LIBOR is an interest rate calculated from bank estimates of the cost to borrow unsecured funds from other banks across different currencies and maturities. Since the 70s, LIBOR has been used as a benchmark for interest rates but is being phased out because it no longer reaches the requirements of a reliable interest rate. According to Santander, $300 trillion in financial products are tied to LIBOR and so the manner with which the world transitions from LIBOR is important for economic stability.

LIBOR ALTERNATIVES

The market that is used to determine LIBOR ( banks assessing their borrowing cost) is now a weak underlying market because banks have changed the way they fund themselves so LIBOR is not based off of a large number of transactions (only an average of nine a day) and therefore the rate is estimated by experts rather than these real transactions. This means that, the derivatives market, for example, is set by interest rates that are not based on real transactions. Because of this, the FCA has said that LIBOR no longer fits the requirements for a robust interest rate benchmark, and this is why LIBOR being discontinued.

In the UK, the proposed replacement of LIBOR is SONIA and the US alternative is SOFR- both are RFR’s. Both of these are based off of a large volume of transactions which will accurately show the cost of buying and lending.

RFR’s are different from IBOR’s: RFRs are considered risk-free whereas IBOR’s account for possible risk by building in premiums for long-term loans and bank credit risk. This is because RFS’s are backward-facing interest rates but IBOR’s are forward-facing. A forward-facing interest rate means that the interest is set at the start of the borrowing period to calculate the end borrowing charges, meaning that the entity/individual is certain of what funding is/will be required for the loan by the time it matures. Backward facing interest rates are set based on secured overnight borrowing rates. Because premiums are not included in RFR’s, the fixings will probably be lower than IBOR’s which will affect how financial instruments and services are valued.

Who Will Be Affected?

If LIBOR is high it suggests that the banking industry is struggling and this makes it more difficult to get a loan, affects mortgage rates and the value of financial instruments. Because of this, replacing LIBOR was considered for a while because removing it is disruptive. However, all alternatives had the same issue- a lack of underlying transitions. So now the issue is how financial markets can successfully shift from this system that is at the heart of the everyday operations of firms around the world.

Those that work in financial services will be directly affected because the transition from LIBOR to new rates will affect the buying and selling activities of brokers and asset managers. LIBOR also informs the rates of loans and pensions so insurance companies and pension funds will be impacted. The transition could make it harder for normal people to get loans, especially since LIBOR dominates the loan markets.

Mortgage rates are an example of long-term contracts that will be outstanding by the time LIBOR is phased out. Contracts that mature after 2021 will need to be revised or transitioned to the new RFR infrastructure. The energy sector is another that has a higher proportion of long-term financing deals and could mean that the financial models to fund new energy infrastructure will no longer be accurate when the new benchmark rate is introduced.

In countries where student loans have a variable interest rate that is tied to LIBOR, that rate will also be affected by the transition.

IMPORTANCE OF Regulation

During the financial crisis, banks came under fire for undervaluing borrowing costs in order to make the banking industry seem stronger than it was to restore public confidence. This is just one example of when LIBOR has been manipulated and brings up the question of how the required regulation will continue in the new system. LIBOR is under UK law, regulated by the Financial Services Act 2012. This regulation makes it a criminal offence to make false statements about the interest rate.

Because regulators will probably want this transition to be market-driven (the issue with LIBOR was its separation from physical transactions), it could lead to firms taking different views on how contracts linked to LIBOR should be renegotiated. A lack of a regulatory centre-point could mean that RFR’s are adopted differently causing a mismatch between the underlying market and the derivative linked to that market.

SONIA futures have increased but are still a small proportion of the total futures contracts which suggests that at the moment, the transition is moving slowly. However, some financing agreements have included replacement benchmark infrastructure in the transaction in preparation for this change which is arguably all that can be done at this stage; prepare for the shift without damaging potential gains by shifting too early in financial markets still based on the old system. This is not an issue for shorter term financing agreements.

Closing Thoughts

I think that just as LIBOR started with a group of brokers coming together to get greater, more consistent return, the same thing could happen during this transition. Finance has changed but the fact remains that if the dominant firms team up with regulatory bodies to bring some sort of uniformity the rest of the world will follow.

SOURCES

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