The switch from LIBOR

The London Interbank Offered Rate (LIBOR) is a measure of the average rate at which large London based banks can borrow unsecured funding from each other for short-term loans. It is a benchmark interest rate used in financial markets to price trillions of dollars of loan and derivative products around the world.

LIBOR is calculated and published each day by the ICE Benchmark Administration by taking a trimmed mean of the rates that the 16 main banks can provide. It is produced for 5 currencies (USD, GBP, EUR, JPY and CHF) and the rates have term structure that reflect market negotiated rates for seven varying tenors of up to 1 year.

So what is the problem with LIBOR?

The amount of activity in the interbank lending markets has significantly decreased over the last decade. This was influenced by stressed market conditions since the 2008 financial crisis but also due to the LIBOR scandal of 2012 which ultimately revealed that LIBOR is a flawed instrument vulnerable to abuse.

Figure 1- A graph of daily US interbank lending against time showing a clear downwards trend since 2008

Subsequently, the volume of daily transactions in the interbank lending market has plummeted and it can be seen in figure 1 that the volume in the US market has diminished from $500bn at its peak to under $100bn per day. This lack of liquidity in the market is why central banks are searching for alternatives.

In March 2021 the Financial Conduct Authority (FCA) announced that LIBOR was being phased out and would be replaced by alternative reference rates (ARRs) for all non-USD denominated currencies by the end of 2021.

The Sterling Overnight Index Average (SONIA) is set to be the UK’s replacement for LIBOR. SONIA has been an actively published interest rate since 1997 and in 2018 the Bank of England took responsibility for producing it. Like LIBOR, it is used to measure the cost of short term borrowing for banks however it has some fundamental differences.

First, it will be based on actual transactions as opposed to predictions based on analytical models and is supported by a market where the average value of transactions since April 2018 has been £45bn per day according to the Bank of England.

Secondly, it is an “overnight” rate and as such has no term structure or credit risk component, making it a better measure than LIBOR. It is also applicable for tenors longer than one day thanks to the SONIA compounded rate which is calculated iteratively using the SONIA compounded index by the Bank of England.

However the transition is not expected to be plain sailing with many experts worried that the switch could have widespread negative effects on various markets.

The floating-rate debt market is set to suffer because the compounded SONIA rate is a backwards looking rate (i.e. it is calculated using previous market data) and thus coupons cannot be calculated until right before maturity. This may disincentivise investment into floating rate products as there is uncertainty about what the rate will be.

The change is also likely to have a disruptive effect on existing products as the benchmark rate will have to be altered. Any contracts expiring after the cut-off will need to be redrafted with reference to SONIA instead of LIBOR. According to data from Oliver Wyman, this is expected to cost 14 of the world’s top banks $1.2bn.

With 2022 looming and ARRs set to take over from LIBOR as benchmark rate for all non-USD denominated currencies it will be interesting to see how the loan and derivative markets react to this change and ultimately, whether the benefits of the switch outweigh the costs in the long-run.