LIBOR's Looming Demise Is a Massive Financial Engineering Task

The end is coming for LIBOR, and financial markets need to get ready.

That’s the view of Morgan Stanley’s Tom Wipf. He heads the Federal Reserve’s Alternative Reference Rates Committee (ARRC), which on Thursday released recommendations for language to enable contracts linked to the beleaguered London interbank offered rate (LIBOR) to work even if the benchmark disappears. Darrell Duffie, a finance professor at Stanford University, has also underscored the risks involved with shifting away from a set of benchmarks that underpin some $200 trillion in dollar-denominated instruments.

“This is the largest financial engineering project the world has ever seen,” Duffie said on a conference call hosted by financial-technology firm GLMX on Thursday. He said that the risks associated with shifting from LIBOR to the Secured Overnight Financing Rate (SOFR)—the ARRC’s preferred alternative—can be mitigated if market participants convert contracts early and if regulators announce the change date “well in advance.”

Such a transition is by no means assured, though. While LIBOR suffers from various defects and has been tainted by rigging controversies, the battle to replace it is far from over. The ARRC is backing SOFR, but the new benchmark developed by the New York Fed and the U.S. Treasury still has yet to fully prove itself more than a year after its debut. There are also other potential contenders, such as Ameribor and the ICE Benchmark Administration’s Bank Yield Index, and some remain reluctant to get rid of LIBOR at all.

Wipf, who is vice chairman of institutional securities at Morgan Stanley, is not among those who see a future for the maligned rate.

“It’s no longer a question of if, but when, LIBOR will become unusable,” he said in a statement. He added that most contracts referencing the benchmark don’t adequately account for its demise, and that poses “a massive risk to financial stability and market participants.”

The principles recommended by the ARRC on Thursday relate to so-called fallback language for floating-rate notes and syndicated loans, and the group plans to release recommendations for bilateral business loans and securitizations soon. The committee also expects to consult on similar language for consumer products.

Of course, fallback language is not the only hurdle. Other challenges include the lack of a term structure for SOFR, its lack of a credit component and the impact of periodic volatility in the market for repurchase agreements that underpins the setting of the benchmark.

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