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Date: December 18, 2017
Category: Credit

Replacing LIBOR: Challenges and Possibilities

Imagine a single number so powerful that it affects financial instruments around the world ranging from credit derivatives to credit cards, touching the lives of investors and consumers everywhere. A number so influential that it underpins $350 trillion worth of loans.1

Now, imagine that number going away.

That number is called LIBOR, and it is scheduled to vanish from our financial system in 2021. You may have heard that LIBOR is being replaced, and wondered if this was relevant to you. It almost certainly is.

If you have a variable-rate student loan or an adjustable-rate mortgage, there’s a good chance that your monthly bill moves up and down in line with LIBOR and, if you’re an investor, many elements of your portfolio are similarly exposed. That means the end of LIBOR may have a direct impact on your bottom line.

What is LIBOR?

LIBOR, the London interbank offered rate, is a benchmark interest rate that is widely used to set interest rates on a range of different debt instruments.2

LIBOR is an index of the interest rates that London-based banks charge one another for unsecured loans. Every morning, Reuters publishes LIBOR rates for five currencies—the U.S. dollar, euro, British pound, Japanese yen, and Swiss franc—and for seven time periods that range from one day to one year. Banks and other financial institutions use this information to set the interest rates that they charge companies, governments, and individuals for various loans.

At least, that’s how things have worked until now. Major changes are afoot due to dramatic revelations about the quality and sustainability of LIBOR.3

It started with a scandal in 2012, when it came to light that the bankers who set LIBOR had been manipulating the rate to generate trading profits. Regulators fined the banks billions of dollars and several bankers went to prison.

The U.K.’s Financial Conduct Authority (FCA) took control of LIBOR and implemented various reforms to make the index more transparent and reliable. However, in July 2017, the FCA announced that it was planning to phase out LIBOR by 2021.

According to the FCA, banks no longer want to participate in setting the rate, primarily because the interbank lending that LIBOR is meant to track had dried up as financial markets changed after the 2008 crisis. With fewer trades to track, the index was increasingly based on thin data supplemented by bankers’ so-called “expert judgement” of what the rate should be.4 In short, according to the FCA, LIBOR is no longer a useful measure and must be replaced.

What will replace it?

Currently, $350 trillion in loans are indexed to LIBOR. For the most part, this means that the rates those loans pay is tied to LIBOR. So when LIBOR rises, these borrowers pay more, and when LIBOR falls they pay less. Once the FCA phases out LIBOR, these loans will need to find a suitable replacement to use when determining the rates they must pay.

Various alternatives have been debated, and in the U.S., the Federal Reserve has settled on a candidate. In August, the Fed requested public comment on a proposed rate based on overnight repurchase transactions secured by Treasuries, the Secured Overnight Financing Rate (SOFR).5

A repurchase agreement (repo) is a transaction where one party sells an asset to another with a promise to repurchase it at a specified date. Repos are essentially collateralized loans.6 The collateral provider needs cash, and agrees to “sell” an asset to the cash investor. The collateral provider gets the cash it needs, and then at an agreed-upon date, it buys back the asset so the cash provider is reimbursed for the “loan.”

In the U.S., the repo market plays a major role in funding for banks and hedge funds, and most repo trades are backed by U.S. Treasuries.7 Therefore, the Treasury-backed repo market is large and relatively deep, so the SOFR should, in theory, be a reasonably robust measure.

However, some have expressed concern because the SOFR excludes a large number of repo deals. In particular, it doesn’t include deals that involve just a buyer and seller, with no clearing bank or third party, or deals in which the Fed acts as a counterparty. These deals make up a sizeable chunk of the market, so their exclusion may make the SOFR less robust.

The outlook: update in progress

The Fed will be addressing these and other concerns over the next few months. Once the revision period is concluded, the Fed will begin publishing the SOFR in the first half of 2018.

When the new index is established, it will then be up to the lawyers to start working out how to transition existing loan contracts that specify the use of LIBOR to the new rate. This all adds up to interesting times ahead for credit markets.

Bloomberg. Libor Funeral Set for 2021 as FCA Abandons Scandal-tarred Rate. 7/27/17.

The Balance. What is Libor? 7/27/17.

Council on Foreign Relations. Understanding the Libor Scandal. 10/12/16.

BBVA. Libor: Is There a Right Time to Pull the Switch? 8/29/17.

Federal Reserve Board. Federal Reserve Board Requests Public Comment on Proposal to Produce Three New Reference Rates. 8/24/17.

New York Federal Reserve. Everything You Wanted to Know about the Tri-Party Repo Market, but Didn’t Know to Ask. 4/11/11.

Risk. Libor’s Sunset Sees US Repo Market Cast a Longer Shadow. 9/11/17.

This information is educational in nature and does not constitute a financial promotion, investment advice, or an inducement or incitement to participate in any product, offering or investment. It is not intended to be used as a tool to determine your clients’ specific financial situation, tax status, investment objectives, investment experience, suitability for any specific investment, risk tolerance or investment profile. Resource is not adopting, making a recommendation for or endorsing any investment strategy or particular security.

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