The London Interbank Offered Rate (Libor) is used in millions of financial products for unsecured bank lending, with a value of more than $240 trillion, according to an article by experts at Oliver Wyman. But following the Libor-fixing scandal, regulators have said they want a reference rate based on market prices, rather than on self-reported values from banks. So Libor is set to end in 2021, when the UK Financial Conduct Authority will no longer require banks to submit data for Libor. “Given the vast number of products, contracts and processes Libor is 'baked into', moving to alternative rates will inevitably be a burdensome and lengthy process,” write Adam Schneider and Serge Gwynne, both partners at Oliver Wyman.
The move away from the self-reported data to a market-based reference rate is a move towards transparency in financial markets and interbank lending – but ending Libor will bring challenges for all market participants. The Oliver Wyman article highlights some of the challenges facing banks and users of Libor-based financial products:
- There is a question market over the practicality of objective reporting of rates following a dramatic decrease in the past 10 years in the market for unsecured interbank lending. Schneider and Gwynne write that this makes “objective reporting of rates practically impossible”.
- Rates such as the Sterling Overnight Index Average (Sonia) and, in the US, the Secured Overnight Financing Rate (SOFR), could replace Libor, while for the euro market, Euribor's calculation method is set to be revised and Eonia will probably be scrapped after 1 January 2020. But replacing Libor with an alternative reference rate will not be straightforward. Schneider and Gwynne explain that “a transition to these new reference rates will not be a simple matter of replacing old rates with new. The new rates are structurally different from Libor”. The different structures of the rates will affect interest on financial products. The partners at Oliver Wyman add: “ Simply substituting Sonia for Libor in products or contracts that reference it would therefore radically alter expected cash flows and the way they behave as interest rates change.”
- They also flag up the problem that many financial products based on Libor will mature after the reference rate is no longer in use. While these contracts make provision for a temporary unavailability of Libor, the 'fallback' position can often change the nature of the product, for example from floating rate to fixed rate. Schneider and Gwynne write: “One of the counterparties to a Libor contract may suffer material losses while the other receives windfall gains.”
- Many products/contracts will have to be individually renegotiated to revise the terms that involve Libor rates. Schneider and Gwynne write: “Bespoke contracts with corporate customers will usually require individual renegotiation. By contrast, the standardisation of many derivative products and sophistication of the counterparties involved, may mean that revising them will be relatively straightforward, which is fortunate given the extraordinary gross exposures.”
- The risks of continuing to use Libor-based retail products are considerable. The Oliver Wyman articles states: “Retail products that reference Libor will also need a standardised rather than individually negotiated revision. But here the risks of getting it wrong are considerable.”
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