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The end of LIBOR

This piece was updated on January 25th 2022

The London Interbank Offered Rate (LIBOR) is one of the main interest-rate benchmarks used in global financial markets. By the end of 2021, LIBOR reference rates and other Interbank Offered Rates (IBORs) will be retired. What will replace LIBOR and other IBORs, and what does this mean for investors?

Established in 1986, LIBOR is seen as one of the most important interest rates in the global finance industry. In addition to deciding the price of transactions, the rate is seen as a measure of trust and reflects the confidence that banks have in each other.

 

What is LIBOR?

LIBOR is a measure of the average rate at which banks are able to borrow wholesale unsecured funds. It is administered by the ICE benchmark administration and is calculated using submissions from a panel of global banks. Banks submit an estimate of what they would pay other banks to borrow for a specific period of time if they borrowed money on the day the rate is being set. Depending on how many banks submit estimates, roughly the top and bottom quartile of submissions are discarded, before an average is set.

Published in five currencies (U.S. dollar, sterling, euro, Swiss franc and Japanese yen) and a range of tenors (from overnight up to 12 months), LIBOR Is used as a reference rate in financial contracts that include derivatives, bonds and loans. Overall, it underpins about US$300 trillion-worth of deals.

 

Why is it being replaced?

The rates that are submitted are estimates and not based on actual transactions, which has resulted in some high-profile cases of LIBOR manipulation. Coupled with a decline in interbank lending, this prompted Andrew Bailey, then CEO Of the Financial Conduct Authority (FCA) and current governor of the Bank of England, to call for an end to the use of LIBOR and a “transition to alternative reference rates that are based firmly on transactions.”1

At that time, Bailey said that the FCA would not compel banks to make LIBOR submissions beyond 2021. Similarly, the Bank of England Financial Policy Committee stated in its Financial Stability Report that “The continued reliance of global financial markets on LIBOR poses a risk to financial stability that can only be reduced through in transition to alternative risk-free rates (RFRs) by the end of 2021.”2

As such, the FCA secured panel-bank support to continue submitting to LIBOR, but only until the end of 2021. Beyond this date, the future of LIBOR is not guaranteed.

 

What is it being replaced with?

Following the Financial Stability Board’s recommendation in 2014, industry working groups in the different jurisdictions were established to find and recommend alternative risk-free rates that are expected to replace LIBOR and other IBORs. As table 1 illustrates, these risk-free rates are not direct replacements. There are differences in calculation methodologies as well as collateralisation levels and although the alternative rates have been selected, it is not yet clear how they will be adopted in certain markets.

Figure 1. Selected risk-free rates for the five major currencies of LIBOR

Jurisdiction

Working group

Alternative reference rate name

Administrator

Collateralisations

Description

US

Alternative Reference Rates Committee

Secured Overnight Financing Rate (SOFR)

Federal Reserve Bank of New York

Secured

Secured rate that covers multiple overnight repo market segments

UK

Working Group on Sterling Risk-Free Reference Rates

Sterling Overnight Index Average (SONIA)

Bank of England

Unsecured

Unsecured rate that covers overnight wholesale deposit transactions

Switzerland

The National Working Group on CHF Reference Rates

Swiss Average Rate Overnight (SARON)

SIX Exchange

Secured

Secured rate that reflects interest paid on interbank overnight repo rate

Japan

Study Group on Risk-Free Reference Rates

Tokyo Overnight Average Rate (TONAR)

Bank of Japan

Unsecured

Unsecured rate that captures overnight call rate market

Euro area

Working Group on Risk-Free Reference Rates for the Euro Area

Euro short-term rate (€STR)

European Central Bank

Unsecured

Unsecured rate that captures overnight wholesale deposit transactions

Source: Financial Conduct Authority, as at September 2019.

In order to remain fair to all parties, these replacement rates will need to be adjusted. For example, there will need to be agreed methodology to compound and calculate the daily rate to create one that matches the maturity of the agreed term. Because some of these RFRs are backwards looking, a timing challenge arises when calculating coupons. As a result, lack mechanisms will have to be put in place.

IBOR rates reflect the terms at which banks would lend to each other at the unsecured level. Conversely, some of the new RFRs being considered reflect secured lending terms. This results in a lower credit risk and most likely a lower quoted rate.

 

How is the international business of Federated Hermes managing the transition?

At the international business of Federated Hermes, we understand that the transition to RFRs will have different implications for our clients. We are committed to working with them to understand the impact across asset classes and portfolios and have set up a dedicated programme and project resource to manage the transition.

We have an assigned working group and project manager who is responsible for ensuring we are equipped and ready to move away from LIBOR and other IBORs. They are responsible for leading project governance and frequently updating senior members of the company (including our CIO, the project sponsor) about our exposure, the development of suitable alternative reference rates and next steps for our transition.

We have also installed a client communications committee and will be providing regular updates on how we are managing the transition.

 

What is the ISDA Protocol?

LIBOR Swaps are governed by the International Swaps and Derivatives Association (ISDA) documentation. On 23 October 2020, ISDA launched the IBOR Fallbacks Supplement to the 2006 ISDA Definitions (the “Supplement”), and the ISDA 2020 IBOR Fallbacks Protocol (the “Protocol”)3. Both have an effective date of 25 January 2021. From this date all new contracts that incorporate the 2006 ISDA Definitions – and reference one of the covered IBORs set out in the Supplement – will contain the new fallbacks.

This means that on final cessation of the applicable IBOR, The relevant replacement rate will apply. The new calculation methodology and a standardised spread adjustment will be used, unless the counterparties involved have agreed on an adjustment spread bilaterally before the cessation occurs.

While adherence is voluntary, as with all ISDA protocols, we have signed up to it.

 

Will GBP LIBOR disappear at the end of 2021?

Markets participants have taken active measures to shrink the pool of contracts referencing GBP LIBOR as far as possible, leaving behind only those contracts that genuinely have no or inappropriate alternatives to using the rate and where there is no realistic ability that these contracts can be renegotiated or amended – so called “tough legacy” contracts. The FCA recognised that it is not practicable to convert all outstanding GBP LIBOR contracts by the end of the year.

On 29 September 2021, the FCA confirmed that to avoid disruption to legacy contracts that reference the 1-, 3- and 6-month sterling and Japanese yen LIBOR settings, it will require the LIBOR benchmark administrator to publish these settings under a “synthetic” methodology for the duration of 2022. The synthetic rate  will no longer, however, be representative as defined by the Benchmarks Regulation (BMR) and is only available for use in some legacy contracts and not for use in new business.

 

What happens to USD LIBOR?

In November 2020, ICE benchmark administration (IBA) announced that it would be consulting on its intention to cease USD LIBOR, and move the Financial Conduct Authority (FCA) welcomed and supported4. Subject to confirmation following consultation, the IBA said it intended to cease publication of one week and two months USD LIBOR after 2021. It also said it would cease, publication of overnight, one, three, six, and 12-month USD LIBOR after 30 June 2023.

Although the remaining USD LIBOR settings will continue to be published beyond the end of 2021, regulators and industry working groups have emphasised the need to cease entering into new contracts that reference USD LIBOR as soon as possible and in any event by the end of 2021.

The Financial Conduct Authority (FCA) has confirmed its intention to use their supervisory powers under the UK benchmark regulation to formally prohibit the use of USD LIBOR in  overnight, 1-, 3-, 6- and 12-month tenors by supervised institutions in new deals from 1 January 2022.

 

What is the international business of Federated Hermes’s risk appetite for LIBOR cash securities in 2022?

For public markets securities the transition lies ultimately with the issuer and as such the international business of Federated Hermes might continue to hold GBP LIBOR securities but only if it is in the best interest of our clients. We have established clear internal governance and oversight and a risk tolerance framework that is signed off by senior management.  Holdings in non-transitioned GBP LIBOR securities through risk management exceptions will be kept at a prudent minimum and de-risked either through consent solicitation, issuer calls or sale-off through the coming months.

From 1 January 2022, we will not acquire any issues in GBP LIBOR or primary US LIBOR linked cash securities irrespective of maturity dates. The transition of USD LIBOR securities will be in line with the guidance from regulators and industry working group recommendations.

  1. 1‘The future of LIBOR, speech by Andrey Bailey, Chief Executive of the FCA, at Bloomberg London’, published on 27 July 2017.
  2. 2‘Financial Stability Report’, published by the Bank of England in December 2019.
  3. 3 See https://www.isda.org/2020/10/23/isda-launches-ibor-fallbacks-supplement-and-protocol/
  4. 4See https://www.fca.org.uk/news/statements/fca-response-iba-proposed-consultation-intention-cease-us-dollar-libor

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