The London Inter Bank Offered Rate, more commonly referred to as LIBOR, is being wound up, which is likely to affect over $400 trillion of financial arrangements globally.
Having gained widespread use in the mid-1980s, the globally recognised benchmark interest rate has been subject to manipulation scandals following the global financial crisis, and questions as to its validity, on account of low underlying real transaction volumes.
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What is LIBOR?
Every morning just before 11am GMT the ICE Benchmark Administration (IBA) determines a set of rates, having asked a panel of large international banks the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am London time?”
A total of 35 LIBOR rates are published with seven different maturities for each of five major currencies: the Swiss franc, the euro, pound sterling, the Japanese yen and the US dollar.
How is LIBOR used?
LIBOR is used in financial products worldwide:
- Standard interbank products: forward rate agreements, interest rate swaps, interest rate futures, options and swaptions.
- Commercial products: floating rate certificate of deposits and notes, variable rate mortgages, bilateral and syndicated loans.
- Hybrid products: collateralised debt obligations, collateralised mortgage obligations and a variety of accrual notes, callable notes and perpetual notes.
- Consumer loan-related products: mortgages and student loans.
LIBOR has been used by financial markets as a standard gauge of market expectation for interest rates. Reflecting banks’ credit risk premium it has acted as an indicator of the overall health of the banking system. It’s used as a reference rate in the investment industry for derivatives products, as well as for processes such as interest calculation in debt products, clearing, price discovery and product valuation.
When is LIBOR ending?
LIBOR will be largely phased out immediately after 31 December 2021, and this year is the most critical in executing the transition and to launch alternative products. The FCA announced on March 5th the long-awaited schedule for cessation of the rates, with the majority ceasing to be published on a representative basis from January 1 2022, and only some longer-dated US dollar settings being maintained until mid-2023 to facilitate transition of USD legacy portfolios.
Why is this important?
While the end of LIBOR may not be a headline grabber, particularly given strong competition from a pandemic and Brexit, at least from a business perspective, the transition is one of the biggest market reforms ever, and a particularly important step in ensuring post-global financial crisis stability.
For businesses with exposure to debt or credit exposure rated against LIBOR, this is the year to get on board with the transition. Large or small, uncertainty is an unwanted commodity for any business.
Meanwhile, for banks, LIBOR transition has been a huge operational endeavour, from systems upgrades, product development and enterprise readiness to large-scale portfolio analysis and client outreach.
For businesses that have borrowed from banks, it’s important to review all loan documentation for references to LIBOR, said Fiona Cameron, partner, Banking and Finance at law firm Shoosmiths. “Have early conversations with lenders or other counterparties to agree what changes will be required. It’s essential that businesses have an understanding of the changes so that they are adequately prepared for these discussions and so that they will be able to prepare adequate accounting and management information going forward.”
Given the regulatory requirements, most businesses with LIBOR borrowings from a mainstream bank should already have heard or expect to hear from them very soon. However, it would be prudent, suggested Cameron, for businesses to make contact as soon as possible if they have not heard anything.
Check the small print
“LIBOR will essentially cease from 31 December 2021. Many loans priced off LIBOR will contain ‘fallback’ wording that may allow the lender to price the loan at its ‘cost of funds’ (essentially the amount the lender states it costs it to fund the loan). This may kick in if the loan agreement is not amended to refer to an alternative benchmark rate. This is far from ideal for borrowers as it is an amount set at the discretion of the lender, rather than an official rate, which may result in disagreements or uncertainty,” she said.
Businesses should also cast an eye over ancillary finance documents that may be impacted, such as interest rate hedging products and foreign exchange and trade finance contracts.
“While LIBOR transition has been a hot topic in the loan markets for a few years, it’s probably a lot less prominent in commercial spheres. This means that commercial contracts that reference LIBOR may be the ticking time bomb of the transition. Following the cessation at the end of this year, businesses looking to enforce a commercial contract provision that references LIBOR may find themselves litigating. It is therefore essential that this is addressed and changes are made before the end of this year,” said Cameron.
The impact on hedge accounting
Hedge accounting seeks to reduce income statement volatility by allowing businesses to provide a modified treatment for recognising gains and losses on hedging products and the exposure they are intended to hedge, reported not separately but in the same accounting period.
The LIBOR transition will affect companies that report under IFRS and UK GAAP and have applied hedge accounting for LIBOR-related hedges, such as hedges of loans, bonds and borrowings with instruments such as interest rate swaps, interest rate options, forward rate agreements and cross-currency swaps.
Amendments to IFRS 9, IAS 39 and IFRS 7 issued by the International Accounting Standards Board (IASB), as well as to the Financial Reporting Council’s (FRC) FRS 102, provide some relief for LIBOR replacement issues that impact hedge accounting. This means that in most cases hedge relationships will not cease directly as a result of anticipated LIBOR cessation or actual contract transition.
What comes after LIBOR?
Finance and treasury functions, whether big or small, like certainty. However, for SMEs, it’s unusual to have this kind of uncertainty. LIBOR has been notably volatile during the Covid-19 crisis, with rates at times going very high, to the detriment of borrowers. But whether it’s cessation is a good or a bad thing is not yet clearly known.
The end of LIBOR may help mitigate uncertainty, as borrowers shop around for rate options, but ultimately when LIBOR disappears there will be a bit of a cliff edge moment, which means preparation and understanding of the alternatives are key.
The replacement rate for sterling is SONIA, the Sterling Over Night Interest Average. “SONIA is quite a different animal to LIBOR so this has been no mean feat. We are not quite at the stage yet where we can say that there is a ‘market standard’, but we are not too far away from that,” said Cameron.
However, a SONIA calculation is not straightforward, which may put off some borrowers, she pointed out. “There will also be some lenders who, at least in the short term, do not have the systems capacity to calculate and administer SONIA. We have seen some contracts simply move back to Bank of England Base Rate or an agreed fixed rate,” continued Cameron.
Ulrike Koeppl, director, Capital Markets Advisory, Financial Services Group at Grant Thornton, also notes challenges to incorporating SONIA pertaining to moving from LIBOR, going from a term floating rate to an overnight rate. “A term rate is forward-looking, where you know months before a payment is made how much it’s going to be, while an overnight rate is backward-looking compounded, so the actual rate is determined only close to the payment date.”
While this will help mitigate the risk of manipulation, with overnight rates based on actual historical transactions, effectively, a borrower or lender will not know the amount of a payment until a few days before it needs to be made, which may pose challenges to planning and cash flow management.
For tough legacy contracts, where businesses struggle to transition, there has been talk of a “synthetic” LIBOR. “There is potential that there might be a LIBOR rate in some shape or form beyond the cessation date, but this isn’t something anyone should rely on because you might not get the result you want. And the regulators are actively pushing to transition away from LIBOR. I think people will get used to the new rates as time passes,” said Koeppl.
Watch out for mis-selling and misconduct
Any transition and upheaval to a system or process comes with misconduct risk, and the end of LIBOR is no different, applying to all products and entities, with particular emphasis on regulated financial services firms.
“Banks don’t want the LIBOR transition to be the next conduct risk and mis-selling crisis, because customers were sold products with conditions they didn’t fully understand,” said Koeppl.
Furthermore, debt issuance is a potential challenge for large non-financial corporates, not just for banks said Koeppl. “So for example, if a corporate issued a floating rate note, they need to identify and reach out to their bond holders to solicit their consent to undertake the transition, to communicate a new rate and spread, and there shouldn’t be a value transfer in doing so, said Koeppl.
Alternatives to LIBOR
- SONIA for contracts denominated in sterling.
- SOFR is the new rate for US dollar-denominated contracts.
- Euribor for euro contracts, though is also under review for reform.
- HIBOR (Hong Kong) and SIBOR (Singapore) are also facing review.
- SARON is being pushed as the new rate in Switzerland
- TONAR is the alternative reference rate for the Japanese yen.
Neil Johnson is a freelance business journalist who contributes regularly to trade publications and member organisations, covering employability, recruitment, business trends and industrial analysis.