What is LIBOR? What has gone wrong?
The London Interbank Offered Rate (LIBOR) is a measure of the average rate at which banks are willing to borrow from each other. It is calculated from daily submissions of panels banks, taking the average rate after removing top and bottom of the submissions. It is the rate which banks can borrow from each other in five currencies in US dollars, sterling, Swiss francs, yen and euros up to a year without security.
In 2012, LIBOR was undermined by a rate fixing scandal which regulators in many countries brought enforcement against number of world largest banks in the panels, resulting in billions of dollars in settlement. The UK regulator, Financial Conduct Authority which is tasked to oversee the benchmark rate after the post scandal has made clear that it will not compel the banks to submit the rate beyond end of 2021.
What happened next?
As there is no obvious single benchmark rate to replace LIBOR, central banks from all major countries are establishing their rates trying to replace LIBOR in their own currencies. As at today, the more established one include the following:
SOFR = Secured Overnight Financing Rate is based on the overnight US Treasury repurchase market (repo), treasuries loaned or borrowed overnight; established since April 2018
SONIA = Reformed Sterling Overnight Index Average is based on the money market transactions in the sterling overnight unsecured market; established since April 2018
SARON = Swiss Average Rate Overnight is based on the overnight secured funding of executed repo trades in Swiss francs; established since August 2009
TONAR = Tokyo Overnight Average Rate is based on uncollateralised overnight money market in Japanese yen, established since June 2017
ESTER = Euro Short Term Rate is based on the overnight money market transactions which Eurozone banks offer to lend unsecured funds to each other in euro interbank market; established in October 2019
Out of all currencies, US dollars (USD) has the most influential role in the LIBOR market. Based on the Alternative Reference Rate Committee report in March 18, it was estimated that USD constituted of around $200 trillion (or more than 80% of total) worth of derivatives, loans and bonds maturing by end 2021. Since SOFR was first published in April 2018, the SOFR market is still mainly concentrated in the US Treasury overnight repo market, which accounted for around USD750b daily. While some SOFR bonds have been issued, they are mainly by US government agencies.
For a wider acceptance of the new interbank offered rates, a deeper & wider market will be required. Fresh issued debt should start linking to the new reference rates, swaps & future markets need to be further developed, and a robust contractual framework be established to deal with both new and legacy contracts.
Why does it take so long to change?
While the timeline is getting closer, many banks are still pegging their rates to LIBOR, even for the new products or transactions that are stretched over 2021. Few reasons for this:
- Unlike LIBOR which offers future looking term rates including one-, three-, six- and 12-month rates, new reference rates are mainly based on overnight rate and term rates are not fully developed
- New reference rates are administrated by respective countries central banks, in theory the rates can be influenced by countries political agenda includes protectionism and promotion of negative interest rate
- The depth and stability of new reference rates are still being developed and tested. We noted that the US overnight repo rate was unusually soared up to a record 6.94% before it dropped back to the normal target range of around 2.25% level in Sep 2019.
- Some banks are still adopting a wait and see approach and hoping LIBOR will continue after 2021
- LIBOR is deeply rooted and fully integrated in many systems and risk calculation. The bigger the financial institution is and the more complicated products it provided, the longer and costly it will take to switch to other reference rates
What are the options for the Financial Institutions?
Unless LIBOR will continue after 2021, Banks will have limited choices but to use different reference rates for different currencies in near future. As an immediate action, banks should relook their business & currency strategies, identify products, systems and contracts that will be impacted. Bank should be mindful that any changes in reference rates may lead to a change in accounting treatment and valuation, which will have an impact to their balance sheet & P&L. Banks should also ensure that their systems can handle new interest calculation methods (like compounding) and negative interest rate scenario. As a prudent approach, Banks should get their system ready and start testing out new reference rates in their new transactions while amending the existing contracts to allow the flexibility to change in future. Of course, if the global regulators can agree on a new interbank offered rate based on new common currency or commodity, that will be the beginning of new era in the financial industry.