The financial markets are well underway to replace one of the most widely used interest rate benchmarks – the London Inter-Bank Offered Rates (LIBOR).
The big question is “Are we prepared?” Probably not today.
“But will we be prepared in time?” We must be.
Background
To provide some context, LIBOR is an interest rate benchmark based on which large global banks borrow and lend unsecured funds in the interbank market for a short term, in a given currency. It forms the basis of borrowing and derivative contracts that banks enter with other financial institutions, corporates as well as retail customers. In a nutshell, it’s an indicator of the prevailing short-term market rate of interest for each of the respective currencies. British Bankers Association (BBA) initially administered LIBOR rates from around the 1990s up until January 2014. The LIBOR rates were published based on data submitted by a few selected banks (panel banks) for ten currencies with 15 maturities quoted for each currency – ranging from overnight to 12 months – thus producing 150 rates each business day.
The panel banks would submit the LIBOR rates for each currency based on the actual transactions they have undertaken or if sufficient transactions of reasonable size hadn’t taken place, then based on their expectation and judgement. This room for panel banks to make judgements involved in providing quotes created an avenue for manipulation. These limitations of the LIBOR benchmark were exploited by the traders at many of these panel banks. They colluded to manipulate the rates that were being published to benefit their trading and derivative activities. A number of these large banks were heavily penalized by multiple regulators. Owing to the scandal, LIBOR was handed over to ICE Benchmark Association – the new administrator, the number of quoted currencies was reduced to 5 currencies (USD, GBP, EUR, JPY, CHF), modifications were made to the calculation methodology, and it was decided to cease publication of LIBOR and to replace the benchmark rate. Accordingly, LIBOR is scheduled to be phased out by December 2021 for most of the quoted currencies and by June 2023 for USD currency.
Challenges, Progress of the transition and Expectations
The challenges with replacing a benchmark so deeply rooted in the financial systems cannot be understated. The outstanding exposure to LIBOR globally is estimated at approximately USD 390 trillion. This exposure is by way of derivative contracts, borrowings, floating rate notes, bonds, mortgages, syndicate loans, etc. Separate working groups were formed for each currency to identify an alternative benchmark that could be used to replace LIBOR. Accordingly, alternative reference rates (ARRs) such as SOFR (USD), SONIA (GBP), €STER (EUR), TONA (JPY) and SARON (CHF) were recommended by the working groups. These ARRs are based on actual transactions in the overnight market and are considered near risk-free rates.
Re-drafting of Contracts with LIBOR reference: Although the critical task of identifying the alternative rates was complete, the bigger challenge of transitioning away from LIBOR had only begun. To put this in perspective, thousands of contracts in the markets refer to the LIBOR rates. Typically, the language in these contracts mention the alternative rate to be considered if LIBOR was not available temporarily for any reason (known as the ‘fallback clauses’ or ‘fallback language’). However, the fallback language in these contracts do not factor the possibility of LIBOR being unavailable permanently.
This would mean if LIBOR stops being published, thousands of contracts would be vulnerable to legal risks and litigation. Every single contract that had the LIBOR referenced in it, will have to be renegotiated and amended.
Challenges of establishing the new ARRs:
1. Tenor Issue: The new rate environment comes with other challenges as well. The ARR being overnight rates do not indicate the rate of interest to be charged for a longer tenor borrowing.
Further, the credit risk associated with an overnight rate would be much lower than a longer tenor rate. In reality, neither do market participants borrow only for an overnight tenor, nor are the parties to contracts considered credit risk-free. Therefore, using an overnight rate in its current form would be challenging.
The working groups and market participants came up with certain market conventions to address this challenge. One of them is to compound the overnight rate on a daily basis, for the period of borrowing. Another was to add a credit adjustment spread over and above the compounded overnight risk-free rate to make it equivalent to what a credit adjusted rate could be.
2. Backward Looking rates: One of the advantages of LIBOR rate was that it was a forward-looking rate. Parties to a contract would know at the start of a period the cashflow that would be exchanged at the end of the period. For example, in a contract linked to a 3-month USD LIBOR, the interest payment for the 3-month period would be known at the start of the 3-month period. However, since ARRs are overnight rates and backward looking, the interest payment for the 3-month period would be known only at the end of the 3-month period based on the daily overnight rate fixing during the period. This would not give parties sufficient time to plan for the cash outflows/ inflows.
3. Near credit risk free nature of ARR: Since LIBOR rates would typically be higher than the ARR due to the presence of a credit risk component in it, LIBOR rates cannot simply be replaced with ARRs in existing contracts. That would lead to a transfer of value to one of the parties to the contract depending on the position i.e. receiver or payer of LIBOR. Therefore, a methodology for a credit adjustment spread was developed to address the imbalance between the two rates. The methodology recommended for the credit adjustment spread is to consider the historical median of the difference between LIBOR and the respective ARR over a five-year lookback period.
4. Possible Illiquidity due to lack of market depth of ARRs: Currently, the markets linked to the ARR are not deep enough i.e. sufficient transactions are not taking place and liquidity is a concern. As we move closer to the transition date, new events continue to unfold. Other alternative rates other than the recommended ARRs rates have started to emerge. It is likely that with the end of LIBOR, markets will move from a single rate environment to a multi-rate environment in each currency. For example, the USD LIBOR rate is likely to be replaced by more than one alternative USD rate. The legacy of LIBOR may be too much for a single replacement rate to handle.
Conclusion
The impact of the transition is significant, especially for banks and financial institutions which have numerous transactions in LIBOR. The transition requires changes to be made to their products, the pricing of these products, documentation of existing contracts, asset-liability management strategies, valuation and risk management models and would have an impact on systems, taxation and accounting.
Most large banks and institutions have set up working groups internally to manage the organization’s transition plan across each area. The transition is going to change the way how transactions will be undertaken in the future, how credit spreads will be agreed, and it would be exciting to see how the new rate environment plays out.
The issue of any new contracts linked to GBP LIBOR have been discontinued effective 31 March 2021. That’s how close we are to the end of LIBOR. We have made considerable progress in the transition, but a lot more needs to be done!
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