Libor (London Interbank Offered Rate) is used as a benchmark for most financial instruments such as loans, bonds, derivatives and structured products and has reigned supreme for more than three decades. However, the euro, Swiss-franc, sterling and yen versions of Libor will no longer be published from the start of next year, although the dollar version will survive until 2023 for its most common maturities. Libor rates have lost credibility because of the manipulation they have suffered and the decline of the interbank market. They will be replaced by new benchmark risk-free rates known as Alternative Reference Rates or ARRs. These are regarded as more reliable and robust by the Financial Stability Board, which is overseeing this international reform.
Renegotiating existing contracts
Whereas Libor was based on estimates made by a panel of banks, ARRs are calculated on the basis of actual transactions. Because of the complexity and amounts involved – in mid-2018, there were USD 400,000 billion of contracts linked to various Libor rates – this attempt to revolutionise benchmarks looked like an almost insurmountable challenge when it got underway in 2014. However, although some uncertainties remain, the finance industry has made extensive preparations for the great leap forward. It has done so in a spirit of international co-ordination that is rarely seen, although preparedness varies between countries. At the national level, the reform has been guided by working groups bringing together central banks, regulators and industry representatives. It has consisted of several major projects, such as identifying the new ARR, renegotiating existing contracts to adjust them to the new benchmark and adopting that benchmark for new contracts.
The UK seems set for a smooth transition on 1 January. SONIA (Sterling Overnight Index Average), which will replace Libor, is already widely used in the bond and derivatives markets. New sterling-denominated contracts and products stopped being linked to Libor in spring 2021. The eurozone is also ready to replace some of its benchmark rates, although it will keep its main one – Euribor – having revised its calculation method. €STR (Euro Short-Term Rate), which was launched in 2019, will replace Eonia (Euro Overnight Index Average).
Japan still has work to do. “There is only limited time left,” warned a Bank of Japan official recently, alarmed by the slow progress made by financial institutions in converting Libor-linked products to one of the three alternatives being considered, including TORF (Tokyo Term Risk Free Rate), launched in early 2021.
The transition is also making a lot of people nervous in the United States. To give market participants more time to renegotiate existing contracts, US-dollar Libor will continue to be published until mid-2023, although regulators are demanding that new contracts stop referring to it from the end of 2021. SOFR (Secured Overnight Financing Rate), published by the New York Federal Reserve, has been chosen as the new benchmark. However, it will see competition from well-established benchmarks such as the Fed Funds and Overnight Index rates. Many people, including Treasury Secretary Janet Yellen, have called for those concerned to ensure a more orderly transition.
The situation appears to be better in Switzerland, where preparations for the post-Libor era are progressing according to the Finma roadmap. Switzerland already had a benchmark with a solid history of liquidity in the form of SARON (Swiss Average Rate Overnight). SARON, created in the aftermath of the 2008 crisis, reflects the terms of overnight transactions in the money market, and is the logical successor to Libor. It has been adopted by all banks, and on 30 June became the benchmark for all new contracts.
Preparations for 1 January, however rigorous they have been, have not been enough to dispel all doubts. Unlike Libor, which is calculated for maturities ranging from one day to one year, the new benchmarks are backward-looking, and this has forced banks to develop costly techniques to ensure that their clients still have access to rates that are known in advance.
Switzerland has opted for an ARR
In addition, since ARRs only reflect “risk-free” short-term transactions and so do not take into account liquidity and counterparty risks (unlike Libor), the industry will have to learn how to factor these risks back into the cost of credit. Various benchmarks have been created for that purpose (Bloomberg Short Term Bank Yield Index, American Interbank Offered Rate, IHS Markit USD Credit Inclusive Term Rate, etc.), but there is no clear front-runner among them.
Finally, the finance industry will have to juggle rates that are difficult to compare. Countries like Switzerland have opted for an ARR based on secured loans, while others have not. It is therefore impossible to say which benchmarks will come out on top for the financing of international commercial transactions (trade finance or syndicated loans), an area in which Libor used to be the undisputed leader. The industry must therefore expect to go through an adjustment phase, in which new standards will emerge. As in any period of change, this will involve learning from experience.
Philip Adler
Global Head of Treasury & Trading