At your own risk
The maths wunderkind, Thomas Alexander William Hayes, described in David Enrich's book “The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History” is meticulous, and believed that the key to his personal success lay in making money. After completing his studies in mathematics and engineering, Hayes began his career as an intern at UBS and later joined RBS. At RBS, he leveraged his extensive network of brokers and traders to manipulate the London Interbank Offered Rate (LIBOR) in a manner that would yield him substantial profits. As an example, a mere one basis point shift in LIBOR during 2008 had a $750,000 effect on his bottom line. The scam, the manipulation of benchmark exchange rates, involved traders at various leading banks including UBS, Bank of America, Citigroup, JP Morgan, Barclays, and RBS, resulting in substantial fines amounting to $5.6 billion. Hayes himself received a 14-year prison sentence. The regulatory bodies all get unfavourable mentions due to their perceived lack of scrutiny in monitoring and supervising the activities surrounding LIBOR.
Once considered a brilliant concept, the story of LIBOR itself traces back to 1969 when the central bank of Iran sought an $80m loan. Minos Zombanakis, the international banker, faced a challenge: how to determine the interest rate for a high-risk loan, to a country without the foreign-exchange reserves to cover it, amidst volatile and rising inflation rates. Zombanakis devised a solution known as LIBOR. Under this system, each participating bank would report its borrowing costs for each interest period. The average of these costs, along with a profit margin, would determine the loan's interest rate. This approach allowed lenders to adjust their income as their costs fluctuated over time, mitigating the risk of being out of pocket due to fixed rates. The concept gained traction rapidly, leading to the expansion of the syndicated loan market. By 1982, this market had grown to a value of $46bn, with a significant portion linked to LIBOR. Subsequently, derivatives, home loans, and credit cards all became linked to the benchmark. By 2012, LIBOR influenced the interest rates of contracts governing a staggering $550tn - over seven times the global GDP.
However, LIBOR has been on a steady decline since then – by the time of its disgrace, Zombanakis had distanced himself from the market, calling it a “monster” and a “prostitution racket run by pimps” – and in the coming month, the final few fixings of LIBOR, specifically for dollar lending, will be permanently discontinued, marking the end of an era for this once-dominant benchmark rate. LIBOR played a crucial role in hedging strategies as a widely used benchmark interest rate for financial institutions and market participants seeking to manage interest rate risks.
Hedging strategies can be very beneficial when it works in your favour, but when they go wrong, they can amplify risk and lead to substantial losses. This was particularly the case in the aftermath of the LIBOR manipulation scandal when banks had to write off billions to settle mis-selling claims.
With just 30 days remaining until the expiration of LIBOR, approximately half of the $1.4tn US junk loan market remains tied to the benchmark rate with limited deal activity hindering the transition to its replacement. Fresh borrowing in the low-grade loan market has been “quite anaemic” according to Lotfi Karoui, chief credit strategist at Goldman Sachs. “In an ideal world, you want a big chunk of the transition to happen via refinancing where you’re just replacing some of these old loans that reference LIBOR with new ones,” said Karoui. “In a more robust primary market environment, things would have happened organically.” White & Case’s Ridley concurred that “the natural opportunity to transition via some larger transaction…effectively dried up during the course of last year”.
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The transition from LIBOR to SOFR in USD markets commenced in 2017 following the announcement by the Financial Conduct Authority that LIBOR was at risk of discontinuation by the end of 2021 and that the ICE Benchmark Administration (IBA) would only continue to publish USD LIBOR rates until June 30, 2023, after which the rates were expected to be deemed non-representative. The transition from LIBOR is led by the industry-led Working Group on Sterling Risk-Free Reference Rates, which offers guidance and support to financial and non-financial firms. The Bank of England and the FCA participate in this group and released a joint statement urging market participants to take proactive steps. These include actively transitioning USD LIBOR contracts before the end of June 2023, ensuring preparedness for significant operational events like planned CCP conversion events, adopting the most robust risk-free rates and continuing the active transition of any remaining legacy contracts from synthetic GBP LIBOR to SONIA.
The international Financial Stability Board (FSB) has urged market participants to act promptly to ensure an orderly transition, encouraging market participants to complete the transition of any remaining USD LIBOR-linked contracts to avoid operational risks and market disruptions. To address contracts that lack provisions for replacing LIBOR, the LIBOR Act was enacted in the United States. Under this law; overnight, one-month, three-month, six-month, and 12-month USD LIBOR references in these contracts will be replaced with a SOFR-based benchmark identified by the Federal Reserve Board (FRB). The FRB has adopted a final rule to implement the LIBOR Act. The final rule incorporates safe harbour protections and clarifies the criteria for selecting and using the replacement benchmark rate. It also ensures that LIBOR contracts adopting the replacement rate selected by the Board will not be interrupted or terminated upon LIBOR's replacement.
Unlike LIBOR, which is a forward-looking rate, both SOFR and SONIA (the replacement of GBP LIBOR) are both overnight backward-looking rates, which means that they can’t be manipulated easily by the likes of Hayes. In addition, unlike LIBOR which is unsecured bank-to-bank lending rate and subject to credit risk, SOFR is secured by US Treasuries, which makes it a better proxy to a risk-free rate.
Meanwhile the benchmark rates in both the US and Europe are on the rise, which in turn is also making it extremely difficult to get hedging right, which also makes one question if even SOFR and SONIA are risk-free rates. In March 2023, the US Federal Reserve raised interest rates by 0.25%, marking the ninth increase since March 2022. Similarly, the Bank of England responded to unexpected inflation by raising rates by 0.25%, while the European Central Bank announced its own 0.50% increase. The upward trend in interest rates has led to higher borrowing costs, discouraging borrowers from seeking new financing and putting the brakes on opportunistic refinancing. In the US, average margins on first lien institutional loans came in at 4.01% for Q1 2023. While this is an improvement on the 4.19% registered in Q4 2022, prices remain elevated when compared to the sub-4% margins on offer in the bull market of 2021. European markets have experienced a similar pattern, with margins for Q1 2023 coming in at 4.93%. This represents an improvement from the Q3 2022 margins of 5.26% when pricing peaked in the region. Nevertheless, the margins offered to borrowers are still significantly higher than those available in 2021.In response, lenders and investors have turned their attention to secondary debt markets, where existing loans have been traded at substantial discounts to their par value, presenting a more appealing value proposition compared to backing new loans. In the US secondary markets, loans were traded at discounts ranging from 7% to 8% in Q1 2023. In Europe, the bid price of secondary institutional loans dropped from 93.3% to 92.8% of par in March alone.
Hedging strategies can also be tricky to implement. Standard Chartered reported taking a $97m hit in the last quarter after underestimating the pace of interest rate rises. Bill Winters, chief executive of Standard Chartered, conceded to City analysts that the bank had erred in decisions it had made: “With the benefit of hindsight, our timing was wrong, no ifs, ands or buts about that. But given that these were hedges of our existing sensitivity to rising rates, and it was a relatively small percentage of our overall sensitivity, that’s the call that we took.”
The Risk-Free Rate has proven to be anything but risk free for those trying to trade in it, hedge with it, or regulate it; and change in the risk-free rate - its name and its level - is now disrupting the market, and its obsolescence increasingly waylaid by anaemic borrowing. Risk free by name but anything but risk free in practice.