Amidst the noise of coronavirus, climate change and Brexit, the financial sector is about to undergo a significant change regarding the means by which interest rates are determined. In 2017, the Working Group on Sterling Risk-Free Reference Rates recommended SONIA as their preferred replacement risk-free rate for LIBOR, which is currently a widely used reference rate across sterling and global markets. LIBOR is due to be discontinued after 31 December 2021. As such, financial markets will need to adapt to this transition over the next year to understand what this change means for them and how best to navigate this transition with as little disruption as possible.
What is LIBOR and why is it important?
LIBOR stands for the London Interbank Offered Rate and is one of the most commonly used benchmark reference rates against which a multitude of interest rates are pegged. Having been in existence since the 1980s and widely used by financial institutions, LIBOR is currently referenced in approximately $200 trillion to $300 trillion worth of mortgages, consumer loans, corporate debt, derivatives and other financial instruments.
It is determined by calculating the average rate at which a panel of leading banks can borrow money from each other, thereby indicating the average interbank borrowing rate. It is calculated in five different currencies and a variety of maturities up to one year and can consequently be used when determining the appropriate interest rate for several loan types, from consumer mortgages to corporate debt. It is issued daily by the ICE Benchmark Administration.
A particularly relevant characteristic of LIBOR is that it is a forward-looking rate. This means that it is agreed at the commencement of an interest period, so both the borrowing and lending parties have some idea of what the interest rate will be throughout the term.
Why is it being phased out?
The decision to phase out LIBOR arose for a number of reasons, a particularly catalytic one being the LIBOR-rigging scandal of 2012 when it came to light that various leading banks had been reporting artificially low or high interest rates to benefit their derivatives traders. These set of actions consequently undermined a major benchmark for interest rates and financial products, illustrating that it could indeed be manipulated. This was significant as LIBOR did and still does play a central role in global finance.
At the time of LIBOR’s inception, interbank borrowing was a significant means by which banks would fund themselves. However, after the 2008 financial crisis, this is no longer the case; banks’ funding pattern significantly changed after the crash. In the context of LIBOR, this means that the interbank borrowing market upon which it is based is no longer particularly active. In fact, only 15 interbank lending transactions of appropriate length and size were made in 2019. LIBOR has instead been sustained by use of “expert judgement”, i.e. what banks would expect to pay should a transaction on the interbank market take place. The absence of an active market underlying LIBOR is another reason why is no longer deemed to be the optimal reference rate for financial markets.
What is replacing it?
LIBOR is a globally utilised reference rate; thus, each jurisdiction affected by the phase-out is having to undergo a process of deciding what to replace it with. The UK has opted to use SONIA, which stands for Sterling Overnight Index Average. Unlike LIBOR, it is a backward facing rate based on actual overnight rates in active and liquid wholesale cash and derivatives markets. It is administered daily by the Bank of England and has been in place since 1997, meaning that its use is relatively familiar to financial institutions. For instance, it is already currently used to value $30 trillion worth of assets.
SONIA is generally considered to be more robust and less vulnerable to manipulation than LIBOR. As it is backward looking, it is also measured based on actual reported transactions, not speculation as LIBOR is.
How will this impact financial markets?
Despite the recommendation to transition between benchmark rates, the Bank of England has been keen to stress that it will not be a like-for-like swap. The transition will affect many financial instruments and will likely be a challenging one.
As SONIA is backward looking, it will impact how interest is determined in financial contracts. Rather than being agreed at the start of a loan term, borrowers will no longer have upfront certainty about their interest payments as it cannot be ascertained until the end of the period. Some commentators warn that this could lead to an uptake of fixed interest rates and a move away from floating rates as parties reach for more upfront certainty.
There is no prescribed mechanism that can dictate replacement rates in existing contracts. For contracts that reference LIBOR that are already in existence and due to mature after the end of 2021, parties will need to reference or adopt “fallback” clauses into their agreements to deal with the transition to the alternative reference rate. Reuters has noted the slow progress to transition to SONIA as indicative of the challenges that both lenders and borrowers are facing as LIBOR is phased out. Data from business management consultant Oliver Wyman Ltd forecasts that leading banks may spend up to $1.2 billion on the transition. Indeed, the established reference rate is “embedded everywhere in the plumbing of the financial world”, and it will be tricky to ensure a completely seamless switch.
Companies and parties to financial contracts will need to be mindful of where their exposure to LIBOR lies and negotiate strategies to best deal with the change. That being said, the uptake of a benchmark reference rate with roots in an active and liquid market is an important step in ensuring that the financial sector keeps pace with the rate of change that is constantly pushing forward.