Libor alternatives (and the concerns they raise)

"Bigger than Brexit" shift from benchmark no easy task

By Edwin Boadu | 6 August 2018

Dubbed “bigger than Brexit” by the Deutsche Bank treasurer, the shift away from the Libor benchmark is unprecedented.


Ever since evidence emerged of ‘the Libor Scandal’ back in 2008, and particularly its role in the crisis, global regulators are eager to move away from the benchmark.

Libor at a glance
The London Interbank Offered Rate (Libor and previously BBA Libor) is a benchmark rate based on five currencies –CHF (Swiss Franc), EUR (Euro), GBP (Pound Sterling), JPY (Japanese Yen) and USD (US Dollar) – that some of the world’s leading banks charge each other for short-term loans. Administrated by the ICE Benchmark (IBA), it serves seven different maturities: overnight, one week, 1, 2, 3 and 12 months. The review by the Financial Conduct Authority (FCA) initiated in 2013 unveils concerns with regards to the unsustainable nature of Libor as a benchmark and the urgency to move to another, more-sustainable benchmark.

$9bn levied by US and UK regulators in response to Libor collusion

Regulators in all major financial centres have already started publishing alternate reference rates, such as SOFR in the US, Sonia in the UK, Saron in Switzerland and Tonar in Japan. Finally, UK’s FCA announced, in the summer of 2017, that it will no longer require banks to submit rates required to calculate Libor after 2021.

Financial institutions are setting up task forces to deal with the impending loss of this benchmark in the financial services industry.

Here are the proposed solutions for global benchmarks and the concerns they raise.

Proposed solutions

LIBOR+

IBA may publish an improved version of Libor that operates on different calculation methodology linked to transactions from a much larger set of submitting institutions. Needless to be said, should Libor continue to be published albeit with a facelift, time and effort spent on the complete transition to another benchmark, would be reduced.

Risk Free Rates (RFRs)

In order to find new rates to use as benchmarks, efforts have been placed on the strengthening of existing Interbank Offered Rate (Ibor) and investigating alternatives to Ibors (namely, RFRs). The Financial Stability Board (FSB), with input from the Board of the International Organisation of Securities Commission, takes the lead in the investigation of such alternatives.

 

Concerns

Hedging

New Risk-Free Rates may not be congruent with all the different types of financial contracts. From this, an economic mismatch could arise between a derivative and the underlying hedged exposure. The mismatch could lead to broken hedges.

Contractual consequences

The Libor transition, coupled with the EU Benchmark Regulatory requirements (EU BMR), will make compulsory firms’ review and amendment of their contractual documentation with their counterparties. While 2021 will see the end of Libor, firms have until 1 January 2020 to make such amendments. Contract reference rate negotiations will be far from being easy.

Debt finance

The potential choice to use Sterling Overnight Interbank Average Rate (Sonia) may give way to structural complications. As such a replacement rate has yet not been tested as a forward-looking rate.

Update of systems, processes and controls

The transition will require firms to update their internal systems, processes and controls. For instance, payments systems will need to reflect the change in reference rates. Another example is that firms that hold intercompany loans and deposits that use Libor will have to take into consideration the implications of the transition on intercompany funding arrangements.

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