After being wrought with scandal for too many years now, the U.K. Financial Conduct Authority that regulates LIBOR finally announced last week the phase out of the index by the end of 2021. LIBOR which stands for the London interbank offered rate measures the interest rate at which banks lend to each other, and is often used as a benchmark to price the interest rate on loans and in derivative contracts. The impact on existing agreements whether on mortgages, asset backed loans or associated derivatives remains unclear.
While LIBOR’s current administrator, the ICE Benchmark Administration, intends to fight plans to replace the index and could continue to provide LIBOR levels, banks may not be compelled to do so as they are now. LIBOR users need to consider a change in the current basis for the index on contracts that extend beyond 2021.
Several alternative solutions have been proposed including:
- In the U.S. the Alternative Reference Rates Committee (ARRC) suggested using a broad Treasuries repo rate, which could be linked to the cost of borrowing capital against U.S. government debt. The overnight index swap rate (OIS) and/or the fed funds rate could also play a bigger role in lieu of LIBOR.
- Similarly, the Bank of England’s Risk-Free Rate Working Group in the UK selected SONIA (Sterling Overnight Index Average) as its proposed alternative benchmark. Further, as Brexit negotiations continue and as the UK prepares to leave the EU, the importance of the London financial markets may dwindle, resulting in increased volatility in LIBOR and prompting a shift to other benchmark rates.
- Other overnight rates could serve as benchmarks in their respective currencies, including the euro’s overnight rate (EONIA), Swiss SARON and Japan’s TONAR.
Here are some of the challenges and key points BMA sees that Clients should consider addressing:
- Ensure any proposed alternative continues to have depth and liquidity – amended terms should also include a proposed backup index.
- The term fixings of the proposed alternative index should be comparable to existing terms.
- Mutually agreed upon strategy with legacy deals to ensure smooth transition.
- Increased volatility and reduced liquidity will likely be a result with the end of LIBOR, unless a “suitable” index and/or “fair” replacement strategies are designed, particularly for legacy trades.
Lessons can be learned from our friendly neighbors to the north. The Canadian authorities have taken steps to improve the governance framework for its domestic benchmarks. For example, the Canadian Dealer Offer Rate (CDOR – Canada’s answer to LIBOR), is based on an executable lending rate referenced by the major Canadian banks in their lending facilities for banker’s acceptances (BAs), as opposed to a theoretical rate that drives LIBOR. The consistency of an executable lending rate is further sharpened as CDOR submissions are provided from the bank side, rather than from the dealer side, of each institution.
Market practitioners such as PIMCO remain skeptical that this is the end for LIBOR. PIMCO believes given the volume of transactions based on the index coupled with the complexity of doing away with index, may give way to LIBOR’s survival after 2021. Whether they are right or not, it’s wise to come up with a Plan B.
