What is LIBOR?
The London Interbank Offered Rate (LIBOR) is the reference interest rate for tens of millions of contracts worth more than USD 240 trillion, ranging from complex derivatives to residential mortgages. LIBOR is also hardwired into all manner of financial activity, such as risk, valuation, performance modelling and commercial contracts. It has been called the “world’s most important number”.
However, significantly reduced volumes of interbank unsecured term borrowing, which is the basis for LIBOR, is calling into question its ability to continue playing this central role.
Working groups convened by regulators in the most used LIBOR currencies have already converged on alternative reference rates. In addition, the UK’s Financial Conduct Authority (FCA) last year announced that after 2021 it would no longer persuade or compel panel banks to submit the rates required to calculate LIBOR.
Publication of LIBOR rates will not necessarily end after 2021. Nothing prevents banks from continuing to submit the relevant data and ICE Benchmark Administration from publishing the rates. However, the submitting banks are conscious of the conduct risk inherent in making judgment-based submissions to a benchmark that determines the value of a vast number of contracts. Even if LIBOR is not discontinued, regulatory pressure to transition to new rates is expected to increase.
The implications of LIBOR replacement for financial firms
The transition from LIBOR will bring considerable costs and risks for financial firms. Since the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR. The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design and hedging strategies.
LIBOR may become unavailable even though products referencing it remain in force. These contracts typically include “fall-back provisions” which specify contract terms in case LIBOR is unavailable. If the period of unavailability is brief, as envisaged when the contracts were drafted, the resulting losses and gains are manageable. But if fall-back terms are used for the remaining life of the contract, the economic impact is likely to be significant, with one side a winner and the other a loser.
The financial, customer and operational impact of replacing LIBOR
Renegotiating a large volume of contracts would be difficult, especially when one party has a contractual right to a windfall gain. If contracts are left to convert to fall-back provisions if LIBOR becomes unavailable, a vast number of price changes would occur in a short period. The associated financial, customer and operational impacts would be difficult to manage.
Financial firms will also face a serious communication challenge with retail customers. For example, most variable rate mortgage customers in the US may understand that their rate is LIBOR+200 basis points (or similar) but have little understanding of LIBOR itself. Unless appropriately communicated, they are likely to think that a proposed alternative rate of the Secured Overnight Financing Rate (SOFR)+230 basis points is a worse deal, even if SOFR is on average 30 basis points lower than LIBOR.
Why financial firms need to start planning now
Transitioning away from LIBOR could create considerable conduct, reputational and legal risk. Even today, writing long-dated business that may extend beyond a LIBOR transition period entails conduct risk. Without clarity about the alternative rates or when the transition will happen, it is difficult to know how contracts should be priced. The longer uncertainty persists, the greater the mis-selling risk incurred by financial firms.
Financial firms still have the opportunity to work with regulators to influence the transition process and outcomes. The alternative rates are defined but market expectations and choices are not.
A wait-and-see approach would be unwise. Given the volume of products and processes that will have to change, transition away from LIBOR entails considerable work and risk. Preparations should start immediately.
More information on LIBOR transition
For more information or advice about the impact replacing the LIBOR rate will have for your business, download the full report or contact a member of our dedicated LIBOR transition team.