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The end of LIBOR: implications for investors

The London Inter-bank 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 (US 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 $300trn-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’s 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 a transition to alternative risk-free rates (RFRs) by end 2021.”2

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

What is it being replaced with?

The replacements for LIBOR and IBORs have not all been agreed. Some have been confirmed: for example, the Sterling Overnight Index Average (SONIA) will replace sterling LIBOR, while the Secured Overnight Financing Rate (SOFR) will replace US dollar LIBOR. As table 1 illustrates, these risk-free rates (RFRs) are not direct replacements, with differences in calculation methodologies as well as collateralisation levels. There remains a significant degree of uncertainty: although the alternative rates have been selected, it is not yet clear how they will be adopted in certain markets.

Figure 1. Alternatives to 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 methodologies 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, lag 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 are we 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 at the end of 2021. 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.

Through our impact assessment, we have found that the key areas likely to be affected are:

  • Operations: we are working to ensure that our systems and processes can handle the new alternative reference rates and perform accrued interest calculations.
  • Performance and benchmarking: we are making sure that our benchmarks and performance analytics are re-baselined (where applicable) to the new RFRs.
  • Legal contracts: a range of procurement, counterparty and client contracts reference LIBOR and other IBORs. As a result, we are working to assess the materiality of the impact of the LIBOR transition and will revise our contracts where appropriate.

In addition, we have installed a client communications committee and will be providing regular updates on how we are managing the transition. If you have any questions on our move away from LIBOR, please contact your sales representative.

  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.

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