Life after LIBOR

What happens when the “the world’s most important number” disappears? That is the scenario that the financial industry faces in the coming years as the London Interbank Offered Rate (LIBOR) is phased out.

The LIBOR ecosystem of interest rates has been a mainstay of the financial industry since the 1960s. Essentially, LIBOR is what some of the world’s biggest banks estimate they would charge to lend money to their peers. At present, these interbank rates provide the benchmarks for global transactions running into the hundreds of trillions of dollars.

But there are problems with LIBOR. Since the global financial crisis, there is not nearly so much interbank lending as there was before. So the banks’ LIBOR estimates are based more on judgement than actual transactions. As a result, and as successive scandals have shown, interbank offered rates have been open to manipulation by unscrupulous traders. Several have been jailed, and various banks have been heavily fined. LIBOR, then, has been deemed no longer fit for purpose.

Banks have been increasingly reluctant to publish their LIBOR submissions because of the conduct risks involved. The UK’s Financial Conduct Authority has announced that they won’t be required to do this from the end of 2021. So we will find ourselves in a completely different environment where some LIBOR rates will not be sufficiently supported.

The LIBOR benchmarks will be replaced by a whole host of new risk-free rates (RFRs)

The LIBOR benchmarks will be replaced by a whole host of new risk-free rates (RFRs). In the UK, the new benchmark will be SONIA, the Sterling Overnight Index Average. This RFR has been around for 20 years, but it has been administered by the Bank of England (BoE) since April 2016. The BoE implemented a reformed version in April 2018. As SONIA is based on actual transactions rather than estimates, it’s much more robust. In the US, the Federal Reserve now publishes the Secured Overnight Financing Rate (SOFR) so it can be considered robust and a sound reference point. In the Eurozone, the picture is less clear; one possibility is that ESTER, the Euro Short-Term Rate, will replace interbank rates. Meanwhile, other regional RFRs will thicken the acronym soup.

So far, so simple. But the actual process of switching from the LIBOR ecosystem to the new RFRs entails considerable challenges. It is not simply a matter of using RFRs for new contracts. While there has been significant growth in the number of transactions benchmarked to SONIA and SOFR, existing contracts still pose problems. Given the myriads of contracts that depend on LIBOR, with more created every day, there is much work to be done by just about every financial institution on the planet.

Fallback clauses are crucial here. Many contracts contain provisions for the event of LIBOR becoming unavailable. But this was generally envisaged as a temporary disruption, not a permanent retirement. Therefore, the consequences of relying on those clauses could be undesirable, with the possibility of unintended transfers of value between the parties involved. There’s a risk of instability in the financial system if a vast number of contracts are suddenly benchmarked at a different rate. Accordingly, the International Swaps and Derivatives Association is reviewing choices for more appropriate fallback clauses.

With all this in play, 2019 will be an important year. All financial institutions must ensure that their preparations for the end of LIBOR are well on track. This is not a task that anyone should underestimate. We are well advanced in our planning of this process.

So what will we be doing in 2019? Well, we are already actively participating in the official consultations on the subject. And we have representatives in working groups at all levels of the industry, engaging with the Bank of England, the Investment Association and other industry bodies. In the year ahead, we will be monitoring and leading market developments to ensure that both our teams and our clients are fully prepared.

As part of this, we are already undertaking a thorough assessment of the impact on the industry. This will be a key focus in 2019. In the case of contracts that mature beyond 2021, we will be making provisions for transitions that entail only minimal disturbance of the assets under management.

Meanwhile, we will be developing our capabilities to adapt to the new RFR environment so that we can continue to meet our clients’ requirements without disruption.

There is little doubt that the switch to RFRs is needed for the long-term health of the financial industry. The RFRs should prove more robust and reliable, and threaten the LIBOR ecosystem. Nevertheless, their adoption is one of the biggest shakeups that markets have faced in a lifetime. We will therefore be using 2019 to ensure that our clients experience a seamless transition to life after LIBOR. It is certain that all of us involved in the financial industry will be forced to adapt to this new environment over the coming years.

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