August 26, 2020 / 01:03 PM / By Dr. Dayo Abinusawa of Awa Brokers / Header Image Credit: Wikipedia
Why is LIBOR Important?
LIBOR related activity is estimated at $300 trillion globally. It is often referenced in derivative, bond and loan documentation, and in a range of consumer lending instruments such as mortgages and student loans. It is also used as a gauge of market expectation regarding central bank interest rates, liquidity premiums in the money markets, and during periods of stress, as an indicator of the health of the banking system.
LIBOR is currently produced for five currencies (USD, GBP, EUR, CHF and JPY) and for seven tenors in respect of each currency, each business day2. The benchmark is derived from a daily survey of bankers who estimate how much they would charge each other to borrow
Why is LIBOR Being Replaced?
For over 50 years, the Interbank Offered Rates (IBORs), especially the London Interbank Offered Rate (LIBOR), have served as a benchmark interest rate at which financial services firms lend. While LIBOR is considered to be one of the most crucial interest rates in finance, it is being replaced due to (a) the 2013 scandal and (b) changes in the interbank funding markets which have meant that IBOR panel bank submissions were based less on observable transactions, and more on expert judgement.
Though significant improvements have been made to the benchmark since 2013, the absence of active underlying markets raised a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets. This concern underlined the 2017 announcement by the then Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey who said it was the FCA's intention that, at the end of 2021, it would no longer be necessary for the FCA to persuade, or compel, banks to submit to LIBOR4. An indication that all market participants including lenders and borrowers will need to make changes over the coming months and years, but few firms are prepared.
Why are Risk Free Rates an Alternative to LIBOR?
Regulated firms such as banks, insurers and asset managers are required to have a plan for cessation or material change in a benchmark like LIBOR5. While LIBOR will continue to be published until end-2021, to address financial stability risk, regulators expect firms to turn focus towards developing alternative rates and a smooth transition away from LIBOR before its cessation.
In producing a fair replacement rate for LIBOR, regulatory authorities are focused on enhancing the robustness of derivatives contracts and interest rate benchmarks that are considered to play the most fundamental role in the global financial system6. These replacement rates are based on the Risk Free Rates (RFR) recommended as alternatives to LIBOR by the relevant authorities in different currency jurisdictions, as follows:
A smooth transition towards the RFR is necessary for the stability of the financial markets. Having robust fallbacks for financial contracts that reference an IBOR is critical for stability because if an IBOR permanently ceases to exist, it is vital that market participants have certainty that their existing IBOR contracts will fall back to a robust and clearly defined reference rate7. Additionally, it's important that a switch to the RFR occurs with the minimal amount of disruption, which is why market participants should have removed dependencies on LIBOR by its cessation.
About the Author
Dr. Dayo Abinusawa is the strategy advser at Awa Brokers.