The death of Libor

Published on January 27, 2020 by Hitesh Acharya

The London Interbank Offered Rate (Libor), often referred to as the world’s most important number, has served as the benchmark pricing rate for loans and derivatives since 1984 under the supervision of the UK Financial Conduct Authority (FCA). However, after the Libor manipulation scandal in 2012, banking regulators decided to establish an alternative benchmark rate that would be more widely accepted and be based on actual market transactions rather than on bankers’ estimates (as is the case with Libor). The UK FCA stated that it will no longer require banks to submit interbank lending data by the end of 2021, effectively signifying the end of Libor.

In 2014, the US Federal Reserve Board and the Federal Reserve Bank of New York set up the Alternative Reference Rates Committee (ARRC), comprising banking market participants and regulatory bodies, to recommend an alternative to Libor. Based on the ARRC’s suggestion, the Federal Reserve Bank of New York introduced an alternative benchmark interest rate called the Secured Overnight Financing Rate (SOFR) in April 2018. Actual data from overnight Treasury repurchase market activity is used to determine the daily SOFR. The SOFR was initially designed to work alongside Libor to reduce the banking market’s dependence on Libor, and eventually replace it.

Adoption of non-Libor benchmark rates: The Federal National Mortgage Association, commonly known as Fannie Mae, issued USD11bn worth of securities priced at the SOFR from July 2018 to October 2018, and Barclays became the first bank to issue USD525m of SOFR-linked debt in August 2018. Following the expected substitution of Libor, many banking agreements started including provisions that allowed the agent bank/lender and borrower to decide on the use of an alternative benchmark rate. American Airlines, in a recent regulatory filing, mentioned that any increase in interest rates as a result of the benchmark rate change could result in an increase in its interest outgoings. Collateralised loan obligations (CLOs) have also started including clauses to permit the use of a Libor alternative, subject to approval of the majority of investors. Furthermore, at a Libor seminar hosted in July 2019, Federal Reserve Bank of New York President John C Williams advocated the urgent substitution and replacement of Libor.

Challenges to the SOFR: Making the SOFR the new global reference rate could be challenging, due to the following factors:

• A large portion of outstanding Libor-linked contracts is likely to mature after 2021. Thus, the change in reference rate could require a grandfathering clause.

• The derivatives market, particularly interest rate swaps, along with other loans such as commercial paper, adjustable-rate mortgages and student loans could be impacted due to the introduction of a new benchmark rate. For instance, if the SOFR is higher than Libor when the fixed-rate period of a mortgage ends, homeowners will likely have to pay a higher variable rate of interest on their mortgages.

• Repricing contracts is not always simple. Since the SOFR represents Treasury bond-backed loans outstanding only for a day, it tends to be lower than Libor (which represents unsecured loan pricing). The difference could be up to 20bps or even wider. Thus, the SOFR may require an upward adjustment to match the current Libor pricing.

• Global consensus for an alternative benchmark rate has to solidify in favour of the SOFR for it to gain worldwide acceptance. Currently, only one reference overnight rate is published for the SOFR, as opposed to the 35 rates (5 currencies x 7 borrowing periods) published for Libor. Thus, a British committee has opted to use the Sterling Overnight Index Average (SONIA) as an alternative to GBP Libor, and Japan has opted to use the Tokyo Overnight Average Rate (TONAR) as an alternative to JPY Libor.

• Amending the terms of the existing loan contracts will likely be onerous.

Despite the challenges outlined above, Libor will likely be phased out. It remains to be seen whether the SOFR will be able to replace it smoothly. Acuity Knowledge Partners’ Commercial Lending team has the expertise to help banks and their borrowers make an accurate and streamlined transition to an alternate benchmark rate.

Sources:

• Newyorkfed.org – A User’s Guide to SOFR, The Alternative Reference Rates Committee, April 2019

• Reuters.com - What is SOFR? The new U.S. Libor alternative

• Wikipedia - https://en.wikipedia.org/wiki/SOFR

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