THE END OF AN ERA: THE DISAPPEARANCE OF THE LIBOR RATE.
Javier Edwards Renard.
The LIBOR (London Interbank Offered Rate) has been published daily since 1986, officially, for five currencies. As a result of the financial crisis of 2008, trust between banks was significantly weakened, hence revealing the Achilles Heel of the rate determination.
What is the LIBOR rate?
The LIBOR (London InterBank Offered Rate) is a daily reference rate based on the interest rates at which banks offer uninsured funds to other banks in the wholesale money market or interbank market. The LIBOR will be slightly higher than the London Interbank Bid Rate, the effective rate at which banks are prepared to accept deposits. It is approximately comparable to the Federal funds rate of the United States. The LIBOR is set by the British Bankers Association, and the result is published around 11:00 GMT.
The LIBOR is published daily for five currencies and terms ranging from overnight to 12 months. Additionally, for global use, the definition of contractual conditions in the financial market is published, for credits, derivatives and bonds with variable payments. This interbank interest rate, since February 2014, is under the supervision of the Intercontinental Exchange Benchmark Administration (IBA).
Why its replacement and what comes next?
The LIBOR was in serious trouble during the outbreak of the financial crisis of 2008. At that time, trust among the system’s banks weakened to the point that it was not possible but only to obtain overnight rates. Subsequently, this confidence was further weakened when in 2012 there was a collusion between participants of the panel of banks, which would come from as far back as the year 1991, evidencing that the rate did not have the reliability assigned to it as expected.
In this scenario, and while LIBOR has continued to be the reference rate, a series of measures were taken to recover the lost confidence: /i/ the transfer of LIBOR supervision from the BBA to the regulators of the United Kingdom, in particular, the Financial Services Authority (FSA), /ii/ different market agents, including regulators and labor companies began proposing plans to remove existing reference slabs and initiate a replacement process.
The foregoing resulted in that, in November 2017, the Financial Conduct Authority (FCA) ruled, noting that as of the end of 2021 the bank panel will not be cited to participate in the LIBOR delivery process and the reference rate monitoring. The main reason is the insufficiency of the frequency and volume of transactions that support the relevant parameters for the markets. Additionally, the International Accounting Standard Board (IASB) communicated to the market the draft modification of International Accounting Standard 39 (IAS 39) and International Financial Reporting Standard 9 (IFRS9), proposing as an application date of January 1, 2020, also allowing early adoption.
Consequences of the change
- Considerable costs and risks for financial institutions and corporations: The proposed alternative rates are calculated differently, therefore, payments under contracts that reference the new rates could be different from those referenced to LIBOR. Although today there is a concrete proposal for new indicators by currency, there is uncertainty as to how it will operate and how the current LIBOR contracts will migrate towards the new rates with the lowest impact and possible costs for both banks and their debtors.
- Its use as a reference in operational or service contracts, for payments due to arrears or fines. This implies that its disappearance will not only have effects in the strictly financial field but also in a series of other contracts that use it as referential mechanism.
- Inventory of contractual stipulations that allow to face the change. The affected parties must /i/ if the contracts of the case have a rule for the case that there is no LIBOR available and the replacement mechanism, and /ii/ in case this is not regulated, it will be necessary to initiate renegotiations between entities and, in some cases, to possible arbitrary and/or judgments. Some of this already happened during the financial crisis of 2008, when it was necessary to include in the contracts clauses called “market disruption” to face the fact that LIBOR was not available but only for overnight periods.
With less than two years before the definitive change if the change takes place, it is necessary to incorporate this problem as part of the operational, financial and technological planning of the banks, establishing actions with due anticipation to direct the plans and that these allow to address areas of impact. The earlier this happens, the greater certainty about the protection of the operational stability and financial results of an entity.
USA and the idea of the SOFR: an alternative for economies indexed to the US dollar.
To develop and implement a replacement of the dollar-denominated version of LIBOR, in 2014 the Federal Reserve established the Committee of Alternative Reference Rates (ARRC), an instance that brought together representatives of the private sector and regulators. In May 2016, the committee had reduced the search to two options: /i/ the interbank interest rate of the Federal Reserve of New York and /ii/ a rate based on repurchase agreements, which are transactions for secured day loans by securities of the United States Treasury (SOFR). After discussions and comments from advisory groups, the committee identified the SOFR as the best option.
LIBOR vs SOFR
While the LIBOR depends on the expectations of the bankers, the SOFR is based on real transactions from a number of companies that include brokers, money market funds, asset managers, insurance companies and pension funds. It is also different from the LIBOR in the fact that it is a guaranteed rate, since repurchase rates are derived from secured loans, or backed by assets. It is a one-day interest rate, specifically based on one-day loans; Libor, by contrast, covered loan maturities from one day to one year. And the volume of transactions on which the SOFR is based is significantly higher.
Is the market ready to leave the LIBOR for the SOFR?
Until now there has been a degree of complacency in reducing long-term exposures to LIBOR, according to NatWest’s Blake Gwinn strategist. ARRC has established working groups for credit-based market participants to adopt a backup language in contracts for products such as loans and mortgages in case LIBOR stops publishing. That is a first step towards getting companies to adopt the SOFR as their reference. However, notwithstanding the imminence of its disappearance, there is still a significant degree of uncertainty regarding the financial alternatives to replace the referred rate and its legal and contractual implications. For the moment, it is essential, on the one hand, the review of financials and other contracts that have the LIBOR agreed as a fee, in order to know whether or not they have provisions that allow their replacement and, on the other, to elaborate clauses that regulate the change in this case and in any future scenario of a similar nature.