After 35 years, the curtain falls this week on the era of the London Interbank Offered Rate, aka LIBOR, will no longer be used for new derivatives and loans from 1 January 2022.
The origins of LIBOR date back as far as 1969, but its use was formalised in 1986 and it was subsequently used as the reference rate for a wide range of financial products from student loans and corporate loans to credit cards and mortgages
As the most-used benchmark and reference rate, LIBOR was based on quotes from banks on how much it would cost to borrow short-term funds from one another. This appeared to work well for more than two decades, but its reputation was irredeemably tarnished in the wake of the 2008 financial crisis when authorities found that traders had manipulated LIBOR, prompting calls for reform, swingeing fines imposed on several global banks and work on developing a replacement. However, LIBOR still had an estimated US$265 trillion linked to it globally at the start of 2021, is being scrapped in the biggest shake-up to markets since the introduction of the euro in 1999.
Exception to the rule
Regulators have stipulated that no new business can be conducted after 31 December 2021 using LIBOR and its 35 permutations across five currencies: the dollar (USD), the pound (GBP), the euro (EUR), Swiss franc (CHF) and the yen (JPY); although some LIBOR tenors – the length of time remaining before a contract expires – linked to the USD will continue until the end of June 2023 so that most “legacy” or outstanding contracts can mature.
To minimise potential disruptions, New York state passed a law allowing “tough legacy” contracts – those due to expire after June 2023 that lack fallback language specifying an alternative rate and thus cannot be amended – to use the Secured Overnight Financing Rate (SOFR) recommended by the US Federal Reserve. Congress is working on a similar bill.
Much of the USD derivatives market has already shifted to SOFR, although relatively large exposures based on Libor remain in the Eurodollar space, for short-term contracts used to speculate or hedge against interest rate moves.
Liquidity in these contracts is expected to dwindle, which will likely make it harder for investors to hedge existing LIBOR-based exposures. Investors will also have to adjust to using alternative instruments when making bets on future rate moves.
In the UK, regulators have said that six sterling and yen LIBOR rates will continue in “synthetic” form – the Bank of England’s Sterling Overnight Index Average (SONIA), combined with a fixed spread – for a year, giving market participants more time to shift to alternative rates for existing contracts.
SOFR and SONIA
LIBOR is being replaced by several alternative rates, with SOFR and SONIA perhaps the best known, with a preference toward those recommended by central banks that are based on actual transactions that consequently cannot easily be rigged.
However, the shift from LIBOR to SOFR involves pricing challenges for borrowers and loan issuers, who prefer exposure to credit benchmarks that will adjust to shifts in credit market conditions.
SOFR is based on the US repurchase agreement market, which has no credit risk and may fall during times of stress. LIBOR, by contrast, measures bank borrowing costs and rises during periods of stress – most recently in March 2020 when Covid-19 first became a global pandemic.
Lenders are adapting by pricing loans with a spread to SOFR. However, there are risks that this spread could underprice risks if there are unexpected periods of credit stress.
Separately, UK business daily City AM reports that the transition from LIBOR to SONIA as the principal replacement rate for sterling LIBORs, will produce many ‘winners’ and ‘losers’,
Dan Hemming, partner in banking disputes at law firm RPC, told the paper that as SONIA is a different interest rate from LIBOR and cannot easily be adjusted to produce an identical economic outcome, those on the losing side of the transition might have looked to sue if they felt they were unfairly treated in the transition.
However, UK regulator the Financial Conduct Authority (FCA) recently announced that it would relax the 1 January 2022 deadline for financial services to stop using LIBOR as a reference rate in contracts in order to minimise potential disruption and a wave of litigation. As the FCA confirmed that an unexpectedly wide range of legacy contracts would be permitted to use ‘synthetic’ LIBOR rates through 2022, it is likely this litigation will be postponed.
Had there not been any agreement to publish a synthetic LIBOR or the scope of contracts permitted to use it had been narrower, banks would have to spend the last weeks of December trying to renegotiate all contracts with LIBOR written into them under ever-increasing pressure.
“The hard stop to LIBOR in the FCA’s original timetable of December 31 threatened to make the last month of the year extremely tense and chaotic for financial institutions and their customers. It looks like the FCA has been pragmatic and blinked,” Hemming told City AM.
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