LIBOR: the death knell is ringing, it’s time businesses prepared

Sep 24, 2019 | Articles, Featured, Practice - Data, Practice - Digital

LIBOR, the London Interbank Offered Rate is being demised globally and replaced with other rates which promises to be one of, if not the, biggest change to banks and their clients’ processes in decades. Put simply, LIBOR is a calculated rate across five major currencies and seven maturities at which contributing banks believe they could borrow from each other on the London interbank market. It is also the reference point for setting interest rates on an extensive list of financial products. The changes are not restricted to LIBOR, with other jurisdictions such as Hong Kong and Australia considering following suit.

LIBOR helps set rates for hundreds of trillions of dollars worth of financial instruments, including swaps, annuities, credit cards and mortgages. It is the global benchmark rate at which banks lend to each other in the interbank market for short-term loans. However, there is a problem. It is an estimate and therefore open to potential manipulation – and therein lies the reason for its demise. In 2012, several major banks were reported to have manipulated the LIBOR market, a scandal which culminated in combined fines of around $10 billion and a decision to end LIBOR by the end of 2021.

An estimate rather than an actual transaction rate

LIBOR’s replacement in the US dollar market, SOFR, the Secured Overnight Financing Rate, is based on past transactions and is therefore more accurate. Daily SOFR volumes are regularly between $700 billion and $800 billion, making it a transparent rate that is representative of the current market across a broad range of participants, including fund and asset managers, insurance companies, corporates, securities lenders and pension funds. It is therefore more protected from attempts at manipulation than LIBOR.

Alternative Reference Rates (ARR), such as €STR (Euro short term rate replacing current EONIA in October 2019), reformed EURIBOR (Euro Interbank Offered Rate) and SONIA (Sterling Overnight Index Average – GBP), will be replacing LIBOR in their respective currencies.

There are however substantial challenges. Firstly, the replacements, like SOFR, are based on historical rates meaning fixings cannot happen until after the market has closed. This means lenders and borrowers have less certainty of the actual rate which transactions will be settled at, impacting their ability to hedge and then settle transactions.

A range of repercussions

Secondly, the repapering will have a range of repercussions for the banks and the International Swaps and Derivatives Association (ISDA) has suggested a fallback to all contracts which will have to be agreed by all market participants. As a result, banks will stand to benefit from some transactions and lose from others.

Then there’s the additional workload. Increased regulatory scrutiny and the basic differences between LIBOR and the other ARRs will cause further challenges in transition. For one, all ARRs are risk-free rates (RFR),

whereas LIBOR already includes the risk premium. Buy- and sell-side parties will need to agree on how to incorporate the risk premium into the pricing. Another challenge with the transition is the calculation methodology for instruments with tenors longer than overnight, as the majority of the ARRs are only overnight rates (with the exception of reformed EURIBOR). LIBOR is quoted for a range of forward-looking tenors (including overnight).

Finally, the LIBOR rate, even with its flaws, worked well in the main. Its decommission and replacement with a less tried-and-tested benchmark will have ramifications of its own.

The changes are coming, the time to act is now

So, what does this switch mean for the banks and financial markets?

As with any change, there will be winners and losers. With the impact likely to be felt by billions of people, from financial institutions, insurers and banks through to pension holders, retail investors and mortgage holders, the time to act is now.

Reports state that more than 80 per cent of the LIBOR-linked financial instruments will mature by the end of 2021[1], but many will be renegotiated, and the rest will need to be converted. One of the key challenges will be pricing these new products and their associated risk modelling. In addition, the lack of a set deadline will make the changes more gradual and it is likely that each market will move as and when it is ready, ie. if the three-month SOFR rates are reliable, markets will stop using three-month USD LIBOR rates, prompting the partial demise way before the December 2021 deadline. Others that aren’t ready may take longer. 

 

The impact will be wide-reaching

Consumer loans are likely to be a particular problem, with more than 40 per cent of outstanding LIBOR-based residential mortgage loans due to mature after 2021[2]. If not handled correctly, the fallout could be huge.

The changes will also have an impact on technology, with the need for new systems to cater for new and adjusted products. Platforms, confirmation matching tools and market data providers will all have to be updated, along with valuation models, interest calculations and market feeds. In addition, there are a lot of dependencies with a range of counterparties, so maintaining good relationships with clients is going to be key to ensure transitions happen smoothly.

As with any change, the key, we believe, is to prepare. Ensure you know what exposure your business has to LIBOR and what your options are for the future. You need to manage the transition and stay ahead of the curve to switch with the market in order to be successful. As always, it is the ones who have prepared who are likely to come out on top.

At Brickendon we are working with a number of clients to ensure they are aware of the impacts the changes will have on their business. We have significant experience in regulatory change and our experts are well placed to help your business prepare to not only limit any impact the changes may have but also thrive from the change. To find out more, email Lee Pittaway, one of our partners, or call him on 0203 693 2605.

We are an award-winning transformational consultancy with the drive, skills, knowledge and experience to help you change your business for the better. Let us show you what we can do.

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