By Huw Jones and Marc Jones
LONDON (Reuters) - Critical steps for replacing Libor could be taken by next year, British industry officials told Reuters, increasing the chances of a smooth transition from the interest rate benchmark used to price financial contracts worth tens of trillions of pounds.
When regulators announced last month that scandal-plagued Libor would be replaced by the end of 2021, there was scepticism among some industry players over whether such a huge transition could take place on time - or even at all.
But preparations are already underway to put in place two essential elements for the planned replacement, SONIA, to assume its role in the market.
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The clearing arm of the London Stock Exchange <LSE.L>, which already clears short-dated SONIA swaps - products used to hedge against adverse moves in rates or currencies - told Reuters it was planning to clear the kind of longer-dated swaps covered by Libor.
An industry group, whose members include the 16 top dealers of swaps and other derivatives, meanwhile said it aimed to create SONIA futures contracts.
Francois Jourdain, who chairs the group set up by the Bank of England to promote adoption of SONIA, said he had no doubt that the transition would take place.
"It will happen," he said. "It may be difficult, it may happen on a different time frame depending on different levels of difficulty, but it will happen."
Such moves would be crucial, but even should they come to pass, hurdles would remain to the adoption of SONIA across the British financial industry.
Concerns about the costs associated with changing over - such as in altering IT systems - could deter some companies, particularly those enacting expensive Brexit contingency plans.
Sectors like insurance could also face formidable technical, and potentially legal, hurdles if they were to switch from Libor to assess future liabilities.
Libor - the London Interbank Offered Rate - is a daily rate in a range of currencies which is used to price contracts ranging from home loans and credit cards to derivatives. It is based on submissions from banks of interest rates they believe they would be charged by others for borrowing money.
Banks have been fined billions of dollars for trying to manipulate the benchmark, prompting regulators to come up with alternatives.
Last month the UK's Financial Conduct Authority set the end-2021 deadline for switching to the Bank of England's Sterling Overnight Index Average - SONIA - based on transactions done in the market, rather than Libor-style estimates.
Currently derivatives contracts worth 7.7 trillion pounds are priced against SONIA, but mainly short-term contracts going out 18 months in duration. This compares with Libor-based contracts worth about 30 trillion pounds going out to 50 years.
While the industry group, whose members include the likes of Barclays, BNP Paribas, Citi, Deutsche Bank and HSBC, have backed SONIA as the alternative for Libor, making the change won't be easy or quick.
Industry officials say two crucial milestones must be passed to encourage the switch: a range of exchange-traded futures contracts referencing SONIA; and a clearing house for SONIA swaps traded "over-the-counter" or privately between banks.
LCH, the clearing arm of the London Stock Exchange, said it was about to seek permission from the Bank of England - which regulates clearing houses - to clear longer-dated swaps.
Clearing provides a big financial incentive for banks to switch because they must hold more cash against uncleared swaps than against those that pass through a clearing house like LCH.
"We are planning to extend the eligibility of SONIA interest rate swaps out to 51 years before the end of 2017, as well as developing other SONIA-based over-the-counter and exchange-traded products," LCH told Reuters.
Jourdain said the working group he chairs would flesh out later this quarter the "atomic elements" needed to promote adoption, including a futures contract referencing SONIA, though it would be up to exchanges whether they listed the products.
Exchange traded futures are seen as cheaper and more transparent by many market participants and can build up liquidity rapidly, thereby boosting confidence to switch.
"It can go quite quickly, because the requirements for creating a new future are simpler than for cleared swaps," said Jourdain, who is also head of compliance at Barclays International. "Early next year would be my hope."
The bulk of volume in Libor-based futures contracts is listed on the InterContinental Exchange <ICE.N>, whose IBA unit also administers Libor.
ICE faces a dilemma as listing futures contracts could hasten the demise of Libor, but industry officials said it faced little choice as it would otherwise lose business to a rival.
"It's a commercial dilemma of self-cannibalisation," said one senior official at a dealing bank.
ICE has said Libor had a long-term future, and would not comment on whether it would list SONIA futures products.
Eurex, the futures trading arm of Germany's Deutsche Boerse <DB1Gn.DE> would also not comment on offering SONIA futures.
U.S. exchange CME <CME.O>, the third big derivatives exchange, also declined to comment - though it will offer futures in the Libor alternative rate being published daily by the New York Federal Reserve next year.
Jourdain said the key hurdle to SONIA adoption was inertia.
Market participants could balk at the prospect of change and costs at a time when many are facing major projects, like complying with new European securities rules (MiFID) from next January, or preparing for Britain's EU exit.
"This has been a major focus for our members, especially since the new risk-free rates were selected in Japan, the UK and United States, because of the sheer volume of outstanding derivatives trades referenced to Libor," said Rick Sandilands, senior counsel in Europe for the International Swaps and Derivatives Association (ISDA), a global industry body.
ISDA is working on ways to smooth the transition, such as by identifying fallbacks that can be written into derivatives documentation, creating certainty on which reference rate would be used if Libor was suddenly discontinued.
The trade body has also determined that a "spread" should be added to SONIA to lessen the impact on moving from a rate that stretches out many years to one based on overnight markets.
As Libor extends many years, the holder of a swap contract can work out the interest payment well ahead of the due date. SONIA, however, is an overnight rate, meaning payment due several months away would be based on a rate compounded over the intervening period.
But other, more technical changes would also be needed to encourage a sizable switch to SONIA from the insurance sector.
Under EU law, insurers must use a "risk free" interest rate curve published by the bloc's watchdog European Insurance and Occupational Pensions Authority or EIOPA to value future liabilities, and Libor is an element of these rates.
"There are no plans to amend this legislation nor change materially the methodology EIOPA uses to derive the curves," EIOPA told Reuters. "The shift from Libor to SONIA is therefore not foreseen."
(Reporting by Huw Jones and Marc Jones; Editing by Pravin Char)