Are you ready to transition away from Libor? A quick review of the reasons, the risks and the challenges ahead

5 Aug 2020

The British Bankers’ Association first launched Libor (the London Interbank Offered Rate) 34-years ago in 1986 as a standardised benchmark to determine the rate at which banks could borrow money on unsecured terms in the wholesale markets. Because this rate is based on submissions from a panel of 20 banks and is presented in five currencies – GBP, USD, EUR, JPY and CHF, it has become a truly international standard. So, when cracks were identified, this caused some trepidation.

Now, with Libor likely to be decommissioned by December 2021, the rush is on to transition to an alternative, but with change, as always, comes risk. Therefore, this article provides an overview of what these risks may be and how your financial institution can best manage them.

Cracks in the system
The discovery that some in the banking world had been manipulating the Libor rate to make significant profits on trades or to inflate their creditworthiness led to scandal, fines, jail sentences and, ultimately, a degradation of trust in this industry standard.

Some feel these cracks go back a very long way. US media investigated the possibility of manipulation within the global financial crash of 2008. Court cases ensued in 2012 with terms such as ‘fraud’ and ‘collusion’ being used, and according to Wikipedia 13 traders have been charged by the Serious Fraud Office in the UK as a result of its investigation into the Libor scandal.

With such a large question mark over the benchmark it’s surprising that it has continued to dominate, but then again, its central positioning in trillions of dollars’ worth of financial contracts has meant that the idea of replacing it has seemed to enormous a task until now.

With Libor on the way out the complex job of reviewing every agreement to minimise the risks of this benchmark’s absence can no longer be put off. Many institutions are waking up to the reality of this and employing the significant resources required.

Falling back on the ‘fallback’
The primary worry of many institutions when it comes to transitioning away from Libor is the fallback positions in these contracts, the methodology within the agreements behind determining an alternative rate should Libor become ‘temporarily unavailable’.

These contracts were drafted with the assumption that Libor would go on forever, so a transition from this ‘norm’ will create a risky environment for many.

The cost of transitioning away from Libor has been estimated at somewhere in the low billions, and time is rapidly running out in the search for a smooth move to avoid market hiccups around the 2021 deadline.

The contract analysis required to minimise a bank’s exposure to these changes can be a laborious manual job, which is why some are getting innovative with the task, developing AI solutions to seek out the offending clauses.

What alternatives are available?
As a result, different countries are rushing to implement their own systems to offer an alternative. The US alternative is called SOFR, the EU alternative is ESTER and the UK alternative is SONIA (Sterling Overnight Indexed Average) – which is ‘based on the average of interest rates banks pay to borrow sterling from one another outside market hours, and is published at 9:00 a.m. local time (0800 GMT) daily, after the transactions have been vetted by the Bank of England’ according to Reuters.

The worry some have is that Libor was forward-looking, but SONIA is calculated based on figures from the night before. Due to the confidence and certainty issues this may cause it is reported that a forward-looking SONIA term rate may be in the offing.

Market inertia
Many hedge funds and insurance investors are already transitioning to SONIA, but the majority of UK-based Libor users seem to be being slow to move away from the benchmark. This market inertia may be due to the scale of the task ahead, a lack of understanding of the alternatives or the implications of staying the course, or simply not wanting to be the first to put their heads over the metaphorical parapet, but with the end of Libor now imminent they will need to make their move soon.

Some forward-thinkers in the banking sector though are dedicating whole teams to prepare for the transition, putting themselves in the best possible position come 2022.

What are you doing to adapt your reliance on Libor, to identify the contractual issues that could result, to develop the teams required to dedicate to this task, and to prepare for what may be one of the most significant changes to be thrust upon the financial sector in a very long while? We’re interested to know.