Blog by Sepideh Malekpour, Delivery Manager – Surecomp
In widespread use since 1970, LIBOR – the London Interbank Offered Rate – became the marketplace standard in 1986 and has been serving as a globally accepted benchmark interest rate ever since. The LIBOR is calculated for five currencies and is published daily by the Intercontinental Exchange (ICE) for seven terms ranging from overnight to one year.
It is assumed that $200-$300 trillion in loans, mortgages, corporate debt and other financial instruments are tied to LIBOR, so in terms of trade finance there is significant impact resulting from the decommissioning of this rate. So why – if it plays such a critical role in global markets – is the sun going down on LIBOR?
The demise of LIBOR
Since the 2008 financial crisis, LIBOR was increasingly determined by what the IBA called “market and transaction data-based expert judgment,” meaning it was becoming unreliable and open to manipulation. This led to a loss of market trust with fines being imposed on several banks and a significant decline in the volume of LIBOR-linked transactions. This resulted in regulatory review and a subsequent clamp down, and in 2014, the U.S. Federal Reserve commissioned the Alternative Reference Rate Committee (ARRC) to recommend a benchmark interest rate to replace USD LIBOR. In 2018 the Fed began publishing the Secured Overnight Funding Rate (SOFR).
Subsequently other regulators came forward to propose new risk-free rates (RFRs), which are historical, transaction-based rates secured against collateral assets and as such carry little or no credit risk. Alternative RFRs include the UK’s Sterling Overnight Index Average (SONIA), Switzerland’s Swiss Average Rate Overnight (SARON), the Japanese Tokyo Overnight Average Rate (TONA) and most recently a new unsecured overnight rate called Euro Short-Term Rate (ESTER) published by the Euro zone.
Over the past year the market has been encouraged to avoid entering into new LIBOR-based trading transactions in order to accommodate the pending sunset. The UK Financial Conduct Authority (FCA) has stipulated that beyond 31st December this year, it will no longer expect LIBOR panel banks to provide LIBOR submissions. Effectively, this is the cessation date from which LIBOR will no longer be considered a reliable index, and from June 2023 it will no longer be published at all. The market has now stopped issuing new LIBOR-based loans that expire beyond the end of 2021, and indeed many banks are using RFRs for contracts that expire even earlier.
Are we ready for the LIBOR sunset?
According to the report just published by BAFT which surveyed banks and corporates on their preparedness for and risk mitigation of the cessation of LIBOR, it seems clear there is still much work to be done to ensure a smooth transition. There is a lack of clarity around the availability of RFRs across multiple currencies and this is creating a challenge for banks to effectively communicate a transition plan to their corporate clients.
There are ongoing challenges in identifying, reviewing, and categorizing LIBOR-linked contracts. Such contracts will need to be revised with fallback clauses; some products such as syndicated loans will require more transition time, and multi-currency loans will require multiple RFRs making the transactions more complex.
Challenges will arise from a difference in visibility of interest payments, resulting from LIBOR being a forward-looking rate term and RFRs being historical, backward-looking overnight rates. In effect, RFRs will be calculated based on the median of individual daily rates that market participants pay to borrow cash on an overnight basis, thus making it harder to forecast what the interest payments will be. There will also be challenges with some products that require advance interest calculations such as receivable discounting, Islamic-compliant products (the profit rate is set in advance of the beginning of the relevant period) and project finance…etc.
Addressing the transition challenges
Making a plan to prepare for the transition is key, and there are several areas a bank should review to ensure a smooth transition away from LIBOR:
- Technology – Put measures in place to ensure that any technology applications used to support your processes and calculations have the functionality to support RFR-based finance requests.
- Contracts – Revise contractual agreements, apply fallout clauses to new requests, and conversion procedures to reduce any impact from legacy contracts.
- Strategy – Consider new business strategies to accommodate moving to new rates. Do you need to invest in new product development and pivot your business model?
- Communication – Engage, organize and train your required resources both internally and externally.
The pace of transition is accelerating fast and many market participants are now highly engaged in transition plans. However, if you are lagging behind, we are here to help! Surecomp has been using LIBOR for different calculations in many different areas of its solutions and as a result has also had to make the necessary adjustments to support our global customer base.
Now we are ready for the LIBOR sunset we want to ensure you are too so do get in touch if you’d like to discuss further.