The imminent disappearance of LIBOR will have vast impacts on credit markets in the coming years. In this article, which first appeared in full on BBH.com, BBH Corporate Banking Credit Analyst, Raja Khuri, explores those impacts.
Once dubbed “the world’s most important number,” the London Interbank Offered Rate (LIBOR) informs interest rates for hundreds of trillions of dollars’ worth of contracts around the world. As of May 2019, 90-day LIBOR stood around 2.3% (up from 1.2% two years prior), but as the benchmark is phased out beginning in 2021 following allegations of interest rate manipulation, the impact could be greater than a few basis points.
The Risks of a World Without LIBOR
The disappearance of LIBOR will affect both banks and borrowers, presenting challenges the financial services industry and regulators must overcome together. These challenges include administrative and legal hurdles, as well as the effective management of fundamental risks to banks, individual businesses, and, ultimately, the broader markets.
The various LIBOR rates, derived from submissions from reference banks based on their “expert judgment,” are meant to represent the cost of borrowing cash in the London interbank market on an unsecured basis. LIBOR is a key interest rate option for many, if not most, commercial credit facilities. For these floating rate loans, LIBOR is a key feature of the contracts, many of which will require formal amendments to account for its disappearance. The extent and variety of these contracts poses one of the greatest administrative challenges of the transition.
Many existing credit facilities that are priced based on LIBOR or that offer a LIBOR-based option have general provisions that address the unavailability or insufficiency of LIBOR. These provisions were set up to account for days when LIBOR is not published but borrowers may still borrow – for example, on a UK bank holiday that is not also a US holiday. However, such provisions may not represent sustainable long-term solutions to the potentially permanent discontinuation of LIBOR in 2021.
In addition, some commitments have LIBOR-based options that extend beyond 2021. This could pose significant issues down the line to lenders and borrowers who could be bound to an interest rate that no longer exists.
Many recently completed or amended transactions, and certain prior transactions, include flexible language that specifically allows for the determination of an alternative reference rate. In these facilities, either a targeted amendment or the definition of LIBOR allows the lender(s), with or without the borrowers’ consent, to assign a new alternative rate.
In the broader marketplace, many syndicated facilities that offer LIBOR-based pricing do not include provisions for a permanent event of LIBOR discontinuation. This lack of fallback language exposes lenders to undetermined or undeterminable interest rate risk if their facilities are not flexible enough to adopt an alternative rate. This would likely require multiple simultaneous amendments to any impacted facilities, posing a significant operational challenge to lenders.
In an effort to address LIBOR’s potential discontinuation, market participants have proposed a number of replacement rates.
The Federal Reserve Bank of New York, in cooperation with the US Treasury Department’s Office of Financial Research, chartered the Alternative Reference Rates Committee (ARRC) in 2014, which has developed and published a set of two solutions. One is a “hardwired approach,” which designates the Secured Overnight Financing Rate (SOFR) as the replacement rate in the event of LIBOR discontinuation. The other is an “amendment approach,” which allows for an alternative reference rate to be determined at a later date.
However, even with the flexibility to designate an appropriate alternative reference rate when the time comes, the question remains what that replacement rate will be and if there will be a suitable replacement that applies across the board.
SOFR, So Good? Maybe Not.
The ARRC-devised SOFR is a money market repo rate that tracks the cost of overnight borrowing secured by Treasury securities and reflects activity in the overnight interbank market. It is calculated based on a volume-weighted median using data from actual transactions and, as of April 2, 2018, has been published each US business day. While the ARRC has publicly endorsed SOFR as the rate moving forward, there remain questions and challenges.
The most widely used LIBOR rates in US dollars are not the overnight rate, but the 30-, 60- and 90-day rates. Accordingly, the ultimate replacement for LIBOR will have to contemplate term rates as well as an overnight rate. Proposals for a term structure have been floated that include compounding in arrears, or trailing averages. The jury is still out on which, if any, of these methods will be the most suitable, as each pose certain challenges. Any backward-looking term rate will not incorporate a forward-looking aspect, for which many market participants have expressed a desire. However, forward-looking rates determined in arrears will not be known to the lender or borrower at the beginning of the interest rate period. This could cause both operational challenges and uncertainty for both banks and borrowers.
There is also the question arising from the differences between the transactions reflected by SOFR and those broader categories of transactions for which LIBOR are used. While SOFR is essentially an overnight repo rate, LIBOR is used in longer-term borrowings and is meant to reflect unsecured credit. Accordingly, LIBOR is said to contain a credit component, while essentially risk-free rates, such as SOFR, by definition do not. The addition of a “credit spread” to the index has been offered as potential compensation for this discrepancy, but how such spreads will be calculated has yet to be determined.
As shown in the chart below, overnight LIBOR closely follows the Fed funds rate, while SOFR has exhibited more volatility. This could prove to be impactful were SOFR to be widely adopted in place of LIBOR, particularly when an outlying overnight rate might be used to calculate a term rate. Furthermore, even though the overnight LIBOR might somewhat resemble SOFR and the Fed funds rate, LIBOR term rates are typically higher than overnight rates.
To date, SOFR has also raised concerns regarding its volatility around quarter-end, at which point balance sheet considerations at banks can cause a spike in the short-term interest rate. Around New Year’s Eve, the interest rate experienced a hike of around 70 basis points. Anomalies like this may pose a financial risk or have a financial impact on borrowers whose term rates might be affected by daily outliers in the larger trend of interest rates.
Given the short history of SOFR, there may not yet be enough data to determine whether SOFR is an appropriate replacement.
The Quest for Alternative Replacement Rates
Though the ARRC is endorsing SOFR as the way forward, other market participants feel there is a need to create alternative replacement rates. Richard Sandor, the founder of the Chicago Climate Exchange and an instrumental force in developing the futures markets in the second half of the 20th century, established the American Financial Exchange (AFX) in 2015 partly to address the need for a suitable replacement benchmark rate. The AFX allows small banks to lend to and borrow from each other under mutual lines of credit overnight or for 30-day terms.
The AFX also analyzes the transactions that take place on its platform to create its own benchmark, dubbed Ameribor. As shown in the earlier chart, overnight Ameribor has tracked at a seemingly consistent buffer above overnight LIBOR. It also reflects the unsecured interbank character that LIBOR is intended to represent.
However, despite some similarities to LIBOR, and the transaction-based nature of Ameribor, the interest rate is based on a sample of transactions far smaller than that which is used to establish SOFR. Whereas the value of transactions backing SOFR have fallen in the range of $700 billion to $800 billion per day, the value of transactions backing Ameribor averaged $1.5 billion per day over the first quarter of 2019. The breadth of Ameribor’s sample will need to expand in order to serve as a true LIBOR replacement.
In addition to those proposed by the ARRC and AFX, there’s another replacement rate on the horizon, to be released by ICE, LIBOR’s current administrator. The ICE Bank Yield Index would be based on transaction data reported to the Financial Industry Regulatory Authority and submitted by 13 large, internationally active banks. The benchmark would track unsecured lending and be published for 30-, 60- and 90-day terms. ICE is aiming to begin publishing the index in early 2020.
Waiting Is Not an Option
Though solutions to LIBOR’s discontinuation have been proposed and endorsed by various market stakeholders, the fixes are still in a trial phase and many market participants feel there is not a clear path forward. This has prompted some to request that LIBOR continue to be published and used for contracts that currently exist and extend beyond the potential discontinuation date. However, the current administrators of LIBOR (including the UK’s FCA) and regulators (including the Federal Reserve) have made it quite clear that they intend for LIBOR to be phased out according to the currently announced timeline.
Despite a lack of definitive solutions as this deadline approaches, borrowers and lenders should not ignore the situation. The disappearance of one of the world’s most important interest rates will no doubt affect banks and companies alike.