LIBOR – the London Interbank Offered Rate – has been used since the 1970s in many areas of finance. Whether arranging personal or corporate finance, the chances are you will have come across LIBOR on several occasions. It offers a benchmark interest rate that lenders can charge on a range of different financial products. However, regulators have decided that LIBOR won’t be used from the end of 2021, switching to other “more representative” indicators.
How is LIBOR calculated?
At the moment, LIBOR is calculated using interest rate estimates from up to 18 global banks on a range of different financial products. These estimates are based upon what each bank would expect to pay in interest when borrowing money from another bank on the interbank lending market. The information is submitted daily to the Intercontinental Exchange (ICE). As a means of stripping out potential anomalies, the four highest and the four lower submissions are removed. Then, an average of the remaining estimates is used to calculate LIBOR. This is where the problems begin!
Before we proceed, it is vital to appreciate the global reach of LIBOR, which is calculated in five different currencies:
- UK Sterling
- Swiss Francs
- Japanese Yen
- US Dollar
While considering the impact of removing LIBOR in the UK, it is essential to note the ripple effect across international money markets.
Estimates over transactions
Many people will be surprised to learn that the LIBOR figure is based on estimated borrowing costs against actual borrowing costs, leaving the market open to manipulation. Unfortunately, an investigation in 2012 found evidence of market manipulation by Barclays, Deutsche Bank, Rabobank, UBS and Royal Bank of Scotland. The scale of the manipulation shocked regulators, investors, lenders and borrowers, with evidence of long-term collaboration between various banks.
The main element of LIBOR open to market manipulation is the credit/liquidity risk premium. It appears that the banks colluded to control this risk premium for financial gain. Therefore, it will come as no surprise to learn that the replacement for LIBOR will not include any reference to credit/liquidity risk.
What is replacing LIBOR?
It is fair to say that it will be a difficult transition for many companies, switching from LIBOR to the preferred measurement in their country. The ditching of LIBOR has created a scenario where different countries are looking to regain control of their interest rate measurement tools. LIBOR will be replaced by SONIA (Sterling Overnight Index Average) in the UK, a risk-free measurement of interest rates. International LIBOR figures will be replaced as follows:
- Switzerland, SARON – Swiss franc risk-free rate
- US, SOFR – Secured overnight financing rate
- Japan, TONAR – Tokyo overnight average rate
- Europe, €STR – Euro short-term rate
The transition will be challenging when you consider the trillions of pounds, Swiss francs, US dollars, Japanese yen, and euros of outstanding finance based on LIBOR.
Why did the UK authorities choose SONIA?
Before we look at SONIA in more detail, it is essential to note this is an overnight interest rate. First introduced in March 1997, the Bank of England took responsibility in 2016 and introduced several reforms in 2018. These reforms were needed to ensure that SONIA calculations complied with international best practices. Historically, as well as the overnight LIBOR rate, there were LIBOR rates published for one month, three-month and six-month terms. Therefore, the range of SONIA rates will be nowhere near that of LIBOR.
While it is fair to say that the LIBOR scandal did play a part in the forthcoming switch to SONIA, many already believed LIBOR was an outdated measurement. The fact that it was based upon estimates instead of actual market data left scope for manipulation, as we saw. In the future, SONIA will be based on overnight index swaps for unsecured transactions in the sterling market.
How will existing LIBOR finance contracts operate?
The Financial Conduct Authority (FCA) has ruled that all legacy contracts (except for cleared derivatives) will continue using a synthetic LIBOR rate. While this rate will be calculated without using trading data, it will not be open to the level of manipulation in years gone by. It will be interesting to see how other countries look to manage the long-term move away from LIBOR in relation to existing LIBOR-based contracts.
As LIBOR incorporates an element of credit/liquidity risk, and SONIA does not, this has caused some confusion. The automatic assumption would be that the SONIA rate will be less than the historic LIBOR calculation. However, in reality, financial companies are likely to enhance the published SONIA rate to take into account a degree of credit/liquidity risk. Consequently, you will likely see little difference in the historic LIBOR calculation and its future replacement SONIA, at least in the early days.
Businesses, investors and markets need to adjust
While legacy contracts in the UK, and potentially other countries, will still be based upon a synthetic version of LIBOR, markets will need to adjust at some point. One area of concern is hedging, a type of insurance, when moving from one interest rate index to another. The funds involved in hedging mean that any miscalculations or misinterpretations could prove costly. So investors, regulators and hedge fund managers will be observing these developments very closely!
Early indications suggest that lenders will, in the future, add their own estimated credit/liquidity risk to the UK SONIA rate. So, how will regulators monitor market activity as we approach the end of 2021 and the switch from LIBOR to SONIA? Can widescale market manipulation, which was the final nail in the coffin for LIBOR, be deterred and avoided?
Switch to SONIA, short-term pain, long-term gain
Those reading about recent market investigations into LIBOR manipulation will be astounded that such an important international financial yardstick could be manipulated. Evidence suggests there has been long-term cooperation between banks as a means of increasing their perceived financial strength and ultimately profiting.
There is already a very liquid market in SONIA, but the main challenge will be educating businesses and the broader public about the forthcoming change. While it may take some time for legacy LIBOR contracts to run their term, the days of LIBOR are numbered.