Global financial markets are preparing for the phasing out of the London interbank offered rate, or LIBOR, with the loan, derivatives, securities, and bond markets most affected. As of mid-2018, about $400 trillion worth of financial contracts referenced LIBOR in one of the major currencies. Supervisory pressure on the financial sector to reduce LIBOR inventories suggests that firms must embrace Risk Free Rates (RFRs) across LIBOR portfolios. The transition presents a multitude of challenges.
Why Use Benchmarks?
Financial market participants rely on benchmarks primarily to reduce asymmetric information about the value of the traded financial instrument underlying the benchmark Benchmarks also reduce search costs in bilateral, over-the-counter markets lacking a centralized exchange by improving matching efficiency and increasing participation by less-informed agents. For example, with the publication of an interest-rate benchmark such as LIBOR, bank customers are better able to judge whether a loan rate is competitive. Without a benchmark, intermediaries can take greater advantage of market opaqueness and of the cost to customers of searching for alternative quotes.
Thus, benchmarks should ideally provide a robust and accurate representation of interest rates in core money markets that is not susceptible to manipulation, offer a reference rate for financial contracts that extend beyond the money market, and serve as a reference for term lending and funding.
Why Was LIBOR Discontinued?
The case for moving away from LIBOR is powerful. The rigging scandals in 2012 showed how the process of setting LIBOR could be manipulated and made many banks nervous about participating. LIBOR also changed in response to regulatory recommendations after the scandals. One of the changes was the introduction of a transaction-based calculation method with more transparent and objective submission criteria for the panel of banks setting the rate. The new method included a waterfall process to ensure that a rate could be published in all market circumstances. When there is insufficient market activity, panel banks must supplement transaction data with expert judgment.
However, financial markets and the way banks fund themselves has changed. Banks don’t rely as much on unsecured borrowing, so there are fewer real transactions upon which LIBOR can be based. The money market pricing has become more sensitive to liquidity and credit risk, with banks reducing term lending to each other and increasingly turning to non-banks for unsecured term funding. This has also exacerbated the dispersion among key money-market rates. As a result, LIBOR is defined as “the rate at which banks are not borrowing from one another,” based merely on the judgment of a few banks. Thus, despite efforts to improve the LIBOR-setting process and make it a transaction-based rate, LIBOR is still vulnerable to misconduct.
What Happens Now?
This is not the first major shift towards a fundamentally different set of reference rates in the financial system. However, in contrast to earlier examples of “benchmark tipping,” the reform process is a public-private effort to shift from unsecured interbank rates towards near risk-free rates. Market participants have been involved in examining alternatives to LIBOR and other interbank offered rates (IBORs), and have also considered adding fallback provisions to new and existing debt contracts.
RFRs have been identified for all five LIBOR currencies and four of the five are being used in the market. They differ in the currency referenced:
In the UK, Sterling Overnight Interbank Average Rate (“SONIA”) has emerged as the preferred replacement for LIBOR. Unlike LIBOR, which is a forward looking term rate that resets periodically and takes into account term credit risk and interest rate changes, SONIA resets daily and is compounded, backward looking, and set overnight and so has virtually no term credit risk priced in. This can cause short-term uncertainty over cash flows and potential value transfers because SONIA rates will inherently be lower than LIBOR rates, leading to price differentials in contracts. The economic difference between LIBOR and the replacement RFRs ultimately means that any transition from LIBOR to RFRs will be much more complicated than a straightforward administrative change in the benchmark rate. Adjustments will be needed to the pricing of transactions in order to minimize the economic impact of the transition, most likely by the inclusion of a risk premium. The calculation of this risk premium is further complicated by the fact that the historical spread differential between the RFRs and their corresponding LIBOR rates has not been a fixed but has varied throughout the economic cycle. For instance, LIBOR spiked during the financial crisis in 2008 whereas modelling shows that many of the RFRs would have remained more stable.
While the derivatives market is familiar with overnight rates, the clarity of cash flow and therefore term rates is integral to the loan and debt capital markets. For instance, in the context of loans, treasurers may need to hold additional cash to cover any interest rate movements during an interest period, thus affecting their current cash management processes. Treasury management systems may also need to be updated to accommodate such a fundamental change.
Quite apart from the characteristics of the new RFR-based benchmarks, transition issues loom large. The most pressing is perhaps the migration of legacy LIBOR-linked exposures to the new benchmarks should LIBOR publication cease after 2021.Trillions of dollars of legacy contracts will still be outstanding. Given the material prospect of a possible LIBOR discontinuation, it is crucial for financial stability that credible fallback language be inserted into contracts.
In response, industry organizations, such as the International Swaps and Derivatives Association (ISDA) at the request of the FSB, have been consulting with stakeholders concerning fallback options. The main goal is to agree on the fallbacks before the benchmark ceases to exist and winners and losers are evident. For derivatives contracts, one option could be shifting to a compounded RFR-linked backward-looking term rate plus a (constant) spread based on historical differences with LIBOR.
 International Swaps and Derivatives Association (ISDA) (2018): “Anonymized narrative summary of responses to the ISDA consultation on term fixings and spread adjustment methodologies”, December.
This post comes to us from Shubhangi Agarwalla, a student at the National Law University in Delhi, India.