The implications of Libor’s demise look set to be intriguing
Objective reference points are a necessity of life that is often taken for granted. Think of the directions of the compass used for navigation or watch hands marking the passage of time. We need beacons as references.
One important reference point, perhaps hidden for many people because it is assumed to be too technical, is the global interest rate benchmark known as the London interbank offered rate (Libor). While it is perhaps the most important reference point in all of finance, Libor is a benchmark that isn’t going to be around much longer. The implications are interesting and complex.
Libor is actually not one interest rate, but many. There are interest rates for five different currencies, such as the US dollar, British pound and Japanese yen, and their respective values straddle seven different time horizons. Depending on which currency you want to borrow in and how frequently you would repay interest, you would be quoted a different interest rate.
Libor has been an immensely popular objective reference point — by term and currency — for the cost of money; so popular in fact, that it is now estimated to be the reference interest rate for $400-trillion of financial assets globally.
This reference point is about to change to something completely different. Libor isn’t being reformed, it is being replaced with so-called alternative reference rates (ARRs). This is because it has proved to be an unreliable reference historically, despite its popularity.
Let’s take a step back. As the name suggests it’s an interest rate at which banks lend to each other. The problem is that banks don’t actually transact at this rate in any material size. In fact, Libor is expressed as an expected rate at which banks could borrow from each other.
Specifically, Libor is published daily as an adjusted compilation of the same panel banks’ expectations of where they could borrow in each currency and tenor without needing to place any security for the borrowing. Being based on an expectation and not transactions renders it open to manipulation.
Libor behaved unexpectedly during the global financial crisis of 20072008. Investigations by regulators found that four of the panel banks had taken advantage of these weaknesses for dishonest gain. These banks manipulated their daily Libor quote to appear more financially sound than they really were and, more egregiously, to make the value of certain financial contracts move in their favour. Regulators issued large fines and several bank executives resigned in the wake of the scandal.
The more sustainable remediation is to get rid of Libor altogether, and this is what, after much planning, is about to take place. Libor, for most currencies, will no longer be quoted from December. For US dollar Libor, the cessation date for the most common tenors is slightly later at June 30 2023.
The impact will be difficult to escape. Consider for a moment the range of financial assets that use it as a reference. These can be floating rate mortgages, business loans, asset-backed securitisations, bonds, syndicated loans, derivatives and sovereign borrowings — implying that homeowners, investors (think pensions), businesses of all sizes, banks and governments are all affected to a certain extent if their loans or investments reference a Libor interest rate.
Most, if not all, financial assets are represented by legally enforceable contracts. The contracts that at present reference Libor would need to be amended to reference a new ARR. The new ARRs are intentionally different from Libor, and arriving at a mutually suitable replacement may require informed negotiations between contracting parties.
THE IMPACT WILL BE DIFFICULT TO ESCAPE. CONSIDER THE RANGE OF FINANCIAL ASSETS THAT USE IT AS A REFERENCE
Banks will have to keep a close eye on their conduct towards clients in these negotiations, and borrowers should equally ensure they are obtaining trusted and independent advice to ensure effective negotiations. Market conventions around the transition to ARRs could prove a helpful guide in certain situations.
More sophisticated market participants might find differences in approach and timing in the transition for bond markets, loan markets and derivative markets. All affected parties should ensure they understand the effect of the transition on their cash flows, tax position, accounting treatment and net risk position after the transition.
The scale and complexity of this change is daunting. Understanding the full consequences will require transiting, albeit briefly, through some tough terrain of technical interest rate definitions. But the destination is worth the effort.