Goodbye LIBOR – Hello SOFR, €STER & Co.

LIBOR is considered arguably the most important interest rate in the financial world. From mortgages to corporate credit and from margin loans to the gigantic global derivatives market, a lot depends on this lone percent figure. LIBOR is slated to be replaced by other reference interest rates by the end of 2021 – a process that stands to be far from trivial.


An interest rate that moves the financial world

The London Interbank Offered Rate – LIBOR for short – is a term that probably almost everyone has heard of. This interest rate, a reference rate based on the refinancing costs of banks, has been a linchpin of the world financial system for more than three decades. Banks grant mortgages to homebuilders, issue margin loans to investors and extend liquidity to enterprises on the basis of LIBOR. Numerous valuation models use LIBOR-based interest-rate curves to discount future cash flows to a present value and to compute forward rates. The value of all financial contracts linked to US dollar LIBOR alone is estimated at approximately USD 200 trillion. It thus is no exaggeration to liken the reform of LIBOR currently underway to performing open-heart surgery on the financial system. But why does LIBOR have to be phased out at all?


LIBOR is susceptible to manipulation…

A reference interest rate, like a Swiss Army pocketknife, ideally should fulfill many different purposes and meet an array of criteria. It (1) should derive from actual transactions executed on active, liquid markets, (2) should be invulnerable to manipulation, (3) should be a basis for calculating an interest-rate curve, and (4) should reflect banks’ actual refinancing costs as accurately as possible. LIBOR, however, exposes deficiencies especially with regard to the first two requirements, not least due to its peculiar “price discovery process.” A panel of banks submit daily interest-rate estimates of their refinancing costs. The highest and lowest quotes are then discarded, and a trimmed average is taken of the remaining interest-rate indications. That average then becomes the official LIBOR rate. LIBOR at present is computed for five different currencies across seven different maturities.


It is no exaggeration to liken the reform of LIBOR to performing open-heart surgery on the financial system.


The truthfulness of banks’ interest-rate quotes in this daily procedure is near-impossible to verify, so there is latitude for fudging the numbers – latitude that was often taken advantage of in the past. During the financial crisis, for example, a number of banks intentionally understated their alleged interest costs to create an impression of better creditworthiness and to lower their refinancing expenses. They incidentally even reaped some huge profits this way because most of the banks held large LIBOR positions on their proprietary trading books. Reports on irregularities in the setting of LIBOR could already be read in the Wall Street Journal back in 2008. Many a central banker at that time also raised a critical voice on the veracity of the interest rates quoted by banks. Two years later, US economists corroborated the skepticism in a study. They proved that the increase in prices for bank’s credit default swaps during the crisis years was inadequately reflected in the price of LIBOR. Behind the scenes, regulatory authorities were already hot on the banks’ trail by then. Lawsuits by the dozens began to rain down on banks in 2012, followed by million-dollar and even some billion-dollar fines levied against nearly all of the big names in the banking industry, from US-based JPMorgan and UK-based Barclays to UBS and Deutsche Bank.


…and is hardly representative anymore

But susceptibility to manipulation isn’t the only reason why LIBOR’s days are numbered. There’s an additional problem: the setting of LIBOR these days is based almost exclusively on model values. The number of actual LIBOR-based transactions conducted by the panel banks has continually decreased in recent years. The daily trading volume on the USD 200 trillion market for LIBOR-linked financial products has dwindled these days to just USD 500 million. LIBOR therefore has already long ceased to adequately reflect the banking sector’s refinancing costs. LIBOR’s deficiencies and its immense importance for the financial world made the search for alternative reference interest rates practically inevitable because although the contractual terms of LIBOR-based products or transactions typically include fallback clauses naming an alternative to LIBOR in the event that LIBOR is unavailable, such clauses were conceived solely in case of temporary disruptions of the LIBOR market.


The reform of reference interest rates is well underway

Back in 2013, the G20 nations commissioned the Financial Stability Board (FSB) to conduct a fundamental review of reference interest rates and to draw up reform proposals or recommend alternatives to LIBOR. Various national task forces composed of regulatory officials, central bank executives and market participants have been working around the world since 2014 to devise new interest-rate benchmarks and to develop proposals for transitioning to a new interest-rate regime. One core objective of the efforts to reform LIBOR has been to find near risk-free alternative interest rates that are based as much as possible on actual transactions instead of estimates. New reference interest rates meeting those specifications have been defined in the meantime for all five LIBOR currencies. Their names are SOFR (Secured Overnight Financing Rate) for the US dollar, €STER (Euro Short-Term Rate) for the euro, SARON (Swiss Average Rate Overnight) for the Swiss franc, SONIA (Reformed Sterling Overnight Index Average) for the British pound and TONAR (Tokyo Overnight Average Rate) for the Japanese yen.


New benchmark in the starting gate

SOFR gradually gaining acceptance and importance


1-week LIBOR, 1-month LIBOR and SOFR (Secured Overnight Financing Rate)


In all probability, LIBOR in its present form will cease to exist after the end of 2021. This means that banks will no longer be forced to submit daily quotes for the setting of LIBOR. The transition to the new post-LIBOR interest-rate regime is well underway in the meantime, but is proceeding quite sluggishly here and there. The new benchmarks are gaining growing acceptance among financial institutions and market participants, and more and more financial instruments linked to the new interest rates are being issued. Liquid futures markets for SOFR and SONIA, for instance, have already even formed on futures exchanges. However, LIBOR nonetheless remains firmly ingrained. Most long-term mortgages in the USA, for example, are still being sold based on LIBOR.

The new post-LIBOR interest-rate regime is well underway, but is proceeding quite sluggishly here and there.


A challenge for the banking industry…

But the countdown is ticking – support for LIBOR will probably vanish less than two years from now. Banks must adapt LIBOR-based contracts, products, systems and processes to the new alternative reference interest rates by then. The reform process thus looks destined to further intensify this year. This is a mammoth, complex task because LIBOR plays a part in a vast array of bank products and is deeply embedded in the humongous world of financial derivatives. Since there is a real prospect of LIBOR being abruptly discontinued, an orderly transition to the new interest-rate regime is of utmost importance for the sake of financial stability. For derivative contracts, the respective new risk-free interest rate plus a premium (based on historical differentials to LIBOR) is likely to become an established standard. This approach could also be suitable for other products such as corporate and consumer credit. For variable-rate instruments, on the other hand, conversion into fixed-rate contracts could also be a possibility. Another possible option in isolated instances would be to call products like debt instruments, for example, and replace them with instruments linked to the new reference interest rates.


…and for wealth management

The LIBOR reform also has a lot of relevance for banks primarily active in asset management and private banking (and for their clients). Margin loans and current account overdrafts, for example, are typically linked to LIBOR. Moreover, benchmarks and performance targets for investment products, particularly in the money-market or fixed-income segment and in the alternative assets sector, are often tied to LIBOR. Just like retail banks, private banks, too, must recalibrate their IT and risk management systems to the new reference interest rates and must proactively communicate the transition to the new interest-rate regime to their clients. However, the LIBOR reform should take up somewhat fewer client-facing and back-office resources for them compared to banks focused heavily on lending.

Oliver Hackel, CFA Senior Investment Strategist

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