What is LIBOR and what you need to know

What is IBOR reform and why does it matter?

London Interbank Offered Rates (or LIBORs) and similar rates like Euribor and Tibor (together IBORs) are key interest rates in our financial system. LIBOR is quoted for five major currencies and at multiple tenors, and financial markets use the rate for pricing, valuations, accounting, models, third party contracts and risk systems.

Why is it a problem?

LIBOR rates are largely derived by asking banks to estimate their cost of borrowing (ie, the rate at which they could fund themselves with reference to the unsecured wholesale funding market) and as such rely on the inherently subjective expert judgement of the panel of submitting banks.

This subjectivity, alongside the changing nature of bank funding, mean that regulators around the world are concerned about major interest rate benchmarks that rely on bank submissions. In short, such rates are prone to manipulation and are no longer truly reflective of how banks fund in practice.

The end of Libor?

The Financial Stability Board’s July 2014 report on Reforming Major Interest Rate Benchmarks recommended the development of nearly risk free transaction based replacement rates as an alternative to IBORs. Consequently, the Financial Conduct Authority (FCA) announced that they would no longer compel panel banks to submit LIBOR quotes past the end of 2021.

What is the outlook for LIBOR beyond 2021?

While there is a possibility that LIBOR may survive as a private enterprise after 2021, it is also quite likely that there are no LIBOR rates available past that date. As a result, it is expected that a huge number of loans, interest rate swaps, and other financial instruments referencing LIBOR will have to be amended or renegotiated in the next two years.

The scale of change is huge, the Bank of England Working Group on Sterling Risk-Free Reference Rates have estimated that some 300 trillion dollars’ worth of LIBOR indexed contracts are currently extant, with about 30 trillion of those in GBP markets. The uncertainty arising from this huge change has potential impacts for hedge accounting both today and as the actual transition of financial instruments to the new rate occurs.

What is the plan for the UK?

The expectation is that GBP LIBOR will be replaced by a rate derived from SONIA (Sterling Overnight Indexed Average) and with that in mind, SONIA was reformed in April 2018 to ensure robustness. However, the practical challenges with using SONIA to replace LIBOR are not insignificant. Firstly, LIBOR is available as a forward looking term rate for different tenors, for example one month, three months, and six months, while SONIA is simply an overnight rate.

If a borrower currently has a GBP LIBOR floating loan that has a payment date every three months, a matching three month LIBOR tenor would normally be used to calculate interest payments. The parties to the contract will presumably prefer retaining a three-monthly payment structure on transition to a SONIA-based rate.

Compound vs forward

To date, two main solutions to this problem have been posited.

1. Interest is compounded daily in arrears based on SONIA through the three month interest period, with the interest payable only being known at the end of the interest period. The challenge with this approach is that interest payments will be operationally more complex as exact payment amounts will not be known until shortly before or even on payment date.
2. A forward looking term rate derived from SONIA is developed. In theory such a rate would work very much like LIBOR and therefore would be operationally easier to accommodate as payments would be known at the start of the three month interest period as is currently the case for three month LIBOR. However, as of yet it is uncertain whether a sufficiently liquid SONIA derivatives market will develop to support a transaction-based calculation of a forward looking term rate for SONIA. 

There are a growing number of SONIA floating rate notes in the marketplace and in the absence of a SONIA based term rate at this point in time, interest on these products has generally been calculated on compounded daily in arrears basis but with a five day lag at the end of the interest rate period to provide a five day window of payment certainty.

However, the Bank of England Working Group has invited three market data providers to work to produce a transaction based forward looking term rate for SONIA, and the hope is that at least one of those projects will result in a robust transaction-based rate. 

Practical economic implications of reform

It is important to note that any SONIA based rate will be different from current GBP LIBOR. While both rates are an expression of UK interest rate risk GBP LIBOR includes risk components that do not exist in SONIA (for example interbank credit risk) and consequently a basis between SONIA and GBP LIBOR is expected to exist at transition.

Conduct Risk

This will mean that as well as changing the language of loan and swap contracts to refer to SONIA instead of LIBOR, the adjacent economics of those contracts will have to change – the fixed leg of interest rate swaps will require restriking and margins on loans will require repricing.

Challenges

In addition, it may be difficult to transition swaps and cash products at the same time and in the same way. This could result in periods where there is a mismatch between the swaps and loans. It is expected that transitioning large portfolios of loans will be particularly challenging as each individual loan is normally a discrete bilaterally negotiated contract and amending these contracts may require a large number of negotiations each of which is subtly different.