LIBOR has been an important interest rate benchmark for decades. Any company or individual who either has debt or savings will be affected by any swings in LIBOR. For companies this affects the cost of borrowing and for consumers, affects will be noticed surrounding, mortgages, credit card rates, personal loans to name but a few. As of mid-night, 31stDecember we will be saying good-bye to this very important interest rate benchmark.
The London Interbank Offered Rate or LIBOR as it is referred to by traders worldwide is about to be phased out. The rate came into global usage in the 1970’s, originally as a key benchmark that is indicative of the borrowing costs between banks. The interest rate is calculated in five currencies, Japanese Yen, Swiss Franc, Euro, US Dollar and UK Pound Sterling.
LIBOR is now synonymous with most parts of finance such as the derivatives market, where it is used in foreign currency options, interest rate swaps and forward rate agreements. In fact, in the last 50 years, any on-going or new financial instrument with a variable interest rate, will be using this as its benchmark.
The rate is calculated by the Intercontinental Exchange (ICE) Benchmark Administration, who each day receives submissions from 18 banks with their likely borrowing rates. ICE takes the highest four and the lowest four submissions and then calculates the average rates which they then submit to the markets.
The Financial Conduct Authority announced on 5th March 2021, that as of close of business December 31st 2021 all LIBOR settings for Pounds Sterling, Japanese Yen, Euro, and Swiss Franc, will no longer be representative or will cease. The US Dollar LIBOR one week and 2 months will also be non-representative or will cease. The remaining settings for the US Dollar being overnight, 1-month, 3- month, 6- month and 12-month, will cease or be non-representative as of close of business 30th June 2023.
There are two main reasons as to why the rate is being dropped.
LIBOR Manipulation was uncovered in 2012 where multiple banks, (Deutsche Bank, Barclays Bank, UBS, Royal Bank of Scotland and Rabobank), had for a long time been manipulating this for profit.
Financial Crisis 2008 – There was less lending by banks and with interest rates soaring on literally trillions of dollars on financial products day after day, markets were crashing everywhere. Whilst the rate did not initiate the crash it was key in transmitting the financial crisis throughout the world, leaving governments to seek a safer alternative.
LIBOR touches every consumer on the streets of the United Kingdom, as well as most people living in countries across the globe. In the United Kingdom for example LIBOR underpins all consumer loans including mortgages, credit cards, car loans, and personal loans. It has a massive impact on the person in the street and it is in their interest to understand what is the replacement for LIBOR.
LIBOR affects the cost of borrowing for all companies. If the borrowing company is quoted on the London Stock Exchange for example any swings in the rate can affect their share price. If Sterling LIBOR goes up the cost of borrowing goes up as well. This will have a negative effect on the company’s bottom line, possibly culminating in a sell off of their shares, thus producing a fall in their price. The opposite may be said if Sterling LIBOR falls. The cost of borrowing is then reduced, which will have a positive impact on the company’s bottom line. This may well precipitate orders to buy their shares, which will accordingly increase in price.
Sterling LIBOR is going to be replaced by SONIA, an acronym for Sterling Overnight Index Average. This will be the new reference rate for all sterling transactions. SONIA is already being utilised in certain parts of the market which includes retail banking. It is administered and published by the Bank of England and experts agree it is a reliable market standard.
US Dollar LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR), which is an across-the-board measure of the cost of borrowing overnight cash which is collateralised by treasury securities.
This is a major step being taken by governments and international markets. These reforms have been seven years in the making. As far back as 2014, the FSB, (Financial Stability Board), recommended that IBORs needed to be reformed and replaced by RFRs, (Near Risk Free Rates), which are based on more liquid overnight lending markets.
Firms that have lending contracts in LIBOR will have to change to SONIA and it is hoped that they have started using SONIA long before the final departure date. This will have made the transition much easier, and for those companies with outstanding or “legacy contracts”, exposure to LIBOR will bring legal uncertainty from 1st January 2022.