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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