Regulators and banks always knew investors’ dependence on the Libor interest rate benchmark was going to be difficult. The UK’s Financial Conduct Authority would like banks and institutions to move to other benchmarks by the end of 2021.

While they have made a start, a new problem has emerged. The use of Libor is still rising and it is down to the transition itself. The notional value of long-dated derivatives contracts referencing sterling Libor that mature after 2021 is double that of July last year, according to the Bank of England’s latest Financial Stability Report. It was 18 months ago that the FCA told the market Libor was on borrowed time.

Libor has become so pervasive in the past 30 years that it is still central to thousands of derivatives, bonds, credit cards and loan contracts. The BoE stats are in part misleading because a notional number on a derivatives contract does not remotely reflect the actual exposure in the market. Even so, the interest rate benchmark is a vital component of a derivatives contract.

However as the BoE notes, the rise here is because investors are transacting swaps that exchange cash flows in Libor for cash flows in Sonia as its quoted at a lower rate than Libor. In effect it looks like more Libor swaps are being created as a hedge to the transition from Libor. This really begs two questions: who is acting as a counterparty on these swaps and what risks are they taking? It may need a forward-looking term benchmark based on Sonia and a fallback if Libor is discontinued to resolve the issue.

They are only in early-stage development, which will take years. The 2021 transition date looks ever more fragile.

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