The world’s most highly accepted benchmark reference rate is set to sunset publication as a global reference rate on December 31, 2021. For a long time, the London Inter-Bank Offered Rate (LIBOR) has been an important part of virtually every form of financial commodity available on financial markets worldwide, from comparatively basic consumer goods to the most nuanced and sophisticated regulated commercial products.
LIBOR is regulated by the Intercontinental Exchange, which asks large global banks operating in London financial markets to report how much they would charge other banks for hypothetical and real short-term loans. The rate is essentially averaged or measured using the Waterfall Method, which is a standardized, transaction-based, data-driven, layered method. However, LIBOR has been exposed to manipulation, scandal, and methodological scrutiny, leaving it less trustworthy as a benchmark nowadays. The LIBOR scandal arose when certain banks were accused of either inflating or understating rates in order to potentially profit in trading activity related to the index. Despite this scandal LIBOR continues to underpin many financial contracts around the world.
As Murray Longton, a consultant at Capco who advises financial firms on the LIBOR transition, said: “Libor is embedded everywhere in the plumbing of the financial world, that’s why this is such a big challenge.”(1) He added, “You are changing a product that has been used to create markets for a long time. You are not just taking one thing out and putting one thing in but changing the whole dynamic of how this works.”(1)
Since the recent financial turndown and recession, already underway was an effort to slowly move away from LIBOR to alternative rates such as a more transparent, robust overnight risk-free rate. Following the financial crash of 2008, structural improvements have been made to the global banking structure, forcing banks to concentrate on liquidity indicators and on-hand liquidity in order to minimize the volume of interrelated funding exposure. This change was accompanied by a large decline in interbank loans, and the declining amount of these interbank loans on which the LIBOR rate is based tended to undermine it as a benchmark based on legitimate monetary transactions.
Regulators are currently and actively urging banks and companies to concentrate on moving new business from Libor to alternative rates and formulate a transparent transfer strategy to mitigate their legacy exposure from older LIBOR based contracts. Bank regulators have also signaled that the LIBOR transition will be an examination priority for this year.
With the transition away from LIBOR underway it is not in the best interests of banks and companies to continue to utilize LIBOR effectively raising their risk to an index that is in the process of sunsetting and was previously exposed to illegal market manipulation.
Additionally, there is a threat that LIBOR might end prematurely, either because the number of panel banks slips below the minimum required to formulate the rate or because regulators cause an early cessation of the index. This scenario is unlikely, because panel banks and regulators have a vested interest in a seamless transition away from LIBOR.
As we move closer to yearend 2021, valuation discrepancies may likely occur even under the best situations, especially for interest rate swaps and derivatives. Because of this potential, investors with wide swap books may want to carefully address this risk well in advance of the cessation of the LIBOR rate sunset.
So, so long LIBOR – and a shout out to deceased Minos Zombanakis, known by his peers as “the Greek Banker or Father of LIBOR,” and a leading innovator in international financial markets.
Cruise, S., & White, L. (2019, October 08). The end of libor: The biggest banking challenge you’ve never heard of. Retrieved February 12, 2021, from https://www.reuters.com/article/us-britain-libor-transition-analysis-idUSKBN1WN0H4