What is LIBOR?

The London interbank offered rate (LIBOR) and other IBOR benchmarks are the interest rates banks pay to borrow money from each other and are also the basis for determining the rates charged on many other kinds of loans. It has been a key part of the functioning of financial markets since the 1960s.

Why is it being phased out?

Confidence in the reliability of LIBOR was eroded after the 2008 financial crisis by well-documented cases of attempted manipulation and false reporting. The LIBOR rate was set by a panel of banks that submitted short-term borrowing rates based on expert judgement. It emerged in 2012 that bankers at many major financial institutions colluded in a scheme to manipulate LIBOR for the purposes of profit.

What will replace LIBOR?

The Bank of England established a working group in 2015, consisting of a panel of major banks, which, in April 2017, recommended the Sterling Overnight Index Average (SONIA) benchmark as its preferred risk-free rate, and since then has been focused on how to transition to using SONIA across sterling markets.  

SONIA was launched in March 1997 by the Wholesale Markets Brokers’ Association – now part of the European Venues and Intermediaries Association (EVIA) – but since 2016 has been administered by the Bank of England. According to the Bank of England, the decision to adopt SONIA was based on “robust transaction volumes” and how it measured overnight interest rates in a way that was “considered close to risk-free”, thereby minimising “opportunities for misconduct”.

How does SONIA work?

It tracks the rates of actual overnight funding deals on the wholesale money markets and, unlike LIBOR, does not rely on submitters but on actual transactions. SONIA went through a period of reform, which ended in April 2018, in order to capture a broader range of transactions and increase the underlying volumes that the benchmark was based upon, improving the sustainability and representativeness of the benchmark.

What outstanding notional exposure does LIBOR have?

Based on publicly available data, total outstanding notional exposure to LIBOR has been estimated at over US$370tn, according to the International Swaps and Derivatives Association (ISDA), a trade body for participants in the derivatives market. Derivatives, syndicated loans, securitisations, business and retail loans, floating-rate notes (FRNs) and deposits are all significantly exposed to LIBOR.

This market comprises more than £30tn of over-the-counter derivatives and £4tn of exchange-traded reference LIBOR. LIBOR is also important for the real economy, providing a reference for more than £200bn of small and medium-sized enterprise (SME) and corporate loans, around £125bn of FRNs, and £200bn of structured debt.

Will market participants will be ready?

The IBOR global benchmark transition report, carried out by EY on behalf of ISDA in 2018, involved analysis based off in-person interviews and electronic surveys with 150 market participants in 24 countries. It finds that while almost nine out of ten respondents are concerned about their exposure to LIBOR and other interbank rates, only 12% have developed a preliminary project plan.

How will the sector deal with legacy LIBOR contracts?

Nearly US$2tn in loans may need to have their documentation revised following the discontinuation of LIBOR (and other IBOR) benchmarks in 2021. Millions of documents will need to be reworked for loans that reference LIBOR but that will mature after the switch off date.

ISDA is also working on the development of robust replacement language in new contracts to mitigate the risk of a permanent end to LIBOR. This will require the creation of an alternative rate to replace LIBOR in old and new contracts before 2021. In 2018, Andrew Bailey, head of the FCA, raised the idea of a synthetic LIBOR. However, this remains controversial as it may impede the adoption of risk-free rates, causing market fragmentation.

How is the transition from LIBOR to SONIA progressing?

In May 2019, the Working Group on Sterling Risk-Free Reference Rates (RFRWG), which is made up of experts from major sterling swap dealers and hosted by the Bank of England, said sterling-denominated financial markets had begun to “shift decisively” away from LIBOR and towards SONIA over the past year.

In the derivative markets, the share of swaps traded using SONIA was broadly equivalent to that linked to LIBOR, as of April 2019. Liquidity and open interest in SONIA futures was also growing steadily, the Working Group said: in the previous three months, more than 25,000 lots a day had been traded across three exchanges.

SONIA is also being adopted in cash markets. SONIA-linked FRNs have rapidly become the market norm, and LIBOR-linked sterling FRN issuance beyond 2021 has all but ceased. In April, Nationwide Building Society issued the first SONIA-linked residential mortgage-backed security, following two other securitisations that were retained in December 2018 and March 2019. The Association for Financial Markets in Europe (AFME) has produced model securitisation wording for the new issue of bonds, providing a new and easier mechanism to accommodate the transition from IBOR to an alternative benchmark rate in the event of LIBOR becoming unavailable.

However, while there has been considerable progress in the sterling markets, the cessation of LIBOR, and other IBORs, is an international issue. As we get closer to the likely end of LIBOR in late 2021, there are concerns that the underlying interbank overnight borrowing market, which LIBOR is based upon, suffers from too low a volume to provide a reliable, representative benchmark.

Effort must be made to ensure different jurisdictions have a coordinated transition to risk-free rates. The Global Financial Markets Association, which brings together AFME, the Securities Industry and Financial Markets Association (SIFMA) in the US and ASIFMA in Hong Kong, released in April an IBOR transition document summarising the work completed to date in the five major jurisdictions, including the current state of fallback wording reform and term rate development.

The full article appears in the July 2019 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.

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