Authors: Mark Gill, Katie Bellett
By the end of 2021, the London Inter-Bank Offered Rate (LIBOR) will no longer be the universal benchmark for short-term interest rates.
This article provides an overview of LIBOR and its importance to the global financial market, why it is being phased out, the alternatives that have been identified so far, and how market participants can prepare for the end of LIBOR.
What is LIBOR and why is it important?
Since 1984, major banks across the world have relied on LIBOR to determine short-term interest rates. LIBOR reflects the current rate at which major banks charge each other interest when borrowing for short periods – anywhere between overnight and 12 months. Before 7 a.m. London time every day, a panel of banks answers the question: “at what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?”
The panel is comprised of 11-18 banks per each of the following five currencies: Swiss Franc, Euro, Pound Sterling, Japanese Yen and U.S. Dollar. The panel answers this question by submitting quotes for the five currencies and seven maturity periods (overnight, one week, one month, two months, three months, six months and 12 months). Based on this, the ICE Benchmark Administration Limited determines the 35 LIBOR benchmarks for the day and publishes the results around 11:55 a.m. London time. The most commonly quoted LIBOR is the US dollar three-month rate.
Simply put, LIBOR is the benchmark interest rate at which major global banks lend to one another each day.
LIBOR’s impact is far-reaching, as it is used:
- as the benchmark for many consumer loans (such as mortgages, car loans and student loans);
- to calculate floating and adjustable corporate loans, derivatives, bonds and other financial contracts;
- to gauge the strength of the world economy; and
- to predict central bank interest rates.
According to Business Insider, $350 trillion worth of outstanding loans and trading contracts around the world are based on LIBOR.
The Downfall of LIBOR
So, why is such an influential and universal financial benchmark being phased out next year? The downfall of LIBOR began during the 2007-2008 financial crisis, when it was uncovered that many banks were manipulating LIBOR for their own financial gain. The discovery led to criminal charges and over US$9 billion of fines issued, and exposed a number of weaknesses in the global interest rate. Market participants raised concerns over a number of issues such as:
- the rate is not based on actual transactions, but on quotes from panel banks who estimate their borrowing costs;
- the reliance on good faith estimates resulted in some panel banks submitting artificially low LIBOR quotes to inflate their profits and overstate their financial strength; and
- the lack of a regulatory framework for LIBOR, making it vulnerable to manipulation.
As a response to the LIBOR controversy, the UK’s Financial Conduct Authority (the FCA) launched an extensive investigation and review of LIBOR, with the initial goal of reforming LIBOR. However, as the review continued, LIBOR became increasingly unsustainable due to a shrinking interbank lending market and the reluctance of panel banks to provide quotes based on judgments rather than transactions, given their increased exposure following the aftermath of the 2007-2008 financial crisis. The FCA was given a temporary power to compel banks to quote LIBOR, however this further highlighted the frailties in the declining interest rate standard, and the authority eventually abandoned its hopes of reforming LIBOR in favour of a total phase out. In 2017, the FCA announced that by the end of 2021, the FCA will no longer use its authority to persuade or compel panel banks to quote LIBOR, marking the beginning of the end for the long-used global financial benchmark .
Alternatives to LIBOR
Both the U.K. and the U.S. have recommended their own risk-free benchmarks as alternatives to LIBOR, that rely on actual transactions, not good faith (or, not so good faith) estimates. The U.K. Working Group on Sterling Risk Free Rates (the U.K. Working Group) has promoted the Sterling Overnight Index Average (SONIA) as the preferred alternative to LIBOR for rates quoted in sterling. SONIA is calculated according to the weighted average rate of unsecured transactions in the sterling market brokered by the Wholesale Market Brokers’ Association in London each business day. The goal of the U.K. Working Group is to transition from LIBOR to SONIA as the primary sterling interest rate benchmark by the end of 2021.
In the U.S., the Alternative Reference Rates Committee (the ARRC) has recommended the Secured Overnight Funding Rate (“SOFR”) as its preferred alternative to LIBOR. SOFR is an overnight collateralized rate which is calculated according to transactions in the Treasury repurchase market, which is an established and ever-growing market. Both SONIA and SOFR are relatively risk-free compared to LIBOR, as they rely on transactional data and not submissions from panel banks, and both have been endorsed by the FCA as viable alternatives to LIBOR. However there are a number of notable differences between the U.K. and U.S. alternatives and LIBOR, namely:
- SONIA and SOFR are only available in sterling and USD respectively, whereas LIBOR was offered in multiple currencies;
- SONIA and SOFR are only overnight, backward looking rates, unlike LIBOR which was available in multiple maturities and was a forward looking term rate; and
- unlike LIBOR, SONIA and SOFR do not incorporate bank credit risk.
In Canada, the comparable risk-free benchmark rate is the Canadian Overnight Repo Rate Average (CORRA). CORRA is also based on real transactions and uses calculations from on-screen trades through interdealer brokers. It is generally used for overnight index swaps and related futures. Beginning in 2018, the Bank of Canada established the Canadian Alternative Reference Rate Working Group (the CARR) in order to develop Canada’s own interest rate benchmark for the Canadian dollar. CARR was also tasked with reviewing possible options of strengthening CORRA in order to increase the volume of trades used to calculate the rate. In July 2019, the Bank of Canada announced that it will be the administrator of CORRA in 2020.
Life After LIBOR
Despite the emergence of viable alternatives, there is a general impression that the market is unprepared for a total phase out of LIBOR. This is due in large part to the uncertainty of what the accepted alternative benchmark rates will be, so many lenders and borrowers are delaying their transition away from LIBOR. Currently, the most viable alternatives are SOFR and SONIA, but both are backward looking; lenders and borrowers prefer forward looking term rates because the total interest payable is known at the beginning of the interest period. Ideally one of the options will be developed into a forward looking term rate, which would provide for a smoother transition away from LIBOR.
The uncertainty of a viable alternative to LIBOR does not mean that market participants should not take proactive steps to prepare for the phase out. For example, many credit agreements contain fallback language in the event that LIBOR is unavailable. However, these fallback clauses are for short-term unavailability and do not provide solutions for the total termination of LIBOR. In order to prepare for the discontinuance of LIBOR, parties to credit agreements should review the fallback language in the agreements and consider amending current credit agreements to provide fallback language that adequately addresses the termination of LIBOR. For agreements that will mature after 2021, parties to credit agreements should review the ARRC’s recommendations for fallback contract language (which can be found here) when drafting their fallback clauses.
It is hard to predict exactly how life will look for the financial market post LIBOR, however, Andrew Bailey, Chief Executive of the FCA, has advised market participants that the best way to prepare for the phase out is to avoid entering into new LIBOR based contracts, and to actively transition to an alternative benchmark rate well before the end of 2021.
Note: This article is of a general nature only. Laws and government programs may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.