What is the problem?
London inter-bank offer rate, or LIBOR, as is commonly known, is a major interest rate benchmark that is published by ICE Benchmark Administration (‘IBA’ or the ‘LIBOR administrator’) daily at 11:55am, London time.
Undoubtedly, the benchmark has come a long way since its inception in the 1970s-80s and the manipulation scandal that besieged it in the last decade or so.
However, the road ahead seems to be rough and rightly so. The benchmark is used by hundreds of trillions of dollars of contracts globally but will cease to exist by the end of 2021 which is less than two years from now.
The benchmark is published in five currencies – USD, GBP, EURO, JPY and CHY and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
It is determined by calculating the trimmed average – by taking out the highest and the lowest of submissions made by 11-16 London based panel banks (the ‘contributors’) for each currency and tenor.
The inter-connection of global financial markets means that markets and businesses – both operating in the financial services and in the non-financial services sector – as well as individuals (e.g. where consumer loans reference LIBOR) will be affected by the disappearance of LIBOR.
It is important to mention that LIBOR underwent a massive reform in the years 2012-13 to make it robust and reliable after multiple cases of its manipulation were found by regulators globally.
This reform was spear-headed by the UK’s Financial Conduct Authority (the ‘FCA’). The new regulatory framework included various measures, the most prominent one being to make LIBOR a regulated benchmark, and bring both the contributors and the LIBOR administrator under the direct remit of the FCA.
The UK Government-led reform was further boosted by the recommendations provided by the Financial Stability Board (the ‘FSB’) which required LIBOR to be more anchored to transactional data, thus reducing its dependence on expert judgment.
In response, IBA, after an extensive consultation which lasted a good two year period, introduced a new definition for LIBOR "A wholesale funding rate anchored in LIBOR panel banks’ unsecured wholesale transactions to the greatest extent possible, with a waterfall to enable a rate to be published in all market circumstances".
Notwithstanding all the corrective measures that were taken, very soon it became increasingly clear that no amount of reform could rid LIBOR of the structural weakness from which it suffered. The unsecured wholesale markets which underpin LIBOR were no longer a liquid source of bank funding and so, the benchmark continued to heavily rely on expert judgment of the contributors.
This made FCA finally announce that it will no longer support the benchmark beyond 2021 and will not use its powers to persuade or compel banks to contribute to LIBOR after the end of 2021.
Further, the regulatory call from other major jurisdictions including that from the FSB was clear as bell. For increased market effectiveness, alternative risk-free rates (‘RFRs’) were required. LIBOR as a reference rate, for example, in the derivatives market, in which the bank credit component is neither necessary nor appropriate, was simply not suitable.
What is happening internationally?
The disappearance of LIBOR will not only impact UK but it is expected to have worldwide repercussions. Globally, work has been underway for the development of RFRs and to plan for an orderly transition away from LIBOR.
With the support of the Central banks, Working Groups for each of the five LIBOR currencies have been convened across five main jurisdictions. These Working Groups have developed and announced the alternative RFRs for the overnight market.
These are Secured overnight financing rate (‘SOFR’) for USD, Sterling overnight index average (‘SONIA’) for GBP, Euro short-term rate (‘ESTER’) for EURO, Swiss average rate overnight (‘SARON’) for CHF and Tokyo overnight average rate (‘TONA’) for JPY currency and are already being published.
Being backward-looking rates, these are more suited to derivatives markets. Consultations are ongoing for defining alternative RFRs that are forward-looking, with a term structure, to suit cash markets as these markets maintain that certainty of cash flows is important to their proper functioning. In addition, the Working Groups have published plans to support a smooth transition to RFRs.
Given LIBOR is used by firms across a wide range of financial products (e.g. cash products such as mortgages, commercial and personal loans, bonds, FRNs and derivative products such as futures, forwards and swaps) and affects various processes and systems quite extensively and deeply (e.g. valuation models, computing margins, hedging), efforts of the Working Groups are further supported by various trade organizations, infrastructure providers and central counterparty clearing houses in developing solutions to overcome legal and operational challenges and minimizing economic impact faced by market participants.
These include defining fall back provisions for inclusion in contracts, developing transition protocols and market conventions for products where none existed (e.g. bonds, FRNs, syndicated loans), formulating standardised agreements and consulting on changes to margin rules, trade execution and clearing requirements to remove residual barriers to transition.
Further, accounting standards setters such as IASB and FASB, regulators and tax authorities are looking into resolving accounting treatment dependencies, and provision of regulatory capital and tax relief respectively.
As the robustness of any new rate is heavily dependent on the degree of its market adoption, authorities in differing jurisdictions have been promoting the launch of products referencing the new rates.
More recently, government sponsored enterprises such as Fannie Mae and Freddie Mac in the US have announced that they will discontinue acceptable adjustable-rate mortgages based on LIBOR by the end of 2020. This is a huge step in driving markets away from continuing to do business in LIBOR linked products.
To dispel inertia at a firm level, regulators have been asking firms to prepare for LIBOR transition. UK took the lead in this regard when the Bank of England and the FCA issued ‘Dear CEO’ letters in late 2018 to all major banks and insurance companies. These letters required companies to provide assurance that their senior managers and boards understand the risks associated with LIBOR transition and are taking appropriate action to transition to RFRs ahead of end-2021.
Since then, similar requests have been made by other regulators in the US, Europe, Hong Kong and more recently in Bahrain.
What should you do now?
Being largely an oil economy, UAE market is undoubtedly most exposed to USD LIBOR. Given that cessation of LIBOR is now certain, UAE based firms, starting with financial services institutions, need to take urgent action to make up for the head start that their peers in other jurisdictions have over them.
Sell-side firms such as banks should start by setting up a governance body that oversees and steers the LIBOR transition programme for the firm. It is essential to keep adequate budget aside as LIBOR transition will not be a single year but a multi-year phenomenon, touching almost every aspect of the business.
Firms should kick-off an initial programme of identifying and quantifying their LIBOR exposure at a contract, product, model and/or process and system level.
Developing a communications strategy is another critical element, particularly to apprise customers on how the end of LIBOR and its replacement may affect them. Training of own firm personnel is essential.
A process should be implemented for continuous monitoring of LIBOR exposure and a strategy should be developed and implemented to reduce printing of new business referencing LIBOR to lessen the quantum of contracts that go beyond 2021. Future-proofing contracts should also be undertaken, where possible.
Buy side firms should take similar steps. At a bare minimum, these firms should conduct an evaluation of its legacy contracts that are linked to LIBOR or include a financial covenant referencing LIBOR and will last beyond 2021. Accordingly, they should engage in a dialogue with the counterparties to develop a plan for transitioning such contracts.
Last but not the least, it is important for firms to stay updated with developments, given the rapid advancements and multiple sources internationally delivering solutions related to this topic. LIBOR will eventually die but sadly, for all, it will be a painful and slow death.