NEW YORK (Reuters) - The interest rates derivatives market needs to develop contingency plans in its contracts in case the London interbank offered bank rate (LIBOR) ceases to exist, a special adviser at the Federal Reserve said on Thursday.
LIBOR is a rate benchmark for $200 trillion of dollar-denominated financial products, mostly in interest rate swaps. It is derived from a survey of banks on what they charge each other to borrow dollars.
On a global basis, roughly $350 trillion worth of financial products are exposed to LIBOR across various currencies.
Despite the size of the swaps market and the central role of a reliable reference rate, there are few if any backup plans in swap contracts if LIBOR fails, David Bowman, a Fed senior adviser said.
In the wake of a rigging scandal during the 2007-2009 global credit crisis, regulators have encouraged banks, investors and other players to adopt alternatives to LIBOR as they have secured commitments from bank panels to submit daily quotes to calculate LIBOR through the end of 2021.
One option is for a player to adopt an alternative rate such as the secured overnight funding rate (SOFR), which was launched on April 3 and jointly developed by the New York Federal Reserve and the Office of Financial Research, according to Bowman.
“But the other, for those who want to keep using LIBOR, is to incorporate better contract language that helps to mitigate your risks if LIBOR does fail,” Bowman said in prepared remarks at a conference sponsored by Bloomberg.
SOFR has been slow to gain traction among market participants. Some of them are reluctant to switch to SOFR which they deem as a risk-free rate, instead of a measure of bank funding cost.
Moreover, partly due to its overnight nature, SOFR has shown greater volatility than LIBOR.
The International Swaps and Derivatives Association is expected soon to start a consultation process to develop much safer fallback language, Bowman said.
“Given that derivatives account for more than 90 percent of gross exposures to LIBOR, it is going to be really crucial for market participants to actively engage in the consultation process,” he said.
For cash products like floating-rate loans, the Alternative Reference Rates Committee is working on recommendations for better contract language, he noted.
“It’s not possible to avoid a certain amount of risk if you want to keep using LIBOR,” he said.
Reporting by Richard Leong; Editing by Cynthia Osterman