There are interest rate indices, and there is LIBOR.
There are numbers, and there is LIBOR. In fact, you can even find articles referring to it as “the world’s most important number”. But what is this index the business community is increasingly talking about?
By the end of 2021, LIBOR – a benchmark rate that banks use globally to calculate interest rates for financial transactions – will be gone, though it will persist until the last contracts based on it are due. Concerned about this deadline, regulators and financial institutions are working hard to find an alternative to it.
As you can imagine, there is disagreement about the LIBOR destiny, and a considerable number of representatives of financial institutions would prefer the index to stay. However, regulators and central banks have emphasised the need to find alternative benchmarks (reference rates).
Whichever your connection with the financial world is, the LIBOR fade out will likely affect you, at least indirectly. It isn’t only widely used between financial institutions – for instance, in standard interbank transactions – but it’s also embedded in consumer contracts such as auto loans and mortgages.
With this article, our goal is to explain LIBOR in an uncomplicated way: its rise and scheduled fall, and why it is still “the world’s most important number”. Benjamin Gauthier, PwC Partner, joined us in the venture, and answered several related questions.
How did LIBOR become the global financial benchmark rate?
There are people and things that are, simply, “meant to be”, even if it wasn’t intended. That’s the LIBOR case. Back in the late 60s and early 70s, a bank in the United Kingdom needed a rate loan to lend money to clients abroad. Because no one had established it before, the bank decided to use a fluctuating (variable) rate. After that, slowly but firmly, other banks started using a similar procedure to define rate loans in an increasing number of financial transactions. However, it was in mid 80s when LIBOR really took form and took off when the British Bankers Association (BBA) defined a governance system, including the way it should be defined.
At that time, the market for interest rate-based products started to evolve. Having interest rate swaps, currency derivatives and forward rate agreements becoming popular, LIBOR emerged timely as a uniform measure of interest rates.
Before going further, let’s define LIBOR in very simple words. Imagine you are a banker and you need to raise cash. You decide, then, to borrow money from another bank. What interest rate would you be willing to pay for it? The answer is LIBOR. Because it’s solely based on your creditworthiness and promise to repay, the lender issues the funding that is considered “unsecure”.
LIBOR stands for “London interbank offered rate”. It’s a measure of the interest rate banks are willing to pay one another to borrow unsecure money. It serves seven maturity periods, namely, the period when the financial item becomes due, or must be paid: overnight, one week, and one, two, three, six and twelve months. LIBOR covers five currencies: US dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF).
However, interbank transactions are only a slice of the pie. LIBOR is a benchmark rate for mortgages, corporate loans, government bonds, credit cards and student loans in various countries. When the derivatives market expanded as of 2000, LIBOR became even more influential
The LIBOR’s fall
The nature of the LIBOR calculation makes it, unfortunately, subject to manipulation. The BBA’s methodology that the current LIBOR administrator – ICE Benchmark Administration (IBA) – also uses, is consensus-based. Every day before 11:40, a certain number of influential global banks (panel banks) respond to a recurrent question directly linked to deposit/loan rates that they are using. The answer is called LIBOR submissions.
“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am, London time?”
Then, before 12:00, IBA calculates 35 different LIBOR rates (one per maturity and currency) and publishes them.
The opinion-based rate was subject to scrutiny when, in 2012, American media accused panel banks of altering LIBOR rates to favor certain traders’ requests. They submitted artificially low LIBOR rates to keep traders’ preferred levels. As a result, regulators and policymakers started reviewing financial benchmarks that led to increased oversight and governance.
Although the scandal weakened LIBOR’s reputation, other factors linked to the financial crisis that peaked in 2009 have been relentlessly affecting LIBOR’s relevance. In 2017, The Financial Conduct Authority (FCA), organism that regulates the financial services industry in the UK and operates independently of the government, announced that it would not compel banks to submit it beyond 2021 because the rate had become less robust. Indeed, after 2008, the wholesale unsecured-term money market started to decline.
The crisis that started in the previous decade forced banks and regulators to admit the risks associated with the unsecured borrowing and lending transactions based on LIBOR submissions.
Replacing LIBOR is more than changing five letters
There are interest rate indices, and there is LIBOR, as we wrote before. In the current context, that sentence couldn’t get any truer.
Efforts to replace LIBOR, or, to be more precise, the role LIBOR is playing as benchmark interest rate are ongoing. Relevant financial organisms at each of the nations whose currencies are used for LIBOR submissions have identified potential successors. They fundamentally differ from LIBOR in two ways: 1) They are or are expected to be secured references; 2) they measure the cost of borrowing cash overnight, therefore, they only consider one maturity period. Linked to the former, the EU Benchmark Regulation, enforced on 1 January 2018, mentions that “the use of discretion, and weak governance regimes, increase the vulnerability of benchmarks to manipulation”.
Even in the unlikely scenario that banks and other financial institutions will entirely replace LIBOR after 2021, it won’t fall into oblivion right after. Certainly, LIBOR-based legacy contracts with maturity levels that go beyond 2021 are numerous, and even the ones being written right now refer to LIBOR with maturities beyond that date.
Replacing LIBOR is more than replacing five letters. From interbank transactions like interest rate swaps and interest rate futures to derivative products, price valuations and consumer loan-related products (individual mortgages and student loans, for example), the “most important number” has managed to embed itself in our financial universe so intrinsically, that finding alternative reference rates (ARR) is undeniably challenging.
The ARR or ARRs that could play LIBOR’s role require acceptance, linked to liquidity and how fit they are to drive massive adoption. These requirements have a cause-effect relationship: Liquidity is a result of the adoption of ARRs by banks and investors, and the adoption of ARRs answers to how apt and robust ARRs are to replace LIBOR in all financial transactions where it is used.
The table below shows the ARRs identified as potential LIBOR successors.
|Alternative Reference Rate (ARR)||Country||Administrator||Characteristics|
|Secured Overnight Financing Rate (SOFR)||United Kingdom||Bank of England||Overnight, unsecured reference|
|Euro Overnight Index Average (EONIA)||Europe||European Central Bank||Overnight, unsecured reference|
|Tokyo Overnight Average Rate (TONAR)||Japan||Study Group on Risk-Free Reference Rates||Overnight, unsecured reference|
|Swiss Average Rate Overnight (SARON)||Switzerland||The National Working Group on Swiss Franc Reference Rates||Overnight, secured reference|
When Luxembourg meets LIBOR
Change, and resistance to change, always coexist. Logically, if LIBOR is an old, useful and widely accepted interest rate, a considerable number of financial institutions bet on its continuity. On the other hand, when panel banks have to provide submissions in the absence of borrowing activity that can validate those judgements, they feel uncomfortable.
In any case, regulators will continue to push regulated financial institutions to take the necessary steps to alleviate risks the LIBOR discontinuance will likely generate. In this regard, countries of the LIBOR currencies are progressing unevenly.
For instance, the regulator and working groups in the US and the UK have taken steps that are more concrete and further advanced than the others are. Their derivatives markets and trading in LIBOR replacement rates are more developed and have more liquidity.
Time is running out, and financial institutions in Luxembourg need to be vigilant. There is a nuance making any LIBOR – related preparation particularly challenging, though. Because headquarters are commonly elsewhere, decisions on the measures to put in place may come with some delay or, quite frankly, late. This also has to do with what regulators and working groups agree on, in the coming months.
LIBOR replacement will affect funds, financial products and the tools that Luxembourg financial institutions are using. For now, timely information is key, as it is getting teams linked to LIBOR transactions organised and prepare to deploy an action plan under pressure.
What we think
This change is much more than replacing 5 letters in the existing documentations.
It is certainly a massive change for the financial industry. Considering that no “easy alternatives” are available, the time required to manage properly the transition and its direct as well as indirect impacts, should not be underestimated.