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.
The US, too, has a preferred candidate chosen by the Alternative Reference Rates Committee (ARRC) of banks convened by the Federal Reserve Board and the New York Fed: the SOFR. But it also has a range of alternatives vying to replace Libor. They include Bloomberg’s Short-Term Bank Yield Index (BSBY), the ICE Bank Yield Index (IBYI) and the Across-the-Curve Funding Index (AXI).
The differences between the rates and the issues involved are well illustrated by the two leading contenders for Libor’s crown: SOFR and the American interbank offered rate (Ameribor), the benchmark developed by American businessman and economist Richard Sandor.
Too close for comfort
In one sense, all three benchmarks (Libor, SOFR and Ameribor) can do the job. They are all closely correlated, which is perhaps unsurprising, given that they all aim to reflect interest rates. In timing and degree of movements, they track each other closely. There are, however, significant differences.
Despite not being the favoured solution of the ARRC, Ameribor offers a more straightforward transition from Libor. Set up a decade ago, as an alternative to Libor that better reflected the actual borrowing costs of regional US banks, it shares many of Libor’s characteristics.
It is forward-looking, with the rate given for the next three or six months, for example, and includes an element of credit risk (since it reflects the cost of unsecured lending).
It is also, like Libor, based on submissions - quotes - by participating banks rather than actual lending. That could mean it is potentially more stable. When the SOFR spiked in 2019 due to a liquidity squeeze, Ameribor did not. The use of submissions rather than simply recording transactions means they can use some discretion to eliminate short-term volatility.
Of course, it is also that sort of discretion that allowed big UK banks to collude to manipulate Libor. That largely explains why Ameribor was not the choice of the ARRC, along with the fact that Ameribor potentially replicates another of Libor’s problems: a relatively small underlying market.
Libor rigging was made easier because the market it was supposed to represent (unsecured lending between banks) essentially vanished during the credit crisis and never returned. Libor became, as former Bank of England Monetary Policy Committee member Willem Buiter described it, “the rate at which banks don’t lend to each other”.
That is not so true for Ameribor, with the underlying market of transactions it reflects worth $2.5bn (£1.8bn) against $500m for Libor. Still, it pales compared with more than $1tn of daily repo transactions that set the SOFR.
Too good to be true
The SOFR also addresses some of the other perceived weaknesses of Libor. It is entirely objective, set by trades in the repo market, not by the opinions of what rates will be. It is also a risk-free rate, based on overnight lending, secure with collateral in the form of US Treasury securities.
What might have attracted regulators and the ARRC to SOFR is likely to make it somewhat less appealing to those making the switch from Libor.
First, since SOFR is a risk-free rate, and Libor is an unsecured rate, SOFR will generally be lower than Libor. All contracts will need to be updated to allow for this basis.
More challenging, SOFR is backward-looking, determined in arrears, based on overnight transactions in the US Treasury repo market. It is backward-looking while Libor (like Ameribor) is forward-looking. That will require a significant adjustment – a complete operational change for processing payments, for instance.
For derivatives, the International Swaps and Derivatives Association provides some help with that transition in the form of its “fallback protocol” for trades that reference Libor.
It provides a standard template for dealing with many of the issues. It deals with the credit risk and risk-free spread, for example, by effectively averaging the basis between the risk-free rates and Libor over the past five years (to simplify it).
For other contracts, such as loans and bonds, though, businesses are on their own.
No time to waste
What they cannot do is simply wait it out to see which benchmark wins. While other currencies may not have enough liquidity in multiple rates to keep them relevant, that is probably not the case for the US.
The size of the dollar market is large enough to support multiple rates. Moreover, as Ameribor’s 10-year history shows, the US market is quite used to having numerous rates. It is entirely possible, likely even, that Ameribor, SOFR and others could survive and thrive.
Moving away from Libor, then, organisations will be forced to make not only a transition but also a choice as to which benchmark to use. In doing so, they face a number of challenges.
The first is that the strengths and weaknesses of the different benchmarks, their similarities and differences to Libor and the range of contracts requiring transition mean there is no simple answer to which is best. The circumstances of every organisation and its portfolio of products will be in some respect unique. No one size will fit all.
That may be true both within an organisation and across it. Organisations must look at their exposures in each contract individually but also over their portfolio to avoid unintended consequences.
Hedge accounting is a good example, where cash products hedge derivative products moving from one index to another may impact the hedge effectiveness calculation. If the basis is not correctly hedged, the hedge may become ineffective.
Similarly, if one part of your position migrates immediately and another the next month, there may be a problem of timing.
Regardless of the merits of the new benchmarks, businesses need to make sure they are doing the right thing for their whole portfolio, not just the easiest thing for a particular product.
And they do not have long to decide. The final challenge is the timing.
With the exception of cleared derivatives, all legacy contracts will be able to rely on sterling and yen synthetic Libor after the December 31 deadline, however these rates are only for use in legacy contracts and are not for use in new business. The dollar Libor will continue to be published until 2023 to allow for the transition of legacy books with a live rate, but again, no new products referencing Libor, except for risk management, will be allowed.
Businesses can delay transition for old instruments, but that may simply complicate things because of those inter-relationships in their portfolios. Regardless, loans currently referencing Libor rolling over in the new year will have to use a new rate, for example. Businesses need to be ready to trade and hold positions in a Libor replacement by the December 31 deadline.
If they are not already well underway, there is a lot of work to do and not much time left to do it.
Marcus Morton is managing director of Duff & Phelps
