To The World’s Most Important Number — LIBOR…Goodbye!
LIBOR, or the London Interbank Offered Rate, has held the coveted title of ‘The world’s most important number’ for quite some time now. However, things are changing…
LIBOR is a measure of the rate at which major banks are willing to lend out unsecured short-term loans in the interbank market, where banks borrow and lend to each other. These rates are largely based on the banks’ estimates and do not originate from actual transactions.
Each day, at 11:55 AM, 35 LIBOR rates are published by InterContinental Exchange’s Benchmark Administration (IBA), accounting for the various possible combinations of five currencies (USD, GBP, JPY, Euro and Swiss franc) and seven maturities (overnight/spot next, one week, one month, two months, three months, six months and a year).
LIBOR’s Heydays
LIBOR has been the most popular reference rate for floating interest-rate financial products, with over $400 trillion worth of contracts relying on the same. Complex derivatives, mortgages, floating-rate bonds, even credit card interest payments are linked to LIBOR. A floating interest rate is calculated as the sum of a variable reference rate and a fixed spread. For instance, consider you’ve purchased a floating-rate dollar-denominated bond with a half-yearly coupon payment cycle and coupon rate equalling LIBOR + 30 bps (1 bps = 0.01%). If the LIBOR is 4% at the start of the period, then your first coupon rate would be 4.3%. If, after the first coupon period, the rate rises to 4.1%, your next coupon rate would be 4.4%.
In addition to being used as a reference rate for numerous products, LIBOR and its spread vis-a-vis other benchmarks is also a good measure of investor sentiment in global markets. It is an old, comfortable metric enjoying wide acceptability. Similar to LIBOR, other rates include EURIBOR (European Interbank Offered Rate) and MIBOR (Mumbai Interbank Offered Rate), which are regionally concentrated.
Changing Times
Now, times are changing and LIBOR hasn’t aged too well. LIBOR calculations still follow an outdated process in which the IBA asks certain banks called panel banks to report their rates every morning. Panel banks are those banks highly active in their respective interbank markets and the rates they announce are used to determine LIBOR rates.
And, since the 2008 crisis, the number of unsecured transactions in the interbank market has been on the decline along with the cardinality of the set of panel banks. Thus, the metric is no more a robust indicator of the market but rather an ‘expert judgement based on market and transaction data’.
Further, the infamous LIBOR scandal of 2012 exposed the vulnerabilities of the metric to collusion and manipulation. Banks reported artificially high or low-interest rates to bolster the appearance of their financial positions, offer benefits to derivative traders and reap profits. Indeed, LIBOR emerged quite frazzled and battered post this incident.
Retirement
In July 2017, Britain’s Financial Conduct Authority (FCA) announced that banks would not be required to submit interest rates for LIBOR calculation purposes after 2021. This would mean phasing out of LIBOR and its dependent products. LIBOR may still be published by IBA though, since banks may very well continue to reveal the requisite rates. However, the use cases would reduce significantly given the shifting trend towards alternative reference rates. Regulatory pressure for the transition is also expected to rise.
Alternative reference rates (ARRs) for LIBOR pertaining to the five main currencies are currently in the works. The Secured Overnight Funding Rate (SOFR), Sterling Overnight Index Average (SONIA), Euro Short-Term Rate (ESTR), Swiss Average Rate Overnight (SARON) and the Tokyo Overnight Average Rate (TONA) are the frontrunners to replace the dollar, pound, euro, Swiss franc and yen LIBOR rates respectively. These rates cannot be superposed precisely to match their corresponding LIBOR rates owing to certain differences.
SOFR, for instance, is based on transactions occurring in the US Treasury repo market, where investors offer banks overnight loans backed by Treasuries. Essentially, we’re looking at rates pertaining to secured overnight loans. In contrast, LIBOR considers unsecured loans and thus inherently includes a credit risk component that SOFR doesn’t incorporate. SOFR is a pure overnight rate unlike LIBOR, which offers different rates for different term maturities. Hence, there must be a compounding aspect to SOFR to calculate the effective rates for various time durations.
But, while LIBOR encompasses a degree of expert judgement, SOFR relies entirely on actual transaction data. Considering the enormous volume of transactions happening in the Treasury repo market, SOFR is indeed a more accurate measure of borrowing costs, albeit quite different from LIBOR. A few modifications would be necessary to enable its functioning as a US dollar LIBOR replacement.
While SOFR is quite young (these rates were published from Q2 2018 only), SONIA is relatively more mature and has already been widely used as the reference index rate for Overnight Index Swaps in Britain. It represents interests rates for unsecured overnight loans and is based on actual transactions.
Implications for the Financial Markets
Various countries, their central banks and special committees are working to ensure a smooth transition away from LIBOR. Financial institutions ranging from banks to hedge funds offer products linked to LIBOR. There will be costs that these players would have to incur owing to the transition. While their current risk models, valuation tools, algorithms and hedging strategies may be wired towards LIBOR, modifications must be made to replace the same with the appropriate ARR.
With LIBOR on the path to becoming obsolete after 2021, companies would have to focus on switching to ARRs in existing contractual agreements as well. Those contracts with maturities beyond the LIBOR transition deadline would be affected. While contracts usually have fall-back clauses in the eventuality of LIBOR becoming unavailable, these are designed keeping in mind short-term disruptions. Given that no one foresaw such an announcement while designing those contracts, a dearth of a cushioning effect to the transition is a challenge that must be tackled. Banks and firms will have to renegotiate contracts where robust fall-back clauses are absent and this will be a mammoth task considering the prodigious volume of contracts.
Communicating this change to the customers is another aspect firms should focus on. A lot of people may not understand what LIBOR is, let alone reconcile the average spread between LIBOR and SOFR (SOFR rates are usually 30bps lower than LIBOR). Convincing customers that LIBOR + 300 bps is equivalent to SOFR + 330 bps would be a challenge.
Further, as the exact date for LIBOR’s retirement isn’t announced, things get even murkier, with firms not having a solid idea of the timeline for the transition. However, it’s a common consensus that they ought to start preparing for the same as early as possible.
Conclusion
Covid-19 has affected the expedition of this transition and banks are currently having to juggle various impacts of the downturn, including moratoriums, write-downs and digitisation while also keeping an eye on ARRs. Indeed, 2020 is turning out to be a year of immense changes for the financial industry, and the coming decade will ride on sustainable, transparent and digital banking.
