We are transiting from the London Interbank Exchange Rate (LIBOR)
The London Interbank Offered Rate (LIBOR) – one of the most widely used interest rate benchmarks by banks in the world, will be replaced by alternative, risk-free reference rates by the end of 2021.
LIBOR and its determination process have come under scrutiny from global regulators following the 2008-2009 Global Financial Crisis, due to inherent problems with its construction and misconduct in its determination as panel bank traders colluded to rigging the rates in 2008. The UK’s Financial Conduct Authority (FCA) subsequently announced LIBOR’s exit. This will have far-reaching results for financial services worldwide, including the Bank.
The Reference rate reform is a business issue, not a regulatory one – the market is moving, and it will fundamentally affect how we operate. LIBOR’S discontinuation will cause a tremendous shift across financial markets in the coming months and years. It will impact our business and those of our clients and counterparties. It will change the way we transact, trade and interact with our clients, counterparts, debt investors and shareholders.
Market regulators and central banks have defined dates and milestones towards LIBOR’s discontinuation but have not defined how the LIBOR transition should take place within each financial institution. At FirstBank, we would make the necessary operational, legal and risk management changes and implement the most appropriate alternative benchmark rate(s) that would best suit our clients, business, financing and risk management needs.
LIBOR is an acronym for the London Interbank Offered Rate. It is one of the most widely used interest rate benchmarks in the world. It is published in several currencies on a daily basis. It is the prevailing interest rate that banks use to lend to each other. LIBOR is based on loan rate submissions from participant banks (Panel Banks). Practically, it’s the key pillar supporting an estimated US$350-trillion in financial contracts worldwide.
LIBOR has had a long and influential history. Devised in 1969 as a method to price a syndicated loan deal with the Shah of Iran, LIBOR was later formally published by the British Bankers Association and grew to become an international go-to benchmark.
LIBOR globally underpins US$350-trillion worth of loans and derivatives from variable-rate mortgages to interest-rate swaps. LIBOR has been widely used since the 1980s, and its use has paralleled the explosive growth in global capital markets. Today, it serves as a reference rate for the full spectrum of financial transactions (from adjustable-rate mortgages and home equity loans to business loans and interest rate swaps).
After the 2008 financial crisis, authorities in the US, EU, Japan and the UK found that traders had colluded to manipulate and rig the (LIBOR) rates to make a profit at customers and counterparts’ expense. This discovery led to numerous reviews and reports by national and international organisations that fully uncovered the scandal in 2012. In 2017, the UK’s Financial Conduct Authority (FCA) announced that they will no longer compel banks to submit rates for the calculation of LIBOR (post-2021). This propelled a global shift away from the use of Interbank Offered Rates (IBOR).
The case for moving away from LIBOR as a reference rate is powerful. 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 in LIBOR’s publication reputationally.
The interbank lending and borrowing 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.
One of the crucial improvements suggested in these reports is that LIBOR submissions should be anchored, to the greatest extent possible, to actual transactions and their associated costs of financing. Despite enhancements to LIBOR, the benchmark isn’t particularly transparent or robust and the rate-setting process hinges on interbank funding transactions that are declining in volume.
On March 5, 2021, the dates for the cessation of publication of, and non-representativeness of, various settings of the London Interbank Offered Rate (“LIBOR”) was announced:
- CHF, JPY and GBP LIBOR for all tenors after December 31, 2021;
- one week and two month USD LIBOR after December 31, 2021; and
- all other USD LIBOR tenors (e.g., overnight, one month, three month, six month and twelve month) after June 30, 2023.
The LIBOR transition is a market driven event, not a regulator compelled event. Without the FCA’s efforts to secure publication of LIBOR until the end of 2021, we may have already seen panel banks withdraw due to the legal and reputational risk involved. Regulators and central banks aren’t abolishing LIBOR and will not be defining how the LIBOR transition should take place. Instead, they are collaborating with the industry, including trade associations, in mapping a way forward.
The ARRC is a group of market participants initially convened by the Board of Governors of the Federal Reserve System (Federal Reserve Board) and the New York Fed in cooperation with the U.S. Department of the Treasury (Treasury), the U.S. Commodity Futures Trading Commission (CFTC), and the U.S. Office of Financial Research (OFR) to identify an alternative reference rate for use primarily in derivatives contracts. The ARRC was charged with finding a rate that was more firmly based on transactions from a robust underlying market and that would comply with certain standards, including the IOSCO Principles for Financial Benchmarks.
The transition to Alternative Reference Rates (ARRs) will require significant efforts by financial institutions to address the impact on business and control processes, as well as business systems, interactions with clients, risk management and financial performance.
Alternative Reference Rates (ARRs) have been developed in key markets to replace current LIBOR currency rates: US dollar, Euro, British pound, Japanese yen and Swiss franc. In the US, the Alternative Reference Rates Committee selected the Secured Overnight Financing Rate (SOFR) as the preferred alternative reference rate to the US dollar LIBOR.
ARRs are structured differently to LIBOR rates, which will mean complexity for impacted companies. For example, the US dollar LIBOR is typically a forward-looking rate with a 1-month or 3-month tenor that implicitly includes bank credit risk. SOFR is a backward-looking overnight rate and, as a repo rate, is secured by collateral.
Working groups from around the world have proposed alternative reference rates or are working to substantially strengthen existing rates. Five reference rates are emerging as an alternative to LIBOR. These alternative rates differ by region, currency, tenor, and basis.
- SOFR – overseen by the Federal Reserve Bank of New York, (secured rate)
- SARON – administered by Zurich-based SIX Exchange, (secured rate)
- SONIA – (Bank of England) (unsecured rate)
- ESTER – (European Central Bank) (unsecured rate)
- TONAR – (Bank of Japan) (unsecured rate)
As regulators and central banks are not defining how the LIBOR transition should take place, companies will need to determine which alternative benchmark they will use. With regulators issuing few if any hard mandates, financial firms will probably make different operational changes and follow different strategies and timelines.
LIBOR differs significantly from the alternative rates, making the transition especially complicated. LIBOR reflects a degree of bank credit risk. Some of the alternatives are risk-free (or near-risk-free) rates e.g. SARON and SOFR are secured rates, while €STR, SONIA and TONA are unsecured rates. LIBOR is a forward-looking term rate with a range of seven maturities up to a year. The alternatives are backward looking overnight rates.
Timelines have remained mostly the same despite COVID-19. We have seen some delays in the interim milestones but the final date for the transition to the new risk-free reference rates remains scheduled for 31 December 2021.
While there are no penalties, it has become increasingly clear that regulators will not merely sit on the sidelines. Regulators noted that firms who choose to ignore LIBOR transition might be judged unfavourably in the future. One example is the BoE announcement that it would apply progressively increasing haircut add-ons to existing LIBOR linked collateral. This would result in decreased value for existing LIBOR assets as collateral for BoE funding and likely impact to liquidity and pricing. Capital penalties for LIBOR issuances are also being contemplated.
How does the LIBOR transition impact our customers?
The LIBOR transition will impact different transactions and products. A FirstBank customer with a floating rate loan or credit facility, deposit or derivative that has payments linked to LIBOR or other affected legacy benchmarks that mature after 2021 will be affected.
First Bank is working to keep affected customers and their businesses informed through this transition, particularly with details on the Bank’s proposed approach to the use of the alternative interest rate benchmarks, and how it would propose to deal with existing legacy benchmark based transactions or products.