Global efforts on a replacement for the London Interbank Offered Rate (LIBOR) are well underway, but challenges remain about the multi-year transition and the long-term implications for businesses and investors.
LIBOR is an important bank lending rate for the credit-based economy that came under fire amid charges that traders from banks were manipulating their daily estimates for their own gain. Banks have faced billions in fines, as well as criminal charges.
LIBOR supports more than $350 trillion in mortgages, commercial loans, bonds and derivatives, according to the ABA Banking Journal. Interest rate derivatives account for nearly 90 percent of the outstanding gross notional value of financial products referencing Libor.
Since LIBOR is just a survey-based average interest rate that major banks would “expect to pay” if they borrowed from each other, and not based on actual transactions, it is easily prone to manipulation and collusion. This has taken a heavy toll on transaction volume. The dollar LIBOR averaged nearly $500 billion during the height of the real estate bubble in 2007 and had collapsed to just $68 billion during February 2018. The search for a more realistic transaction-based interest rate has created various alternatives.
LIBOR replacement: What comes next
The scandal, which unfolded in 2012, undermined the credibility of a number of benchmarks related to Libor — Eurobor and EONIA in the Euro Zone, and JPY Libor and “Tibor” in Japan. Regulators in the U.K., U.S., Europe and Asia soon began steps to find a replacement.
In the U.K. earlier this year, the Bank of England took over administration of the SONIA rate — the Sterling Overnight Index Average — for use in Sterling derivatives.
Within the Swiss franc market, the Swiss National Bank in 2017 adopted the Swiss Average Rate Overnight (SARON) for the Swiss franc repo market. Term rates of up to 12 months are now in use.
In Japan, the Bank of Japan has identified its Libor replacement as the Tokyo Overnight Average Rate (TONAR) for the yen overnight index swap market.
Within the euro area, the European Central Bank said in late 2017 that it would create a new overnight rate by 2020.
Secured Overnight Funds Rate (SOFR)
In the U.S., the Federal Reserve Bank of New York created the Alternative Reference Rates Committee (ARRC) to find a LIBOR replacement and oversee the transition of the dollar LIBOR. In early 2018, ARRC created the Secured Overnight Financing Rate (SOFR). SOFR measures the cost of overnight cash borrowing that is collateralized by U.S. Treasury securities.
SOFR has the liquidity to absorb the weight of the $200 trillion market cap of LIBOR. Volume has been averaging between $700 to $900 billion a day. The New York Federal Reserve illustrated how the three-month compound Treasury repo rate is less volatile than the three-month LIBOR using rate data from 2014 to 2017. SOFR is smoother than the three-month Libor, based on the compound average of the Treasury repo rate. SOFR is a secured rate while Fed Funds are not.
SOFR versus Libor
SOFR is a secured rate while LIBOR is an unsecured rate, thus SOFR rates will be higher. As a risk-free rate, SOFR does not move with LIBOR and would not have plummeted during the financial crisis or the euro crisis. The absence of a credit component, however, makes it difficult for mortgage lenders to set accurate prices on their loans.
LIBOR is tied to trillions of dollars of derivatives which enable banks and lenders to hedge. The SOFR futures market launched in April 2018, so it will take time to build up volume and liquidity, which are needed to enable effective hedges.
Potential challenges for the Libor replacement
The FCA has announced that it will no longer require banks to calculate estimates for LIBOR after 2021. While it is not yet clear whether LIBOR will be published after 2021, regulators and bankers globally will need to continue their work to find a viable LIBOR replacement for each of their respective markets. It raises questions about legacy contracts that reference LIBOR, along with mark-to-market risks.
A report from Oliver Wyman found that renegotiating a large volume of contracts would be difficult, especially when one party has a contractual right to a windfall gain. If contracts are left to convert to fallback provisions if LIBOR becomes unavailable, a vast number of price changes would occur in a short period, Wyman found. The associated financial, customer and operational impacts would be difficult to manage.
Adding to uncertainty, the Intercontinental Exchange Inc. (ICE), which took over management of LIBOR from the British Bankers’ Association in 2014, announced plans recently to strengthen Libor, suggesting a possible showdown with SOFR and other Libor replacements, reports Bloomberg.
In addition to the uncertain future of LIBOR, there are signs the transition will be bumpy at times. For example, the Federal Reserve Bank of New York recently said it discovered some erroneous data in the daily calculation of SOFR not long after its debut, raising questions for some market participants.
Whether adopting SOFR or alternative interbank offering rates (IBORs) or risk-free rates (RFRs), prudent planning for the transition involves identifying and tackling the key challenges. This includes assessing exposure to IBORs, including legacy products tied to LIBOR, ensuring products have robust fallback provisions, scheduling platform upgrades, training and integrating a long runway for testing and acclimation before rollout.
A scalable single-source-of-truth platform with front-to-back office automation capabilities can make transitions easier by removing compatibility issues and improving transparency and accountability.
Calibrating alternative RFRs by currency
For global firms operating in different currencies and regions, it is important to identify the alternative RFRs to replace Libor. SOFR is the alternative for the USD (U.S. Dollar) Libor in the U.S., SONIA is the alternative for the GBP (Great British Pound) Libor and TONA is the alternative to the JPY (Japanese Yen) Libor. The alternative RFR for the euro Libor will be determined in September 2018. Make sure your systems provider is on the leading edge of RFR developments.
Despite the integration challenges and liquidity concerns, the rollout of SOFR has been making progress. Corporate loan departments with legacy systems and procedures configured to Libor will need to upgrade systems to remain competitive. With $1.2 trillion in mortgages and $1 billion in mortgage-backed securities (MBS) that are already tied to Libor, mortgage lenders could see repercussions and spikes in delinquencies as confused borrowers may dispute their interest rates if payments rise.
Nonetheless, Libor’s easy manipulation shows that it is time for a new replacement that more accurately reflects the market.
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