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The Transition from LIBOR

By Jamie Johnson

What is LIBOR?

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate. This means that it is a standard against which interest rates are determined for loans.

LIBOR is set for five different currencies (the dollar, the pound, the yen and the Swiss franc) and is calculated for seven different loan terms.

How is LIBOR calculated?

LIBOR is calculated by the Intercontinental Exchange (ICE). It suggests what a bank’s cost of borrowing is when it borrows from different banks.

The ICE Benchmark Administration asks 11 to 18 banks every day what interest rate it would get on a loan from another bank that day. This survey data is then used to calculate different LIBOR rates.

Why does LIBOR matter?

LIBOR is used as a benchmark for debt all around the world. An estimated $350 trillion in financial contracts are linked to LIBOR across the globe. For reference, this is over four times the global GDP.

The reason why LIBOR is so essential is that it shows how cheaply credit is realistically available for a bank. Consequently, it makes sense to peg interest payments to the LIBOR rate. If a bank finds it too costly to borrow money from other banks, then it will require more capital from its existing borrowers. In addition, if LIBOR rises then that bank will find that the loans it has taken out from other banks will cost more. Consequently, it will need a larger cash flow to repay these debts.

LIBOR is used internationally because of the need in the 1980s to use a standardised interest rate benchmark. This saw its development as a significant international benchmark, and now it is used throughout the world.

Why is LIBOR being phased out?

There are two principal reasons why LIBOR is being phased out: the LIBOR scandal and the fact that it does not reflect borrowing costs that banks regularly have.

It is unclear precisely when the LIBOR scandal began but it is estimated to have started in 1991. During this scandal, banks falsely reported the cost of borrowing that they would have. This allowed banks to inflate or decrease LIBOR in a way that maximised their profits. The immediate result of the scandal was that the organisation assessing LIBOR became ICE instead of the British Bankers Association (BBA). The longer-term ramification was that regulators did not trust the measure as much.

Linked to the scandal, there is an issue over how appropriate LIBOR is as a measure at all. In 2017, Andrew Bailey (the CEO of the FCA at the time) said that LIBOR measured a market for loans that was not particularly active in the UK. For instance, he noted that LIBOR rates just applied for 15 transactions of a “qualifying size” in 2016. This means that LIBOR does not really reflect borrowing costs that banks regularly have.

What is replacing LIBOR?

LIBOR is being replaced by the Sterling Overnight Index Average (SONIA) in the UK.

SONIA is calculated by looking at reported interest rates in cash and derivative markets. This means that SONIA is retrospective, whereas LIBOR is a projection of what banks should expect as an offered interest rate in the future. SONIA is calculated at the end of an agreed period, which adds a degree of certainty to borrowers as to how much their borrowing will exactly cost.

LIBOR’s transition to SONIA is supposed to finish by the end of the first quarter of 2021.

What are the advantages of the transition from LIBOR to SONIA?

In addition to the issues of the accuracy of LIBOR, loans based on SONIA might have a lower interest payment and may be easier to predict.

The SONIA rate is generally lower than the LIBOR rate because it does not account for the credit risk premium. Thus, existing loans might be lower. However, this is dependent on lenders not adding in clauses such as a credit adjustment spread to make up for the lost interest.

SONIA may also be easier to predict because it is calculated looking back upon transactions that have already occurred. Thus, market participants would find it easier to estimate what the SONIA figure is. Meanwhile, as LIBOR is forward-looking, it would be hard for market participants to predict what the benchmark will be at any particular time.

What are the disadvantages of the transition from LIBOR to SONIA?

There are both legal and financial costs to transitioning towards SONIA.

In terms of legal costs, the transition to SONIA means that contracts currently need to be drafted to account for what will happen to the interest rate when SONIA applies instead of LIBOR. These stipulations could lead to parties disagreeing over how exactly interest should be calculated when SONIA is fully introduced.

In terms of financial costs, actors will need to put in place systems to adapt to the new way in which interest is calculated. Lenders may also find that the rate of return they get from existing loans could decrease if they have not agreed upon a credit adjustment spread with borrowers.

Case studies

Singapore transitions from LIBOR – (September 2020) Singapore has been a leading country when it comes to moving from LIBOR. The Monetary Authority of Singapore (MAS) has encouraged deals to be tied to the Singapore overnight rate average (SORA). Wilmar International and CapitaLand have done Sora-linked bilateral loans worth US$146 million and US$112 million respectively.

The United States delays its transition from LIBOR – (December 2020) The US has announced that it will delay its transition towards the Secured Overnight Funding Rate (SOFR) to June 2023. This delay is greater than the delay in the transition for the UK market. The main reason for this delay is the challenges to firms from the COVID-19 pandemic.

Switzerland struggles in its transition from LIBOR – (March 2020) Despite LIBOR being suspended, approximately 80% of the CHF loans come from CHF LIBOR. Switzerland is planning on transitioning towards the Swiss Average Rate Overnight (SARON).

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