Retiring the LIBOR and the Future of Reference Rates

By Raghav Madhukar

This article is not about the pandemic nor the all-pervading economic crisis. Neither is it about the tumultuous state of American politics. It’s about the most significant news you’ve never heard of. Yes, I’m talking about the LIBOR; more precisely, its retirement. 

The London Interbank Offer Rate has long served as ‘The Undisputed Champion of Reference Rates’ in the international financial system. Today it is slated to be dethroned from its lofty perch after a much anticipated coup led by the Secured Overnight Funding Rate (SOFR). 

LIBOR is the arithmetic mean of the overnight interest rates at which banks expect to be charged for borrowing funds from one another. It is calculated by the Intercontinental Exchange across five currencies with varying maturities spanning one day, one week, and one / three / six / twelve months. LIBOR therefore serves as a benchmark for short-term interest rates internationally. Besides being an indicator of financial sector stability, perhaps the single most important application of LIBOR is in pricing floating-rate bonds and derivatives – interest rate swaps, currency swaps, and collateralized debt obligations in particular. The global market for LIBOR-linked financial instruments is estimated to exceed a whopping $ 200 trillion. 

With the scope and importance of the LIBOR established, why transition to a different reference rate? Simply put, the problems with LIBOR can be distilled down to three key areas of concern: (1) the incorporation of credit risk, (2) the possibility and precedence of rate manipulation, and (3) a diminishing market for interbank debt. 

Incorporation of Credit Risk 

LIBOR is by design calculated as the average value of unsecured interbank lending rates. Therefore, its intrinsic value incorporates a credit risk premium, accounting for the possibility of default. Monetary authorities and market regulators around the world have been advocating for a risk-free reference rate that is independent of such a credit risk premium. The Federal Reserve believes that such a rate would serve as a more appropriate reference for short-term rates. That said, the Market Participants Group (commissioned by the Financial Stability Board) also realizes the need for reference rates that account for bank credit risk – essentially a reformed LIBOR – to complement risk-free rates. A reformed LIBOR is proposed to be different in two ways. Firstly, it will be calculated across a larger universe of banks. Secondly, it will be based on a broader set of money market transactions, including commercial paper and certificate deposits. 

Rate Manipulation 

The second issue of manipulation stems from the “forward-looking” nature of LIBOR. As we established earlier, LIBOR is a survey-based rate which is arrived at by asking banks “at what

rate would you borrow funds in the interbank market ?” Since the LIBOR is based on a bank’s expectations of its borrowing costs as opposed to recent transaction data, it opens up a window 

for manipulation. Banks have in the past falsely influenced LIBOR either with the intention of misrepresenting financial health or to profit from holdings in LIBOR-linked products. 

LIBOR manipulation scandals have popped up in the news periodically since 2003. While several institutions – Barclays, Deutsche Bank, and Rabobank – have been held accountable on different occasions, Tom Hayes, a former trader at UBS and Citigroup in Tokyo, Japan, is perhaps the most famous LIBOR manipulator. Hayes led an international ring of interest-rate traders who colluded to influence LIBOR values to cover their speculatory trading positions. Hayes was the first person to be convicted of LIBOR-manipulation in 2015. 

The Diminishing Interbank Market 

The manipulation issue is exacerbated by another concern: the thinness of the underlying interbank lending market. There are very few transactions that take place per currency and tenor to support the LIBOR values being published. The size of the interbank lending market is less than $1 billion a day, while the LIBOR-dependent market exceeds $ 200 trillion. This imbalance between the underlying and the derived market size is concerning considering the ease of LIBOR manipulation outlined earlier. Moreover, unsecured interbank lending has persistently declined as banks are resorting to secured financing (as it avails borrowing banks lower rates and lending banks protection against defaults). Therefore, with the underlying market for LIBOR becoming less popular, it seems ever more prudent to replace LIBOR with a secured funding rate. 

A Better Alternative 

On the 22nd of June 2017, the United States Federal Reserve announced that it had chosen to replace LIBOR with the Secured Overnight Funding Rate (SOFR). SOFR is computed as the average rate at which investors offer overnight secured loans to banks, collateralized by bond assets. First, SOFR, as the name implies, is a secured funding rate. It is devoid of a credit risk 

premium, thereby giving it the status of a risk-free rate. Second, SOFR is ‘backward-looking’ in that it is computed using recent transaction data. This leaves no room for rate manipulation. Third, the size of the treasury repurchase (repo) market is estimated to be in the vicinity of $ 1 trillion per day, while the interbank equivalent falls short of $ 1 billion per day. Thus, SOFR is better poised to serve as a reference for short-term rates as its underlying market is sizable with respect to that of present LIBOR-linked products. 

Now that a suitable replacement is identified, only the hardest part remains – execution. The logistics of this transition are unsurprisingly challenging, as market participants, regulators, and bankers must work in unison to reprice derivative contracts to convert LIBOR-linked products to SOFR-linked ones. Additionally, SOFR values are bound to be lower than LIBOR as the former is based on secured lending. As a result the current plan is to take into account the LIBOR-SOFR

spread while renewing derivative contracts or floating-rate loans. Presently, this massive undertaking is being spearheaded by the Alternative Reference Rates Committee at the Federal Reserve in the US. The transition is expected to be completed towards the close of 2021. While the SOFR is the rate of choice in the US, other countries have chosen to approve similar replacements for LIBOR. The UK is adopting the Sterling Overnight Index Average (SONIA), while the ECB designed an equivalent Euro Overnight Index Average (EONIA). 

As governments, regulators and investors prepare to oversee the transition from LIBOR to SOFR, it is imperative to acknowledge the scale of operations, volume of contracts, and the sheer logistics of coordination that will have gone towards this effort. The retiring of the LIBOR will be a momentous shift, and is undoubtedly one of the greatest reformations in global finance since the turn of century – perhaps seconded only by the Dodd-Frank Act.