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Replacement still elusive as Libor’s end nears

The London InterBank Offered Rate, aka Libor, will no longer exist as the benchmark interest rate after the end of 2021, but reports suggest that banks, accountants and regulatory bodies are still struggling to find a replacement standard immune to the same manipulation that brought about Libor’s demise.

Bloomberg reports that the use of Libor has been so pervasive that millions of loans extending past the 2021 deadline will be affected and could potentially need to be renegotiated from the ground up as entirely new contracts.

Various potential successors to Libor have emerged. The Financial Accounting Standards Board (FASB) has introduced its own alternative rate – the Secured Overnight Financing Rate (SOFR) – but it has yet to reach the same sort of ubiquity as Libor.

SOFR has been used mainly in the US, being based on the cost of overnight loans, using repurchase agreements secured by US government debt. The European Central Bank (ECB) is developing an unsecured overnight rate based on transaction data available to member central banks.

Japan’s candidate is the Tokyo Overnight Average (TONA), based on unsecured money market rates administered by the Bank of Japan (BoJ). The UK favours the Sterling Overnight Index Average (Sonia), which reflects the unsecured overnight funding rates of banks and building societies. Switzerland proposes the Swiss Average Rate Overnight (Saron), based on repo rates administered by the SIX Swiss Exchange.

A worthy successor?

The case for moving away from Libor as a reference rate is a strong one. As The Economist noted last September: “The rate is based on a panel of banks submitting estimates of their own borrowing costs. The rigging scandals that made Libor notorious in 2012 showed how this process could be manipulated. They have also made many banks nervous of being involved.

“The interbank market has become less important since the financial crisis, because new rules encourage banks to use other forms of borrowing. That means there are fewer transactions to base the rate on. Anyway, it is unclear why a measure depending in part on banks’ credit risk should be part of an interest-rate swap, say, between two companies.

“(So) broadly speaking, Libor’s planned demise is a good thing. But that does not mean it will go smoothly.” Former banker Satyajit Das recently wrote that each of Libor’s potential replacements carries accompanying problems.

“Competing proposals in some currencies and different approaches between rates create inconsistencies and complexity,” said Das. “ICE Benchmark Administration Ltd., currently responsible for overseeing Libor, has proposed switching to the US Dollar ICE Bank Yield Index, which competes with SOFR.

“As Libor isn’t being eliminated -- regulators will simply no longer force banks to continue supporting the benchmark -- it’s possible that different rate mechanisms could co-exist in the future, creating confusion. The proposed benchmarks are untested. It’s unclear whether they will prove robust and less susceptible to manipulation.”

Will emerging technologies come to the rescue as banks face the extensive and costly work of reviewing and revising their contracts for the post-Libor era?

According to Anu Sachdeva, global service line leader for  commercial banking at US professional services firm Genpact, artificial intelligence (AI) can help banks automate the transition and mitigate financial and legal risks associated with contracts maturing beyond 2021 during the three phases that mark the transition away from Libor and preparation for a post-Libor marketplace.

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