Wednesday, August 08, 2018
LIBOR is Headed for the Scrap Heap
LIBOR, the London interbank offered rate, is headed for the scrap heap. Why this occurred and what may replace it are the subjects of this article.
For years, LIBOR was the most reliable benchmark reference rate set by banks daily to establish interest rates in both financial markets and commercial contracts. Interest rate swaps, derivatives, syndicated loans, some bond rates, some student loans, and many domestic residential mortgages use LIBOR as their interest rate benchmark. Last year it was estimated that $370 trillion in financial contracts were indexed to LIBOR.
"Who cares, in America, at what rate London banks
loan money to each other over the short term?
Many US debt vehicle rates are directly tied to it..."
~ telegraph.co.uk, March 2018 (emphasis added)
Benchmark rates were originally developed to assign “end-of-day” values to particular holdings. As the euro-currency markets expanded in the 1960’s LIBOR was developed as a benchmark because it represented an unsecured, risk-free term rate, plus a little added in the event of default.
Rate Rigging and Manipulation
For years, LIBOR was set on a daily basis by a dozen big banks that estimated their short-term borrowing costs. Tampering of LIBOR first came to light in 2008; and by the end of 2016, a dozen banks had paid total penalties approaching $10 billion and a further $2 billion to settle private claims. Banks are still in the process of settling another set of rate-rigging cases relating to manipulation in the $5.3 trillion-a-day currency market, and U.S. regulators are also examining at least ten banks as part of an investigation into rigging of precious metals such as gold and silver. Benchmarks used in oil and derivatives trading have also been shown to be vulnerable to abuse. Those caught up in the rate-rigging probes asserted that they were merely following long-standing banking practices.
In 2013, officials from more than 50 countries established a set of principles to make the benchmark rates more transparent and to minimize conflicts of interest. Benchmark rates are so widely used in financial markets however that they cannot be changed without invalidating existing contracts or introducing the potential of increased volatility.
Last year, in light of the scandals associated with LIBOR, Andrew Bailey, the head of the U.K. Financial Conduct Authority, the regulator for British financial companies and markets, said that as of 2021 it would no longer require banks to provide quotes for various LIBOR rates.1 Although the ICE Benchmark Administration Ltd. (“ICE”) will continue to publish the rates, submitting estimates will be on a voluntary basis, obviously helpful for LIBOR-linked contracts that haven’t been shifted to a new index.
As to what will replace LIBOR, on July 20, 2017 the U.S. Alternative Reference Rates Committee (“ARCC”) announced that it had identified a broad Treasuries repo financing rate as its preferred alternative reference rate to LIBOR, called the Broad Treasury Financing Rate (BTFR). The New York Federal Reserve in April began publishing the Secured Overnight Financing Rate (SOFR). Both the BTFR and SOFR are calculated on the basis of real transaction data drawn from a large volume of deals. Unlike the LIBOR, however, which represents the rate on which banks will lend to each other on an unsecured basis for a fixed period of time, the Treasuries repo rates represent the cost of secured financing at an overnight rate. Suggested alternatives have also included, in the United States, the prime rate and the federal funds rate.
In the U.K. suggestions for alternative benchmarks include the Sterling Overnight Index Average (SONIA), which is a weighted average rate of all unsecured overnight sterling transactions brokered in London by the Wholesale Markets Brokers’ Association member banks. Like BFTR, SONIA is an overnight rate rather than a term rate, but it does have the advantage of being both an unsecured lending rate and a rate based on actual transaction data. Japan has selected TONAR as an alternative to yen LIBOR, also an unsecured rate, and a group in Switzerland selected SARON, a collateralized rate based on the Swiss repo market.
Borrowers and lending institutions will need to amend those contracts that utilize LIBOR as the benchmark rate, a process that may be easy or difficult depending on the market involved. As transactions move away from LIBOR, however, the rate becomes less viable as a market standard. Regulators around the world are looking for a risk-free, transparent rate, divested from the potential for manipulation, with a credit spread to reflect bank risk. Needless to say, time is of the essence.
1. There are many LIBOR rates. The ICE Benchmark Administration Ltd. (“ICE”) publishes daily rates in five currencies and seven maturities. There are additional interbank rates as well: EURIBOR is the Euro Interbank Offered Rate. TIBOR is the Tokyo Interbank Offered Rate. Japan, too, offers a yen-based LIBOR.
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