Libor Is Dead, Almost! What It Was, What Comes Next

(Bloomberg) -- For half a century the series of interest rates known collectively as the London interbank offered rate, or Libor, has helped determine the cost of all sorts of borrowing around the world. But over the last decade it became seen as outdated and discredited, and a decision was made to kill off the benchmark at the end of 2021. That sent the financial world scrambling to adjust the terms in contracts on hundreds of trillions of dollars’ worth of products -- from mortgages and credit cards to interest-rate swaps. Banks collectively spent an estimated $10 billion preparing for Libor’s demise, but fears of a messy transition mean that some existing contracts can linger on, though new deals based on Libor are set to end on New Year’s Eve.

1. What is Libor?

Libor is a daily average of what banks say they would charge to lend to one another. It’s offered in five currencies and over various time periods, up to one year. Formalized by the British Bankers’ Association in 1986 to help set prices for derivatives and syndicated loans, Libor is used by pension and fund managers, insurance providers, big and small lenders and Wall Street banks that package loans into securities. In recent years some $370 trillion worth of financial products have been tied to the benchmark, including equipment leases, student and auto loans and bank deposits. The biggest component is derivatives such as interest-rate swaps -- trades of a fixed interest rate for a floating one or vice versa -- which are used by companies, banks and investors to hedge risk or speculate. Of the five Libor currency rates, the one tied to the U.S. dollar (“dollar Libor”) is most widespread, accounting for more $200 trillion worth of products.

2. Why is it disappearing?

As markets evolved, the trading that helped inform banks’ estimates dried up. Evidence emerged in 2008 that European and U.S. lenders had manipulated rates to benefit their own portfolios, tainting the benchmark and resulting in a dozen banks paying billions of dollars in fines. In 2017, the Bank of England decided that Libor would be phased out by the end of 2021.

3. Why is killing Libor such a challenge?

The finance industry has had to find suitable replacements. Beyond that, there was the fate of millions of Libor-priced contracts that run past 2021, known as legacy contracts. Updating legacy contracts proved a complicated process, raising the risk of a chaotic transition that was likened by some to Y2K, the fear of computer systems misfiring at the end of the last millennium. Rather than planes potentially falling from the sky, the worry was that a mass of litigation would ensue as lenders and borrowers failed to agree on what rate to pay following Libor’s exit.

4. Does that mean trouble is coming?

Several developments have eased much of the concern. Regulators in the derivatives market established a protocol to include so-called fallback language in contracts that will automatically transition them from Libor. In the U.S., New York state approved a law that provides a further backstop for contracts hatched on Wall Street. At federal level the U.S. House has voted through similar proposals, though the draft legislation still needs further approval. Vitally, regulators extended the deadline until the end of June 2023 for dealing with legacy contracts priced in most dollar Libor rates. Most of those contracts will have expired by then. Regulators reiterated that no new dollar Libor contracts can be issued after 2021. In U.K. and Japanese markets meanwhile, Libor’s administrator will print an artificial benchmark through 2022 to help prevent chaos for sterling and yen contracts that are incapable of transitioning.

5. How are Libor’s replacements shaping up?

Central banks have been working to develop benchmarks that are a truer reflection of the cost of capital and based on actual transactions. One common problem was that some new benchmarks, such as the Secured Overnight Financing Rate in the U.S., mostly reflected overnight borrowing rates. Borrowers disliked that because they were less able to predict payments, and loans wouldn’t reflect expectations of rate changes -- key attractions of Libor. Also unlike Libor, the new rates fail to capture the credit risk that banks assume when they lend to each other. During the 2008 financial crisis, Libor jumped even as central banks cut interest rates because of the heightened risk that lenders would go bust.

6. What do these shortcomings mean?

In the U.S., alternative benchmarks that offer longer-term rates and incorporate credit risk gained popularity with borrowers and banks. The likes of Ameribor, published by the American Financial Exchange, have the potential to disrupt the transition to SOFR by splintering the trading that’s needed to establish the official replacement for Libor. (Another alternative, Bloomberg’s Short-Term Bank Yield Index, is administered by Bloomberg Index Services Ltd., a subsidiary of Bloomberg LP, the parent of Bloomberg News.) The rise of such benchmarks pushed officials overseeing the transition to address some of the concerns about the rate’s main replacement, and in July they formally endorsed a series of forward-looking term benchmarks tied to SOFR based on futures trading. Many anticipate this will propel its wider adoption across markets including syndicated corporate loans and collateralized loan obligations, which have been hesitant to embrace the benchmark. Regulators have also warned against what they say are risks and weaknesses in the alternative Libor replacements.

7. Will regular consumers be affected?

There’ll be scrutiny over whether regular borrowers will be forced to pay higher interest rates after the switch from Libor. Analysts say banks and asset managers face a greatly increased risk of fines, litigation and reputational damage if they poorly manage the transition, with regulators likely to be watching closely whether they are treating customers fairly.

The Reference Shelf

• From Bloomberg Businessweek, the illustrated adventures of the world’s most important number.
• Bloomberg Opinion’s Brian Chappatta says SOFR has weaknesses that others are trying to exploit.
• Keep updated by subscribing to Bloomberg’s Libor Countdown newsletter.
• The Bank of England provides resources about the transition, as does the U.S. Federal Reserve here.
• QuickTakes on why Libor’s end is a headache for loan bankers -- and for Switzerland. And another on what China is doing.
• Bloomberg details the new benchmarks emerging to replace Libor.

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