Regulation  

What will replace Libor?

  • Describe why Libor is being replaced
  • Explain how its replacement will work
  • Identify its impact on the fund management sector
CPD
Approx.30min
What will replace Libor?
 Simon Dawson/Bloomberg

Anyone with a passing interest in finance will doubtless be familiar with the London Inter-Bank Offered Rate.

It is used globally as the basis for interest rates that consumers pay on a broad range of financial products, from credit cards and loans to variable rate mortgages. 

In asset management alone, the term is frequently used as a reference point for a fund’s performance, a component of a fund’s name, and/or is an active component of the pay-off of instruments used in portfolio construction.

However, the countdown to Libor’s demise has already begun and in a year’s time, it will cease to exist. This will have wide-reaching implications for the financial services industry.

Put simply, Libor is a series of interest rates that reflect the rate at which a group of large banks are willing to borrow from each other in a specified currency over a specified term.

Libor is quoted in five currencies: US dollar, British pound sterling, euro, Japanese yen, and the Swiss franc.

It also has seven different maturities: overnight, one week, one month, two months, three months, six months, and 12 months. The rate for each currency is set by a panel of between 11 and 18 banks.

This combination of currencies and maturities amounts to 35 different Libor rates reported each business day.

As such, Libor has been widely adopted as a floating-rate benchmark index, used as a reference rate for a large range of securities, derivatives and other instruments worldwide, and also accepted as a barometer for market liquidity and changes in financial conditions. 

Trust in Libor

Trust in Libor was severely damaged when accusations of rate fixing emerged in 2012, resulting in an industry-wide scandal that led to fines, lawsuits and regulatory actions against a broad group of financial institutions in the UK, Europe and US, including Barclays, Royal Bank of Scotland, UBS, Deutsche Bank, ICAP and Rabobank.

At the same time, there has been a significant decline in the unsecured, wholesale borrowing by banks that relies on Libor since the global financial crisis as financial institutions have preferred to use deposits, REPOs or longer-term debt finance.

As a result, and despite its widespread applications in financial products including interest rate swaps and futures, forward rate agreements, cross currency swaps, floating rate notes and mortgage backed securities, global regulators have been clear that Libor is expected to be discontinued after 2021.

For instance, in the UK, the Financial Conduct Authority (FCA) has confirmed that panel banks would no longer be required to submit rates from 2021 and the Bank of England has stated that all counterparties to a financial product or contract referencing Libor will need to act to remove any dependence on the index beyond 2021.

As Libor will cease to exist, new alternatives will have to be put in place to avoid disruption to business and markets. Regulators across the world have prompted several working groups in order to smooth the transition and have come up with their own recommendations.