develop viablerisk-free alternatives.

As the U.K. pushes toward a transaction-based rate, efforts onthe continent have faltered. The European Money Markets Institute,which administers the Euribor benchmark index, decided in May notto move to its proposed transaction-based methodology in the shortterm.

The Bank of England unveiled the Sterling Overnight IndexAverage, or Sonia, in April as a near risk-free alternative toLibor for use in sterling derivatives and other relevant financialcontracts. The replacement benchmark was recommended by aswaps-industry working group led by Francois Jourdain, chiefcompliance officer at Barclays Investment Bank.

The BOE took over administration of Sonia in April 2016. Itreflects bank and building societies' overnight funding rates inthe sterling unsecured market. The BOE is in the process ofreforming the benchmark and expects to roll out the new version byApril 2018.

'Key Steps'

The U.K. industry's embrace of Sonia and a U.S. market panel'schoice of a broad Treasuries repo rate are “key steps” to morereliable benchmarks, Bailey said. He didn't go out of his wayto promote Sonia on Thursday; instead, he outlined the goals thatreplacement rates would need to satisfy.

“I don't rule out that you could have another benchmark thatwould measure what Libor is truly supposed to measure, which isbank credit risk in the funding market,” he said. “But that wouldbe—and I use this term carefully—a synthetic rate because thereisn't a funding market, so I think it would be a combination ofSonia plus a proxy bank credit rate.”

ICE Benchmark Administration, which runs Libor, could evencontinue to produce the benchmark with banks on the rate-settingpanel after 2021 if it chose to do so, Bailey said. Under the FCA'splan, “the benchmark would no longer be sustained through themechanism of the FCA persuading or obliging panel banks to stay,”he said, meaning Libor's survival “could not and would not beguaranteed.”

ICE Benchmark Administration said Bailey's comments would “helpto ensure the transition to our evolved Libor,” and that thebenchmark has a “long-term sustainable future.”

Wholesale Funding

“Our evolution for Libor is based on banks broad wholesalefunding and minimizes the use of subjective judgment unlessnecessary to ensure that the rate can continue to be calculatedeven in the most extreme market conditions where transactions mightnot be available,” a spokesperson for the company saidThursday.

Peter Chatwell, head of European rates strategy at MizuhoInternational in London, said the FCA's decision to drop Liborwithout designating its replacement will inject uncertainty intoswap rates based on the benchmark.

“The market will need guidance as to what a replacement couldbe, and this will lead to increased volatility and, possibly,reduced liquidity in the near term,” Chatwell said.

Bailey also addressed the issue of contracts that referenceLibor and are still in effect at the end of 2021. Their fatedepends on the “preparations that users of Libor make in eitherswitching contracts from the current basis for Libor, or inensuring that their contracts have robust fallbacks in place thatallow for a smooth transition if current Libor did ceasepublication,” he said.

Scott O'Malia, CEO of the International Swaps and DerivativesAssociation, said the “most obvious concerns” about the transitioninclude ensuring adequate liquidity in the new rates and agreeingon a plan for legacy contracts.

“ISDA and its members are also actively working to develop andimplement fallbacks for contracts, including legacy contracts, thatcontinue to reference Libor and other Ibors,” he said.

As to whether the FCA's timeline for transitioning away fromLibor in less than five years is aggressive or lax, Bailey said,“you'll get a range of reactions.”

“It doesn't look lax from where we sit given the amount of workthat needs to be done,” he said.

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