For more than 50 years, a series of interest rates known as the London interbank offered rate, or Libor, has helped determine the cost of various kinds of borrowing all across the world. However, over the last decade, it has become outdated and discredited, and the benchmark will be phased out by the end of 2021. This prompted the financial industry to scramble to change the terms of contracts worth hundreds of trillions of dollars, including mortgages, credit cards, and interest-rate swaps. Banks spent an estimated $10 billion preparing for Libor’s collapse, but fears of a difficult transition mean that some existing contracts can be extended, despite the fact that new Libor-based accords are slated to expire on New Year’s Eve.
What exactly is Libor?
Libor is a daily average of the interest rates that banks claim they would charge each other if they were to lend to each other. It’s available in five currencies and for a variety of time periods ranging from one month to one year. Libor is used by pension and fund managers, insurance providers, big and small lenders, and Wall Street banks that package loans into securities. It was formalized by the British Bankers’ Association in 1986 to help establish rates for derivatives and syndicated loans. Equipment leases, student and vehicle loans, and bank deposits have all been linked to the benchmark in recent years, totaling $370 trillion in value. Derivatives, such as interest-rate swaps (trades of a fixed interest rate for a variable rate or vice versa), are the most important component, which are used by firms, banks, and investors to hedge risk or speculate. The one related to the US dollar (“dollar Libor”) is the most widely used of the five Libor currency rates, accounting for more than $200 trillion in products.
Why is it disappearing?
Trading that helped banks inform their estimates dried up as markets developed. In 2008, evidence surfaced that European and American lenders had manipulated rates to benefit their own portfolios, tainting the benchmark and resulting in a dozen banks to pay billions in fines. Libor will be phased out by the end of 2021, according to a decision made by the Bank of England in 2017.
What makes killing Libor so difficult?
It was necessary for the finance industry to find adequate substitutes. There was also the matter of what would happen to millions of Libor-priced contracts that will expire after 2021, referred to as legacy contracts.
Updating old contracts proved to be a difficult task, raising the risk of a disorderly transition, which some compared to Y2K, the fear of computer systems failing at the end of the last millennium. Rather than planes falling out of the sky, the fear was that a slew of litigation would arise as lenders and borrowers couldn’t agree on what rate to pay in the event of Libor’s collapse.
Does that mean trouble is coming?
A number of developments have eased much of the concern. In the derivatives market, regulators devised a methodology for including “fallback language” in contracts that will automatically convert them away from Libor. In the United States, the state of New York enacted a law that provides an additional protection for contracts hatched on Wall Street. Similar measures have passed the US House of Representatives, albeit the draft law still has to be approved.
Vitally, authorities have extended the deadline for dealing with legacy contracts priced in most USD Libor rates to the end of June 2023. By then, the majority of the contracts will have expired. After 2021, no new dollar Libor contracts can be issued, according to regulators. Meanwhile, Libor’s administrator will print an artificial benchmark in the U.K. and Japanese markets until 2022 to help avoid chaos for sterling and yen contracts that are unable to transfer.
How are Libor’s replacements shaping up?
Central banks have been working on benchmarks that are more accurate representations of capital costs and are based on actual transactions. One recurring issue was that some new benchmarks, such as the United States’ Secured Overnight Financing Rate, primarily represented overnight borrowing rates. Borrowers disliked it because it made it harder to estimate payments and meant that loans didn’t reflect rate changes expectations, which was one of Libor’s major attractions.
Moreover, unlike Libor, the new rates do not reflect the credit risk that banks assume when lending to one another. Because of the increased danger of lenders going bankrupt during the 2008 financial crisis, Libor increased even as central banks cut interest rates.
What exactly do these flaws imply?
Alternative benchmarks that offer longer-term rates and account for credit risk have gained popularity among borrowers and banks in the United States. The American Financial Exchange’s Ameribor, for example, has the potential to disrupt the transition to SOFR by splintering the trade required to establish the official successor for Libor.
The rise of such benchmarks pushed transition authorities to address some of the concerns regarding the rate’s major replacement, and they publicly endorsed a series of forward-looking term benchmarks related to SOFR based on futures trading in July. Many believe that this will accelerate its acceptance across areas that have been resistant to embrace the benchmark, such as syndicated corporate loans and collateralized loan obligations. Regulators have also issued a warning about the dangers and flaws of possible Libor alternatives.
Will regular customers be affected?
Regular borrowers will be scrutinised to see if they will be forced to pay higher interest rates after the move from Libor. Banks and asset managers, according to analysts, stand a much higher risk of fines, litigation, and reputational harm if they mishandle the transition, with regulators expected to be monitoring closely to see if they are treating consumers fairly.
