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What will replace Libor?

What will replace Libor?
 Chris Ratcliffe/Bloomberg

The London interbank offered rate (Libor) has proved one of the UK’s most successful exports. But not everyone is going to feel thankful for that in the coming weeks and months. 

Since coming into widespread use in the 1970s, it has crept into every corner of finance, not just the derivatives market, where it underpins instruments like interest rate swaps, forward rate agreements and foreign currency options.

Libor has become ubiquitous. It is frequently referenced in commercial mortgages and loans and even in some residential lending; some purchasing contracts use it to calculate the interest rate applied for penalties. 

Any financial instrument originated in the last half a century with a variable interest rate will almost certainly be referencing Libor. Not just in the UK, either, but all around the world.

All of this explains why, with Libor for most currencies being discontinued at the end of the year, many organisations face a difficult transition.

Large corporations and big banks have well-funded programmes and staff in place to deal with it. Smaller businesses and those with relatively few contracts referencing are less fortunate.

Since the financial crisis, the unsecured interbank lending market that Libor was intended to reflect has almost ceased to exist as banks have moved to other sources of funding. This reduced liquidity made Libor unrepresentative of lending levels and, as we saw in 2012, vulnerable to manipulation.

This resulted in the Libor manipulation scandal, where many traders colluded to fix the price, putting the final nail in the coffin of an already tarnished metric.

While regulators looked at ways to reform Libor to address its underlying issues, the panel banks were unwilling to continue submitting levels for a market that did not exist and suffer the "cost and risks of submitting expert judgements".

So, in 2017 the regulators agreed that Libor would cease at the end of 2021, with a transition to transaction-based rates such as the sterling overnight index average (Sonia) and secured overnight financing rate (SOFR). 

Double standards

The challenge is particularly acute for those with contracts using the US dollar Libor rate, which is to say, many UK businesses. As the world’s reserve currency, dollars are used for trading commodities, for example, while the US is Britain’s largest trading partner.

US exposure, therefore, like Libor, is everywhere. And those transitioning away from US dollar Libor face an additional challenge: a battle for succession. 

Most territories have settled on a single replacement for Libor, such as Sonia in the UK, Japan’s Tokyo overnight average rate (TONAR) for the yen, or the euro short-term rate (€STR) in the EU. The transition to these rates is not without difficulties but at least businesses know what they are aiming for.

For Sonia, there is a reasonably well-established market in derivatives; for example, people can trade it, hedge it, and there is a well-understood Sonia rate. 

The UK and Japan are also in privileged positions as businesses in the sterling and yen markets could be allowed to continue using synthetic Libor, which is created without using trading data from banks rates, in all legacy contracts except cleared derivatives, as announced by the Financial Conduct Authority at the end of September.