ICE LIBOR ROADMAP – Building Market Credibility!
ICE Benchmark Administration (IBA) published LIBOR Roadmap following extensive consultation with various key stakeholders for the $350 trillion benchmark. Keeping up with the strategic direction set by Financial Stability Board (FSB), the focus of the administrator has been to base LIBOR in transactions to the greatest extent possible.
In line with this, the IBA aims to overhaul the submission rate determination framework using a “Waterfall Methodology” where the rate will be determined based on a variety of inputs in the order of diminishing priority - from contributor’s market transactions to expert judgment driven rate determination.
The approach follows a three tiered usage of inputs to ensure that the rate is available at all times and in all market circumstances. Based on this, the rates submitted by banks should be in the order of:
Level 1 - Transaction Based - Time weighted and Volume Weighted Average Price of bank’s eligible transactions. The list of eligible transactions for Level 1 will be determined by a number of factors such as counterparties, funding locations, trade/product types, volume of the transaction etc. If the banks have adequate transactions for the submission period which fall within the eligible set of the given factors, it would be able to make a Level 1 transaction based submission.
Level 2 - Transaction Derived - Usage of time weighted eligible historical transactions adjusted for market movements, interpolation and parallel shift from neighboring tenors form the Level 2 submission.
Level 3 - Expert Judgment - Where adequate eligible transactions are unavailable, and Level 1 or Level 2 thereby fail to apply, the bank may report rate which is derived using a submitter driven judgment methodology based on transactions in related markets, committed quotes, indicative quotes and other market observations. The exact operational methodology will be predetermined and mutually agreed between IBA and the bank.
Centralized Determination - Riding on Sufficient Volume?
IBA has also announced that it is in the process of conducting a feasibility study to design and transition to the usage of an in-house algorithm for calculating LIBOR rates based on the transaction data provided by the panel banks. While this reduces the computation burden on the panel banks while streamlining and centralizing the rate determination activity, the feasibility of such a methodology needs to be carefully analyzed.
A major assumption under this approach is that the panel banks would have sufficient number of eligible transactions which would enable the administrator (IBA) to determine the benchmark rate using the algorithm. However, the validity of this assumption weakens in the light of the quick study conducted by IBA for Q3 and Q4 of 2015. The study indicated that the LIBOR rate determination has been predominantly through Level 3 - Expert Judgment for a majority of currency-tenor combinations in which LIBOR is published for these quarters.
Though the data might not be conclusive enough, it points to the major dependency on expert driven model where the submitters in the know of the business and current market conditions make judgments based on a variety of trade and market data factors. In this case, IBA would need to develop the ability to exercise expert judgment akin to what panel bank submitters employ.
Also important to note is the other facet of the process - the actual building of the algorithm, necessary infrastructure and processes which support real-time consumption of panel bank’s trade data and related market data will be a complex exercise.
However, it is vital to recognize that this exercise is crucial and marks the dawn of improved benchmark determination methodology.
A Step in Right Direction!
While the actual successful implementation is dependent on banks as well, the efforts of IBA in making LIBOR a robust and transaction based benchmark are inline with the major benchmark reforms from Wheatley review, IOSCO principles, ESMA-EBA principles and FCA guidelines.