The Landscape After LIBOR
Thinking back to 1986, it was an eventful year; a Soviet Nuclear reactor at Chernobyl exploded, BSE or mad cow disease hit the UK, the internet mail access protocol was defined paving the way for e-mail and everyone was left wondering who shot JR?
1986 also saw the launch of LIBOR (London InterBank Offered Rate) which set the interest rate upon which trillions of financial derivative contracts, mortgages, bonds and retail and commercial loans have been tied to. In short, if you have a mortgage or any sort of loan, it will be based on an interest calculation representative of the LIBOR.
Now 33 years on, a decision has been taken to replace LIBOR by the Financial Conduct Authority (FCA) by 2021. The reasons for such a decision stem from the financial crisis according to Forbes, who note that ‘Post financial crisis regulation has significantly reduced bank appetite to issue commercial paper and wholesale deposits’ which in turn has resulted in a low volume of transactions for banks to base their LIBOR on, making it less and less reliable as a basis for determining interest rates. The financial crisis also unveiled the ‘Libor Scandal’ in which traders in major banks were falsifying LIBOR for their own profit.
So, what replaces LIBOR you might ask? The ICE Benchmark Administration (IBA) who are responsible for publishing LIBOR have publicly stated that although it needs to change, it will not cease to exist. So, perhaps a LIBOR 2.0 is on the cards? Much of the focus of the Bank of England supported by the FCA is in identifying so-called Risk Free Rates (RFRs). In contrast to LIBOR, which includes an element of credit risk in its calculation, an RFR is as it states, a theoretical rate based on a completely risk free investment (for example government bonds). And so to the new kids on the block, a number of different RFRs for unsecured overnight transactions per currency; SONIA (for GBP), SOFR (for USD), SARON (for CHF), TONA (for JPY), leaving EUR for which an RFR has yet to be confirmed.
However, there is some scepticism over the ease at which these RFRs can reasonably replace LIBOR given some key issues such as RFRs not being set for varying and longer term maturities, differences in how the varying currency RFRs are calculated, and the backward looking nature of RFRs which would mean borrowers could not easily calculate their interest bill in advance, as is the case with LIBOR currently.
What then does this mean for the financial institutions who have historically relied upon LIBOR and have financial instruments which expire post 2021? It means change - and change which is not without its due level of complication. With those financial contracts maturing beyond the 2021 deadline, the existing agreements and even interest rates may no longer be applicable, requiring a consensus between parties on changes, repapering and so on. Additionally, there are process and technology implications as financial institutions are currently structured to base products and services on LIBOR. They will now need to assess the implications of both handling LIBOR as a continued rate and introducing the new kids on the block to existing products, services and processes. Simultaneously, they will also need to account for modifications to their use as rates in finance transactions extending over longer terms than overnight and allowing for a variable degree of credit risk calculation. Key to the successful delivery of such changes will be the pre-planning, support and education of staff and clients alike on the implications of such changes.
At Marbral Advisory we assist companies in conquering their biggest challenges. We provide specialist thinking, intelligent resourcing, bespoke support and insightful training. Our experts are at the forefront of all regulatory changes and we can help clients who are going through the complexities brought to the fore by the replacement of LIBOR. Find out how we can support you on this journey. Don’t leave it too late, get in touch now with our Head of Client and Product Development Natasha Egré.