The Federal Reserve Bank of New York president, John C. Williams joked at a US Treasury Market Conference, “Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.”
LIBOR (London Interbank Offered Rate) has been the global benchmark for borrowing and lending money for more than 33 years. This precedent was set by the Financial Conduct Authority (FCA) of the UK and will be stopped in December of this year.
The London Interbank Offered Rate (LIBOR) transition will be a landmark event and will majorly impact all of the countries, including India.
LIBOR is the benchmark rate for derivatives, loans, and several financial instruments estimated to be worth nearly $400 Trillion.
Some of these contracts are to be extended beyond 2021 and require a transition to an alternate reference rate that will be interesting to observe. These contract holders will have to put in considerable effort to transition, assess impact, amending contracts, and update their existing system.
While the world’s financial market is bracing itself for this significant change, financial services must accelerate their transitioning efforts. Preparing for the transition beforehand is the only way to mitigate any risk and uncertainties while building actionable solutions.
Before we talk about the effect of shifting from LIBOR, let’s first understand what LIBOR is.
What is LIBOR?
LIBOR (London Interbank Offered Rate) is the officially accepted key benchmark borrowing or lending interest rate between any financial institution. This rate is determined by the Intercontinental Exchange (ICE). However, due to several questions and scandals around its authenticity and fairness, LIBOR is slowly being phased out of commission.
LIBOR is computed for five currencies Swiss Franc, Euro, Pound Sterling, Japanese Yen, and US Dollar, with seven different maturities that can range from a day to a year.
How is the LIBOR rate calculated?
ICE benchmark administration includes 11 to 18 banks that provide their minimum rate for short-term loans. ICE then arranges these rates in descending order and excludes bottom and top quartiles. Then the arithmetic mean of the remaining data is calculated to get the LIBOR rate. This process is done separately for all the five currencies and seven maturity tenures hence providing 35 LIBOR values.
Why is LIBOR important?
LIBOR helps determine the market expectation for interest rates and acts as a standard gauge by central banks. It also helps in accounting for the liquidity premiums of several financial instruments used in the money market and determines a financial institution’s health.
LIBOR is also essential for several derivative projects as the majority of these projects are determined, launched, and traded using LIBOR as a reference. It is also vital for several standard financial processes because it acts as a reference rate for processes such as clearing, price discovery, and product valuation.
Now, as we have a broader understanding of what LIBOR is and how it works, let us talk about how transitioning from LIBOR will impact the financial services sector.
The impact on the financial services sector due to the LIBOR transition
LIBOR’s methodology saw a change from January 2014 onwards and was changed to present a wholesale funding rate rooted in all the transactions. It was done using a standardized transparent methodology to ensure a reduction in expert judgment.
However, there were several accusations of manipulating LIBOR for personal gains, which resulted in the transition from LIBOR to an alternative reference rate (ARRs).
This transition will affect several financial institutes as LIBOR is still being used for several financial products globally. Here is a list of certain points that are worth noting.
- LIBOR has multiple uses for several standard interbank products such as interest rate swaps, forward rate agreements (FRA), interest rate futures, swaptions, and options.
- This transition will also affect several commercial products, such as variable-rate mortgages, floating-rate certificates of deposits, and syndicated loans.
- It will also affect various collateralized debt obligations (CDO), accrual notes, perpetual notes, callable notes, and collateralized mortgage obligations (CMO).
- Even the consumer will be affected by this transition as shifting from LIBOR will affect loan-related products such as student loans and individual mortgages.
Needless to say, the shift from LIBOR to ARRs will bring significant change in financial institutions all over the world. In order to handle this transition efficiently, the financial institutions will require an end-to-end solution. This end-to-end solution will rest on three key pillars which mark a remarkable change in the global economy.
Three key Pillar for an end-to-end LIBOR transition solution
The LIBOR contracts that are still valid after December 2021 will require a thorough assessment to underline the risk factors they have for exposure. Companies will do this risk assessment in three stages to help the institution transition from the current financial rate successfully. These three pillars are:
- Impact Assessment
In order to successfully transit from LIBOR to other ARRs, the first thing every financial institution needs to do is make an exhaustive assessment. By making a thorough assessment, the institution will be able to avoid any risk because of exposure.
To do so efficiently, making an exhaustive library of questions will help. By double-checking every fact, the companies will be able to understand the impact of the LIBOR transition. This assessment’s primary purpose is to understand and quantify the LIBOR exposure at the portfolio and product level.
A thorough impact assessment involves the following challenges:
- The first thing to do for impact assessment is to identify all the contracts that have an expiration date after 2021.
- Then the institute needs to identify all the contracts that use LIBOR as a reference.
- The next step will be to renegotiate the contract terms using the ARR, which replaces LIBOR in all the above contracts.
Reviews on LIBOR
After the regulatory reviews on LIBOR for several scandal accusations, the result focused on two aspects –
- Reforming the LIBOR during the transition period
- Developing an alternative reference rate (ARRs).
In January 2014, LIBOR’s methodology was changed to show a neutral wholesale funding rate dialed down in the transactions as much as possible. For the major global currencies, the ARRs identified nearly have risk-free rates reflecting wholesale transactions from financial institutions.
The rates used to replace LIBOR can be unsecured, and the choice will depend on structural features and liquidy of the referenced money market.
ARRs are efficient in representing money market interest rates but fail to deliver discount rates for longer tenures because of a weaker term structure. Developing these ARRs to have a robust term structure is one of the areas of focus while transitioning from LIBOR.
A suitable alternative to LIBOR
As we are shifting from a precedent system to a new system, we have the opportunity to start from scratch and build up a robust ARR. Ideally, the best benchmark should be reliable, have a liquid term structure, a high correlation with policy rates, and should have an ideal relationship with a bank’s cost of funds.
The Secured Overnight Funding Rate (SOFR) has been recommended as an alternative to replace LIBOR.
Calculation of SOFR is based on the volume-weighted median of transactional level US Treasury repurchase agreement data which reflects the cost of overnight borrowing collateralised by the US Treasury securities.
The major differences between SOFR and LIBOR is as follows:
*LIBOR offers forward-looking term rates while SOFR only looks backward overnight. The contracts that switch from LIBOR to SOFR will need to be adapted.
*As SOFR is based-off on overnight Treasury transactions ,it’s a risk-free rate while LIBOR includes credit risk of bank borrowing.
Majority of LIBOR-referencing contracts do not require the inclusion of this credit risk, yet they contain it. It is due to this the contract parties will require to adjust SOFR while using it to replace LIBOR.
Adapting to contracts for SOFR
Moving forward, all new contracts should refer to SOFR where they have referenced LIBOR. For the LIBOR contracts which mature post-2021, the organizations may need to make significant changes in risk exposure.
Ideally the contracts require renegotiation with reference to SOFR, but it won’t be possible in ass cases. Where they can’t be renegotiated the contracts can be amended to include a robust pathway which clearly lays out the how and the when of transition to SOFR.
Obviously, not all contracts can be treated similarly, making the LIBOR vs SOFT transition a massive project which can be challenging when it comes to navigation.
The LIBOR transition is bound to impact the current market operations. To help you ensure a successful transition and manage any volatile situation, we at Optimar offer expert advisory & consulting services which are in compliance with local laws to improve revenues and operating flexibility at reduced costs.
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