Why Ditching Libor Is Vexing the Financial World
(Bloomberg) -- For half a century, the London interbank offered rate, or Libor, has helped determine the cost of borrowing around the world. Now seen as outdated and discredited, the benchmark is being killed off from the end of 2021. That’s sent the financial world scrambling to adjust contracts on hundreds of trillions of dollars’ worth of products, from mortgages and credit cards to interest-rate swaps -- and to figure out life after Libor.
1. What is Libor and why is it disappearing?
Libor is a daily average of what banks say they would charge to lend to one another. The British Bankers’ Association formalized the gauge in 1986 when it needed a way to price interest-rate swaps and syndicated loans. But 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 penalties. In 2017, the Bank of England declared that Libor would be phased out by the end of 2021.
2. Who uses Libor?
The list is long and includes pension and fund managers, insurance providers, big and small lenders and Wall Street banks that package loans into securities. Some $370 trillion of financial products are tied to the benchmark, including equipment leases, commercial paper, sovereign bonds, student and auto loans and bank deposits. The biggest component is derivatives such as interest-rate swaps, which companies, banks and investors use to hedge risk or to speculate.
3. What’s the worry about killing off Libor?
As well as the need to find suitable replacements, the main concern has centered on the millions of Libor-priced contracts that run beyond 2021, known as legacy contracts. Updating legacy contracts to cover what happens next can prove a slow and complicated process, raising the risk of a chaotic transition that has been likened by some to Y2K and the fear of computer systems misfiring at the end of the last millennium. Rather than planes potentially falling from the sky, the worry is that a mass of litigation will ensue as lenders and borrowers fail to agree on what rate to pay following Libor’s demise.
4. So we’re heading for trouble?
Several developments have eased those concerns. The derivatives market established a protocol to include so-called fallback language in contracts that will automatically transition them from Libor. New York state approved a law providing a further backstop for contracts hatched on Wall Street. The Biden administration and the Federal Reserve are pushing for legislation to mop up the rest. Vitally, regulators extended until the end of June 2023 the deadline for dealing with legacy contracts priced in most U.S. dollar Libor rates. (Used for more than $200 trillion of products, dollar Libor is the most widespread of five Libor currency rates.) That means most dollar Libor contracts will expire naturally, without needing to shift to a new benchmark. Regulators reiterated that no new dollar Libor contracts can be issued after 2021.
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 (the five main replacements are listed below), but in one respect several fall short. Libor offers rates for different time frames, from overnight to one year. Some of the new benchmarks, such as the Secured Overnight Financing Rate in the U.S., or SOFR, mostly reflect overnight rates because they do not yet have the depth of transactions to establish a forward-looking curve.
|Currency||Offical replacement rates||What’s it derived from?|
|U.S. dollar||SOFR (Secured Overnight Financing Rate)||Prices of repurchase agreements|
|Pound sterling||Sonia (Sterling Overnight Index Average)||The rate paid on unsecured overnight funds|
|Euro||ESTR (Euro Short-Term Rate)||Also the rate for overnight unsecured borrowing costs|
|Japanese yen||TONA (Tokyo Overnight Average Rate)||Transactions in the uncollateralized overnight borrowing market|
|Swiss franc||Saron (Swiss Average Rate Overnight)||Prices of repurchase agreements|
6. Why’s that a problem?
Borrowers over longer time frames will no longer know in advance how much interest they will pay, since overnight rates fluctuate. Unlike Libor, the new rates also fail to capture the credit risk that banks assume when they lend to each other. (Libor jumped during the 2008 financial crisis as central banks cut rates.) These shortcomings have had an unintended consequence in the U.S.: Alternative rates are gaining popularity. The likes of Ameribor, published by the American Financial Exchange, have the potential to disrupt the transition to SOFR by attracting the very liquidity that’s needed to establish the official replacement for Libor over longer periods.
7. How will the new rates affect consumers and banks?
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. Most major global banks will spend more than $100 million in 2021 preparing for the end of Libor.
- Bloomberg Opinion writer 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.
- 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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