Many have called it the most important number in the world, but soon it will disappear, the Intercontinental Exchange London Interbank Bank Offered Rate, otherwise known as LIBOR or ICE LIBOR ①(previously BBA LIBOR). LIBOR is the most widely used benchmark for short-term interest rates in the world. Banks and corporates rely on it extensively. So if LIBOR is so popular, why will it disappear and what is replacing it? What happens to LIBOR based products if LIBOR is no longer available.
Most floating rate instruments use LIBOR as reference rate. LIBOR is therefore embedded in the day-to-day activities of most market participants. Underneath the surface of what is immediately related to LIBOR, there is a large area of impact that many haven’t actually appreciated yet.
What is LIBOR?
LIBOR is a set of interest rates that is available across five currencies and seven tenors. It is based on submissions of a group of banks. These – so called – panel banks submit what they see as underlying transactions as well as expert judgement to the extent that transactions are not available for that day. LIBOR underpins a wide range of financial instruments. In fact, it is estimated that up to 240 trillion US dollars’ worth of instruments are based on LIBOR or use LIBOR as a reference rate.
Interestingly, even though LIBOR is used for such a large volume of instruments, it really has not been around for that long. It’s creation can be credited to a Greek banker who needed an interest rate for a large syndicated loan for his client. He reached out to a group of banks to essentially ask for their funding cost, in order for him to price the loan. Over time this method of reaching out to a group of banks for their funding cost as basis for loans became more prevalent. Eventually it was formalized and managed as a set of rates by the British Bankers Association. Hence LIBOR became the bases for a wide range of instruments and essentially the reference rate for that. At its peak, in 2012, more than 150 rates were quoted by panel banks to form LIBOR.
Afterwards it went downhill. The manipulation of LIBOR and the resulting probes that ensued had a headline generating impact of Banks being penalised for their activities. But in the background there is also a more systematic review of how LIBOR is established and how the process can be improved enhanced or changed. Since 2012 there are a set of internationally agreed upon principles in terms of what makes a good benchmark. And when you apply this set of criteria, LIBOR really doesn’t meet the basics. Benchmarks should be transaction-based where possible. LIBOR however is based on a very small set of actual transactions (25%). The rest is based on “expert judgement”.
What is replacing LIBOR?
There are five LIBOR currencies (USD, GBP, EUR, CHF, JPY). Since 2012 the regulators in the various jurisdictions have formed their own working groups focusing on identifying the ideal alternative rates for their respective LIBOR currencies. In other words, not one single benchmark administrator is looking at replacement for all five currencies, but rather currency specific solutions. Four of the five have defined alternative rates ②. The euro is still being considered and currently has a set of short listed options③ .
What is the take away for Finance and Treasury professionals?
There is definitely work to do to figure out the transition from one rate to another. The reason for that is that LIBOR is the cost of funds or rather the cause of lending and borrowing between banks. Implicit within that is a bank credit component. The alternative rates are nearly risk free. Therefore you firstly will need to think whether there’s a need to recreate the bank credit component or should you be pricing your instruments directly from this risk free rate. Secondly, the alternatives are all overnight rates. The more prevalently used LIBOR is a 3-month rate. So there is the need to think through how you would create this term fixing Finance and Treasury professionals really need to understand these rates and assess the impact for their business.
Alternatives are not necessarily designed to be an outright replacement, but intended to be a nearly risk free rate, that any market participant (banks or corporates) can use as an overnight reference. Implicitly it doesn’t have the term fixing elements that LIBOR brings and it also doesn’t include a bank credit component. This will have to be carefully addressed or in any conversion methodologies or transition plans.
What exactly is impacted?
The impact for corporates spans a whole variety of activities. From the financial instruments in use, to the models and systems that underpin the day-to-day activity. So if we look at the financial side there are the obvious linkages to LIBOR: debt lending, committed lines with financial services providers, bond issued on a floating rate basis and exposure hedging based on swaps with a floating leg. Linkages that are not immediately evident: manufacturers need to think through the supply chain finance, agreements with your suppliers with – for example – LIBOR as basis for a late penalty rate embedded. Systems and tools (billing systems with late payment charge) might require updates to use the alternative benchmarks.
The area of the biggest impact is debt obligations. Financial instruments like corporate loans, hedges, committed lines that go past 2021 will need to be transitioned, as there will no longer be a floating rate instrument that is based on LIBOR.
What should you do next?
Start an inventory of what your potential LIBOR exposures are. This could be any financial instrument that uses floating rates. It could also be your systems, tools and models anything that potentially have LIBOR embedded. Take a very close look at contracts as they are not designed with the view that LIBOR could potentially be discontinued (what are the fall back rates?). What are the consent requirements for renegotiations (all stakeholders or solely the lender)?
Multinationals Companies (MNCs) with intercompany lending and activities across a range of currencies need involvement of a large subset of individuals within the organization.
The important thing is to start, so that you are not left with a large amount of effort too close to the potential end date. Gauge to scope of the problem.
① Nowadays LIBOR is administered by the ICE Benchmark Administration (IBA). Previously it was administrated by the British Bankers Association (BBA).
② Unfortunately LIBOR will not be replaced by one single benchmark. Rather 5 specific solutions for 5 currencies. 4 of the 5 have defined alternative rates. USD Secured Overnight Financing Rate, or SOFR GBP Sterling Over Night Index Average, or SONIA CHF Swiss Average Rate Overnight), or SARON JPY Tokyo Overnight Average Rate, or TONAR
③ The euro is still being considered and currently has a set of short listed options. Euro Interbank Offered Rate, or EURIBOR. And Euro Overnight Index Average, or EONIA. The European Central Bank (ECB) is simultaneously developing Euro Short-Term Rate (ESTER), a new euro unsecured overnight interest rate, a possible alternative to Eonia and, potentially, to Euribor. The ECB intends to start publishing ESTER officially before 1 January 2020, with testing data available over 2019.