Why change LIBOR?

The London Interbank Offered Rate (LIBOR) has underpinned numerous financial instruments, but today there is a movement among major central banks to replace it with a rate that is market and transaction driven. LIBOR is a daily survey-based rate that estimates the cost of unsecured loans between 20 large banks. There are two crucial issues surrounding the replacement of LIBOR as a reference rate not only in the U.S., but around the world. First, LIBOR is based on expert judgment rather than anchored by observable transactions, and recent manipulation of the rate used for calculating financial institutions’ own gains reduced the rate’s credibility.1 Second, LIBOR is an estimate of unsecured loans, and the market for such loans following the financial crisis has been dwindling.

The Development of SOFR

Established by the Federal Reserve Board in 2014, the Alternative Reference Rates Committee (ARRC) was set up to develop and implement a replacement for LIBOR. In May 2016, Secured Overnight Financing Rate (SOFR) was chosen as the preferred candidate over the New York Fed’s overnight bank funding rate.2 SOFR addresses the very two issues present in LIBOR.

SOFR is a secured rate based on actual observable transactions, though it is currently only an overnight rate. The ARCC’s Paced Transition Plan calls for turning SOFR into a rate of multiple maturities and developing a term reference rate around it.3

What this means

There are $200 trillion in LIBOR-based contracts outstanding, with a majority maturing before 2022.4 And according to the New York Fed about $36 trillion in outstanding notional of contracts will not mature prior to 2021, when LIBOR is planned to be phased out, and these are expected to be renegotiated.5

Market participants should prepare for the challenges ahead due to the change in rates methodologies, the ensuing system replacement costs, the need to reconcile data, loan renegotiation, portfolio rebalancing and managing multiple rates. The difference between the LIBOR rate and the one proposed by the central bank is that the former is an estimate based on judgement and the latter is based on overnight money market transactions. It is because of this difference, contracts that are written in LIBOR should have winners and losers after the substitution.6

System replacement should represent a huge cost challenge to all market participants. All buy side firm’s reconciliation systems will probably need to be replaced.  And hard-coded LIBOR systems or older systems should result in higher upgrade costs than newer systems or those that aren’t hard-coded.7

Loan renegotiation should be needed for derivatives, securities, loans and deposits. The renegotiation of one-on-one agreements should be relatively easier in comparison to securities or other investments where multiple stakeholders need to agree to any changes to the agreement.8

Rebalancing problems should arise when the changes outpace settlement systems, and cash or margins should be required to settle trades. The higher cost of settlement should lower trade profitability and execution speed, causing issues for all market participants. Furthermore, market participants are expected to deal with more than just one replacement rate, as the proposed replacement rates relate to each central bank’s own currencies, e.g., Fed’s secured overnight financing rate (SOFR); the Bank of England’s sterling overnight index average (SOFIA); Europe Central Banks’s euro short-term rate (ESTER); the Swiss National Bank’s average rate overnight (SARON); and Bank of Japan’s Tokyo overnight average rate (TONAR).9

Conclusion

While there are issues with the LIBOR transition, ARRC’s transition plan is proceeding ahead of schedule. The market is beginning to accept SOFR as an alternative. Futures have been launched in Chicago, while swaps are being cleared in London.10 “We already have enough depth to produce the indicative”11 rate says ARRC Chair Sandra O’Connor. Liquidity still needs to deepen for participants to have confidence in this new rate. It is imperative that market participants begin to conduct impact studies to understand impacted areas within their respective organization. At the same time, effort should be made to better understand SOFR and how it will perform. Lastly, institutions should prepare and plan for this probable transition to a new benchmark and fallback language in loan agreements.12

References

  1. “The Fed is trying to replace a decades-old benchmark rate — here’s what you need to know,” Business Insider, April 4, 2018. Access at: https://www.businessinsider.com/a-new-benchmark-rate-is-replacing-libor-heres-what-you-need-to-know-2018-4
  2. “America’s Libor Replacement Is Taking Its First Steps,” Bloomberg Businessweek, March 26, 2018. Access at: https://www.bloomberg.com/news/articles/2018-03-26/america-s-libor-replacement-is-ready-for-its-debut-quicktake
  3. “LIBOR vs. SOFR: Big Changes Are Coming for U.S. Treasurers,” Association for Financial Professionals, June 19, 2018. Access at: https://www.afponline.org/trends-topics/topics/articles/Details/libor-vs.-sofr-big-changes-are-coming-for-u.s.-treasurers
  4. Ibid
  5. Ibid
  6. “LIBOR replacement to spread headaches,” Pensions & Investments, September 17, 2018. Access at: https://www.pionline.com/article/20180917/PRINT/180919875/libor-replacement-to-spread-headaches
  7. Ibid
  8. Ibid
  9. Ibid
  10. “America’s Libor Alternative Is Gaining Traction on Wall Street,” Bloomberg, September 24, 2018. Access at: https://www.pionline.com/article/20180917/PRINT/180919875/libor-replacement-to-spread-headaches
  11. Ibid
  12. “LIBOR vs. SOFR: Big Changes Are Coming for U.S. Treasurers,” Association for Financial Professionals, June 19, 2018. Access at: https://www.afponline.org/trends-topics/topics/articles/Details/libor-vs.-sofr-big-changes-are-coming-for-u.s.-treasurers

Newsletter Author: Venetia Woo, Mairi Bryan, Tony Liu 

Newsletter Contact Person: Venetia Woo

Visit www.accenture.com/RegulatoryCompliance for latest insights on regulatory remediation and compliance transformation.

 

Disclaimer

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