Replacing LIBOR: The Road to Redemption

LIBOR image

News about the replacement of LIBOR, or the London Interbank Offered Rate, has shaken the market for the last three weeks. The LIBOR is the most widely-used benchmark rate that the world's leading banks charge each other for short-term loans, supporting more than 350 trillion dollars globally in financial products, from home loans and credit cards to small business loans - and now it’s going away. UK regulators want to phase it out by 2021 and replace it with new measures that are more closely tied to the lending markets.

Speculation of scandals and rate manipulation, extreme costs, and non-sustainability have fatally damaged the reputation of LIBOR in recent years. Of course, a replacement won’t be easy and it won’t come overnight. There are undefined implications for finance professionals and especially treasurers, so we’ve brought together pieces of news and commentary to help make you sense of it all.

There could be Multiple Benchmarks

Andrew Bailey, head of UK's Financial Conduct Authority (FCA) argues that the market that supports LIBOR rates is no longer sustainable as a reference rate and that the data is no longer "sufficiently active" to be considered a true reflection of the market.  

If an active market does not exist, how can even the best run benchmark measure it?
— Andrew Bailey questioned.

In an interview with Bloomberg Bailey said he could see a situation where there is more than one benchmark, with some including bank credit risk while others exclude that data. While discussions with banks and other users of LIBOR are at early stages, it may still take a “push” from authorities to move the process forward at times.

A risk-free alternative?

The Bank of England said that a swaps-industry working group had proposed replacing LIBOR in contracts with the Sterling Overnight Index Average, or SONIA, a near risk-free alternative derivatives reference rate that reflects bank and building societies’ overnight funding rates in the Sterling unsecured market. The development comes as a number of groups have been considering alternatives to LIBOR according to Bloomberg.

A more trustworthy and accurate benchmark

LIBOR suffered an irreversible black streak on their record when banks who set the LIBOR benchmark rate were accused of systematically rigging rates. Some banks undermined the process of sending rates to LIBOR by adjusting their submitted rates to benefit their positions, as opposed to reflecting actual rates at which they were making loans.  

It is going to be replaced by a system of rates that is both more closely tied to the interest rates on actual loans.

Despite billions of dollars in fines and tarnishing “the reputations of some of the world’s biggest banks, including Barclays, Deutsche Bank, Royal Bank of Scotland and UBS”, one of the reasons LIBOR has persisted is that few viable alternatives yet exist.

According to the New York Times, it is going to be replaced by a system of rates that is both more closely tied to the interest rates on actual loans and more straightforward, but the details of that system have not been worked out.

However, corporates should not be nervous of a bumpy transition to new rates; “This date is far enough away significantly to reduce the risks and costs of a more sudden change,” said Bailey, adding that setting a future date gives market participants a schedule to plan to in advance.

U.S. replacement starts in 2018

The replacement rate in the U.S. proposed by the ARRC is a newly created index called the Broad Treasury Financing Rate (BTFR). The BTFR rate contains a broad set of U.S. treasury market-based financing transactions, also known as “repo” transactions.

The BTFR rate appears to be the best replacement for U.S. The Federal Reserve is supposed to begin publishing the BTFR index rates in the first half of 2018, but will have to run in parallel with LIBOR for several years in order facilitate a smooth transition from reference interest rate to the new index.

The hard part has yet to come

Regardless of the alternative chosen to replace LIBOR, one thing is certain: challenges lie ahead. The first challenge is building out long-term reference rates from the overnight rate in the event of a permanent LIBOR demise. “In the end, we see the most likely scenario as involving a fractured derivatives market with multiple underlying benchmarks across different countries developing,” says Mr. Cabana to the Financial Times

A swap contract involves the exchange of fixed and floating rate cash flows over a term that can run to 30 years or longer. Such contracts generally rely on three-month dollar LIBOR as the benchmark floating rate so any replacement will have to form a reliable long-term reference rate which simply takes time.

Another challenge is that most likely any LIBOR alternatives will have their flaws. In an Economist article Joshua Roberts of JCRA, a financial-risk consultancy, says that LIBOR is likely to be replaced by transaction-based rates. This means that SONIA, for example, being an overnight rate fixed daily, does not reflect the dependence of rates on the term of a loan. So a borrower pegged to three-month LIBOR will know their interest payments for the next quarter, but with SONIA, they will not.

Any LIBOR alternatives
also have their flaws.

To be sure, replacing LIBOR is a Herculean task with profound and undefined implications. "Getting a rate that’s supported, that’s well built and robust, is very important because they need to move a lot of the swaps market off of LIBOR,” said Darrell Duffie, a finance professor at Stanford University, to Reuters.

However, the process of building trading volumes around the new benchmark is likely to be slow. Asset managers, corporations and other swaps users are unlikely to trade any contracts based on the new rate until liquidity has been established.

David Duffee, a finance partner at law firm Mayer Brown in New York, claims that “Any movement away from LIBOR for United States dollar transactions, however its stage and whatever the scope of that transition, will undoubtedly have profound implications for financial markets throughout the world.”

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