It’s the End of the LIBOR as We Know It
The London Interbank Offered Rate (LIBOR) has been the most widely traded and referenced short-term interest rate index for the U.S. Dollar (USD) in financial markets in recent history. Each day, a panel of major global banks with operations in London financial markets submits the rates at which it believes it could borrow dollar-denominated funds in the interbank market across seven different terms. The trimmed means of these submissions are published daily as the USD LIBOR index.
Trillions of dollars of debt and securities, including business loans, variable/floating rate notes, securitized asset classes (mortgage backed securities, asset backed securities, collateralized loan obligations), and retail loans and mortgages, currently reference USD LIBOR. Furthermore, hundreds of trillions of derivatives notional in the form of interest rate swaps and Eurodollar futures are tied to USD LIBOR. LIBOR also fixes in four other currencies (Euro, British Pound, Japanese Yen, and Swiss Franc) that have tremendous volumes of financial products referencing it.
On July 27, 2017, the U.K.’s Financial Conduct Authority (FCA), which is tasked with overseeing LIBOR, announced that the benchmark will be phased out by the year 2021. Reactions to the announcement have spanned both ends of the spectrum, ranging from “the end of LIBOR will trigger a financial Doomsday” to “there is no way LIBOR will go away.” While the true impact is likely somewhere in between, this announcement begs the following questions:
- Why does the FCA want to phase out LIBOR?
- What does this mean for existing products that reference LIBOR?
- What will replace LIBOR?
The desire to phase out LIBOR stems from the fact that the market LIBOR is supposed to measure has become increasingly defunct, meaning the daily LIBOR submissions are more dependent on the panel banks’ judgment than actual transactions. The recent LIBOR scandals have increased the scrutiny and cost around LIBOR submissions, and several banks have expressed a desire to discontinue their submissions and only continue to do so at the FCA’s behest.
Existing products that rely on LIBOR to determine payment amounts utilize a wide array of provisions in their terms for a LIBOR discontinuation. The most common provisions include: polling a sample of banks for a proxy, using a spread to another reference rate, or converting to a fixed-rate at the last published level. Interest rate swaps and Eurodollar futures, which are priced using future expectations of LIBOR, will face their own set of challenges.
International policymakers have already spent several years developing alternative reference rates based on observable transactions in robust markets. In June 2017, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative to USD LIBOR. This week’s chart shows the historical SOFR calculation alongside overnight USD LIBOR. Yesterday, the NY Fed announced they will publish SOFR daily beginning April 3, 2018.
LIBOR’s current existence is predicated almost entirely on its use as a reference rate. For the longer term, it makes sense for markets to develop around transaction-based reference rates. However, challenges exist in the years ahead. Existing LIBOR-based products will need to be reevaluated for their provisions in the event LIBOR ceases to exist. One example is if a floating-rate asset turns fixed rate after fixing to the last LIBOR print. Going forward, CME Group is looking to launch futures on SOFR shortly after SOFR publication begins. Still, volumes in Federal Fund futures compared with Eurodollar futures suggests there will be difficulty transitioning market participants away from the LIBOR-based markets to which they’ve become so accustomed.
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