The journey away from LIBOR
The London Interbank Offered Rate, LIBOR, is as well-known as it is widely used across the financial services industry. But LIBOR will no longer be published after the end of 2021 and this means that the industry must take significant steps to prepare for it to disappear from funds, investments and legal agreements.
Aberdeen Standard Investments has a programme underway to ensure we manage the impact on our clients and customers in an orderly and effective way. We explain here what we’re doing and why.
What is LIBOR?
LIBOR is the quoted average index rate banks charge each other for short-term loans. It is calculated and published daily in five currencies (USD, GBP, EUR, CHF and JPY) and across seven tenors, or time periods. LIBOR is published by the Intercontinental Exchange Benchmark Administrator and is based on submissions from a selection of panel banks.
It is one of the most widely used interest rate benchmarks in global financial markets and is used in a variety of financial contracts and investments including loans, bonds and derivatives.
Why is LIBOR changing?
Since the 2008 financial crisis, the number of panel banks reporting their funding rate has declined and the remaining banks that do submit a rate are reporting significantly fewer transactions. LIBOR is no longer seen as a robust representative of lending transactions but rather an outcome of the ‘expert judgement’ of panel banks concerning their borrowing costs. This has made LIBOR more open to vulnerabilities and past manipulation.
The Financial Stability Board recommended in 2014 that benchmarks, such as IBORs, be based on actual transactions as far as possible. Substantial consultation followed and in 2017, the Financial Conduct Authority and the Bank of England raised questions about the future sustainability of these rates, obtaining voluntary agreement from the LIBOR panel banks to continue to make their daily submissions only until the end of 2021. It is expected that markets will transition away from LIBOR to alternative reference rates (ARRs) by that time.
What will the replacements be?
Industry working groups in several jurisdictions have already identified the ARRs. The main ones are:
|Country||LIBOR Rate||Alternative Reference Rate|
|United Kingdom||GBP LIBOR||SONIA (Sterling Overnight Index Average)|
|United States||USD LIBOR||SOFR (Secured Overnight Financing Rate)|
|Europe||EONIA and EUR LIBOR||ESTR or €STR (Euro Short Term Rate)
Note – a reformed version of
EURIBOR is expected to be retained
|Switzerland||CHF LIBOR||SARON (Swiss Average Rate Overnight)|
|Japan||TIBOR, JPY LIBOR||TONAR (Tokyo Overnight Average Rate)|
|Australia||BBSW||AONIA (Australian Overnight Interest Average)|
What is the difference between the current rates and the new reference rates?
There are several differences. The current rates are based on ‘expert judgement’ submitted by the panel banks whereas the new ARRs are based entirely on transaction data. Secondly the ARRS are based on daily overnight rates compared with current rates that are forward-looking and vary in tenor from one day to one year.
Lastly, current rates like LIBOR have a built-in credit risk component due to the counterparty risk of interbank lending. ARRs do not incorporate these risk premiums and as such are often referred to as “risk free rates” (RFRs). It should be noted that they are rates free of counterparty risk, not all risk.
As the industry transitions from IBORs to RFRs there will be a spread applied to take these differences into account. There is much discussion on how this should be calculated, and regulators have encouraged the methodology to be outlined in ‘fallback’ clauses in all new contracts.
How will this affect our clients and customers?
The main effect will be on clients invested in our funds, many of which reference LIBOR as a benchmark. To change these benchmarks, we need to seek regulatory approval and potentially approval from the investors in that fund.
We will be writing to all affected investors to let them know what the benchmark of their fund will be changing to and any effect it will have on them. We expect to see the benchmarks change for our different fund ranges during 2021.
For clients that have segregated mandates, we will reach out directly to update any necessary legal documentation, particularly benchmarks within their investment guidelines.
Within our funds and mandates, we invest in a wide range of instruments linked to different IBORs, including loans, bonds and derivatives. As the manager of these portfolios, we always strive to achieve the best outcome for our clients. So we are very carefully monitoring pricing and liquidity in new instruments that replace existing IBOR-related ones and will transition our holdings at the right time for clients. We expect in many cases this will be before the end of 2021 but where this is not right for clients we are working closely with market counterparties to utilise the framework of “fallback protocols”, such as those being developed by the International Swaps and Derivatives Association (ISDA).
If you have any questions on any of the items contained in this article, please contact your usual ASI representative.