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Most corporate and many private bank loans pay interest on a variable, or floating rate, basis. However, there can be no floating rate loans without a benchmark interest rate to determine the floating payment. Hence, when the first floating rate loans were created in the late 1960s, a reference rate had to be defined. This reference rate was LIBOR (London Interbank Offered Rate) and it was supposed to measure the cost of borrowing in the interbank market (i.e. the cost of borrowing between banks).

No one at the time of the creation of LIBOR could have foreseen that, from referencing loans with a value of just a few hundred million dollars, it would become a hugely important benchmark. LIBOR rates in different currencies now reference around USD400 trillion worth of loans (corporate, mortgages, etc) and derivatives contracts (plain vanilla interest rate swaps, basis swaps, cross-currency swaps, etc) globally.

However, over time it became obvious that there were several problems with the reference rate. One issue is that because LIBOR references unsecured lending (i.e. lending without collateral) and banks now mainly borrow and lend with collateral, the volumes that underpin the LIBOR calculation are becoming ever smaller. The second problem is that despite some recent changes to calculation methodology, LIBOR is still based either on real trades or, in the absence of real trades, on estimates submitted by banks. This latter fact allowed certain market participants to manipulate the reference rate.

Manipulation was primarily done for two reasons: The initial reason was to report low LIBOR submissions during the financial crisis, thereby hiding funding stress (i.e. banks came across as having lower funding costs than what they truly had). The second reason was to manipulate submissions in order to create favorable outcomes for settling trades referencing LIBOR. With hundreds of trillions worth of contracts referencing the rate, it is easy to see that manipulated rates had huge financial implications.

So, the LIBOR volumes that underpin the benchmark are low, it doesn’t reference securitized trades and it isn’t necessarily based on real trades. What to do?

Well, regulators are pushing hard to create alternatives to LIBOR which will serve as a better benchmark with higher integrity. It is very likely that regulators ultimately will force a switch to new benchmarks. For example, the Financial Conduct Authority (the FCA) in the UK has said that after 2021 it will no longer force banks to make LIBOR submissions. Given the reputational risks involved, it stands to reason that some banks might stop making submissions post this date. In fact, the ICE (which calculates and publishes LIBOR) does not guarantee that the benchmark will remain in place post-2021.

This leads to two key issues.

The first one is the development of new and more robust benchmarks. This is comparatively straightforward. The most significant of the global LIBOR replacement initiatives is the SOFR (Secured Overnight Financing Rate) in the USA. The volume in the market used to calculate SOFR is several hundred billion dollars daily of actual trades. As the name suggests, the SOFR references secured trades which have grown in significance over the last years. So, lots of real secured trades and no estimation involved in SOFR!

Another secured benchmark rate is the SARON (Swiss Average Rate Overnight) in Switzerland.

The UK with SONIA (Sterling Overnight Index Average), Japan with TONAR (Tokyo Overnight Average Rate), and the EU with ESTER (Euro Short-Term Rate, launching later this year) have set their targets lower, referencing unsecured (but real) transactions only (for now!).

Secondly, and probably much harder to tackle, is the issue of what to do with all existing loans and contracts should the publication of LIBOR stop. Suddenly trillions of dollars of contracts could be referencing something that is no longer in existence!

Contracts that reference LIBOR typically have “fallback provisions” in place that determine what rate to use if the benchmark is not published. However, these fallbacks were originally written to deal with a temporary absence of published rates (say a couple of days) and were not expected to be applied for the remaining life of a contract, as would be the case if LIBOR disappears. This is significant, as any replacement will likely differ substantially in terms of level (the SOFR, for example, is an average of 30 basis points lower than LIBOR). Any replacements could then lead to significant changes in costs/benefits for the parties to the transaction unless the spread to the reference rate is also adjusted. It’s easy to see how challenging it could be for two counterparties to agree on a new reference rate and a new spread. This creates a big risk for financial firms in terms of pricing, financial risk management, operations and not least, reputational risk.

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