In 1969, Minos Zombanakis, a Greek banker based in London, sought to construct an $80 million loan to Iran; a country with limited foreign currency reserves at a time when interest rates were highly unstable. To achieve this, he was required to look beyond the traditional bond market and identify an alternative source of capital.
By marketing the loan to a syndicate of banks, Zombanakis funded the loan with a series of rolling deposits, for which the charging rates would be recalculated every few months, based on the participating entities’ funding costs, before the loan rollover date. The weighted average, rounded to the nearest eighth of a percentage point, plus spread for profit, became the price of the loan for the next period. And so the London Interbank Offered Rate (LIBOR) was born.
Soon, the benchmark evolved from a tool to price individual loans and bonds to the reference rate for derivatives worth billions. Today, it is estimated that LIBOR backs over $350 trillion of assets.
Transitioning away from LIBOR
In 2012 LIBOR was at the heart of one of the financial services industry’s biggest scandals. Its manipulation resulted in fines of over $10 billion around the world. Following a familiar pattern, the misconduct was addressed by introducing national and international measures to strengthen the rate’s transparency and reliability.
Despite the significant improvements made to LIBOR governance, the market for unsecured wholesale term lending to banks is no longer sufficiently active due to higher credit requirements. The rate is formulated using the expert judgement of the panel banks. The absence of an active underlying market means that reliance on the benchmark is no longer sustainable.
In July 2017, Andrew Bailey, Financial Conduct Authority (FCA) Chief Executive, announced that, from 2021, the regulator would no longer compel panel banks to submit rates to enable the calculation of LIBOR.
Mr Bailey announced a four-year period to allow for the development of alternative rates to ensure a smooth transition. Nevertheless, LIBOR is so deeply rooted in industry products and firms’ operating models, market participants face significant challenges to phase it out.
Switching to newly created near risk-free rates (RFRs) could profoundly affect business activities, product development, client interaction and financial performance, in addition to systems and controls. A proactive and coordinated approach, both intra- and inter-institution, will be crucial to ensure the development of alternative rates does not further complicate transition. The first step for institutions will be to develop a comprehensive assessment of the products, processes and systems likely to be impacted.
The first challenge market operators face is the replacement of existing LIBOR clauses. Most contracts contain fall-back language allowing for LIBOR to be replaced with an alternative rate. However, the use of such clauses is normally reserved for occasions when the benchmark is temporarily unavailable, not as a solution for its permanent replacement.
The use and nature of fall-back clauses varies depending on the type of contract. Some prevent their modification unless all or most parties agree to the changes, which poses an unprecedented administrative challenge. For instance, modifying syndicated credit agreements with a large number of lenders could lead to complex counterparty negotiations. Others, such as derivatives contracts, are likely to benefit from industry-wide guidance expected in early 2019.
Businesses face an intricate situation: by continuing with the provision of long-dated LIBOR products they increase the scale of the transition challenge. On the other hand, most systems are not yet ready to switch to alternative rates.
Institutions must initiate their responses, beginning with the futureproofing of new contracts, by including fall-back language that provides for the discontinuation of LIBOR. Before modifying any clauses, firms will need to undertake a detailed analysis to adapt their solution to the characteristics of differing business segments and product areas. This exercise will reduce legacy exposure and contribute to raising awareness about the transition, both internally and with clients.
The underlying complexity of LIBOR transition is quite different to a simple rate conversion. After all, LIBOR is published for multiple term rates (typically, one, three and six months), yet it is proposed that new rates are overnight. As a result, the transition could lead to disruptive value transfers, which could in turn affect risk and control management.
It is crucial that institutions develop adequate transfer models to manage the transition and, ultimately, mitigate the risk of future remediation scandals. This is particularly relevant in the case of retail clients, where the consequences of adverse impact will likely be significant (consider the far-reaching repercussions of IRHP and PPI mis-selling). As is the case with fall-back language, a detailed scenario analysis (possibly industry-wide) will be an essential building-block in understanding, then managing, an orderly transition.
There remain outstanding questions relating to the impact on interest rate models as a result of the loss of LIBOR derivatives market data. We are advising firms to begin monitoring the liquidity of both legacy LIBOR and new RFR-linked products across different jurisdictions. For instance, the Alternative Reference Rates Committee (ARRC) estimated that it would need three years to develop a liquid derivative market based on the Secured Overnight Financing Rate (SOFR). The active monitoring of RFR working groups’ publications will provide clarity and unity in efforts to overcome these challenges.
In addition, firms are also concerned by the tax consequences that the reissuance or amendments of certain contracts may have. For example, the replacement of intra-group LIBOR funding could lead to the contravention of corporate interest restriction rules, transfer pricing and thin capitalisation norms. The early identification of the parts of the business that could be affected by these issues will be essential for appropriate tax planning.
Fragmented global approach
The challenges global institutions face with the discontinuation of LIBOR will be intensified by the lack of coordination across jurisdictions. Regulators want the transition to be a market-driven event. However, the lack of top-level guidance could result in conflicting approaches, not only as far as the nature of the rates is concerned, but also in terms of transition timelines.
RFRs Across Jurisdictions
Go Live Date
Reformed Sterling Overnight Index Average (SONIA)
Bank of England
23 April 2018
Live Fully Transaction Based Cleared
Secured Overnight Financing Rate (SOFR)
Federal Reserve Bank of New York
3 April 2018
Live Fully Transaction Based Cleared Secured
Euro Short-Term Rate (ESTER)
European Central bank
By October 2019
Fully Transaction BasedNot Cleared
Swiss Average Rate Overnight (SARON)
Six Swiss Exchange
25 August 2009 (long history of publication)
Live Secured Cleared
Not Fully Transaction Based
Tokyo Overnight Average Rate (TONA)
Bank of Japan
1 November 1997 (long history of publication)
Live Fully Transaction Based Cleared
According to a recent survey by the International Swaps and Derivatives Association (ISDA), 75% of respondents had started to consider the LIBOR transition issue. Only a third had taken steps towards mobilisation. However, as the clock ticks down on the discontinuation of the rate, firms must redouble transition efforts. Some organisations have entered a vicious circle: they are wary of transitioning to new rates as they consider that there is not enough liquidity, yet building liquidity will be impossible until more firms adopt the new rates.
While the task appears daunting, market participants may remember that such a transition has occurred before, albeit on a smaller scale. In 2017, the Swiss successfully transitioned from an unsecured overnight index rate (TOIS) to the Swiss Average Rate Overnight (SARON). Given their wider resources, we expect large banks and global institutions to lead the way. Their early engagement with the regulators will be key to avoid future misconduct scandals, but, more importantly, to influence the most effective way to deal with the discontinuation of the benchmark.
Considerations and next steps:
Adopt a proactive and coordinated approach, both intra- and inter-institution, to ensure the development of alternative rates does not further complicate transition to RFRs
Conduct a comprehensive assessment of the products, processes and systems likely to be impacted
Undertake a detailed exposure analysis, assessing characteristics of fall-back language for contracts in differing business segments and product areas
Initiate future-proofing exercise, by including fall-back language that provides for the discontinuation of LIBOR in all new contracts
Develop adequate transfer models, founded upon detailed scenario analysis, to manage and mitigate transition risk
Monitor the liquidity of both legacy LIBOR and new RFR-linked products across jurisdictions and observe RFR working group publications to promote industry-wide clarity and unity of effort