The London Interbank Offered Rate (LIBOR) is the dominant interest rate benchmark and plays a central role in the daily dynamics of the financial markets. Financial institutions rely on LIBOR to represent their own funding cost and transfer it to the clients. It is used as a reference rate in more than $400 trillion of financial instruments, from retail, like credit cards, auto loans and student loans, to more sophisticated instruments, like derivatives, which play an essential role in helping financial institutions manage their risks.
To fully understand LIBOR and its importance, one needs to go back to the origins and development of the London money market and the history of the Eurodollar. Nearly half a century ago, global corporations and international banks started placing short-term excess liquidity with each other, in the form of US dollar deposits in London. This market was a bit of a club, only accessible to prime institutions of high creditworthiness, and operating on an unsecured basis. Given the large volumes, high liquidity and ample range of maturities, the LIBOR market gradually became a global reference for funding costs of the largest corporates. As interest rate volatility skyrocketed in the 1980s, it prompted the development of a derivative markets, soon to become the largest asset class in the world in nominal terms. The interest rate swaps were primarily based on LIBOR as their reference.
The Beginning of the End for LIBOR
It all came to an end when confidence in mutual creditworthiness was lost in the run-up to the Global Financial Crisis. Institutions continued to place excess funding with each other but required a pledge of security (a bit like pawnbrokers do) and for much shorter maturities, primarily overnight. The money market as we used to know it essentially disappeared, but the continued reliance and large volumes of interest rate derivatives created powerful incentives for manipulation. It is ironic that many think of manipulation as the reason for the dismissal of LIBOR, when the true reason is quite the opposite. It was the lack of liquidity in the money market that made manipulation possible. The new secured money market is now based on repurchase agreements (repos), where bonds are used as security.
The financial services industry started to plan the transition from LIBOR to other reference rates that overcome LIBOR’s weak points. A key focus is to ensure the new benchmarks are credible and robust. The proposed replacement rate for the US dollar market is based upon the repo markets that replaced LIBOR a decade ago. Despite its thirty-year long fame and worldwide dependency, the Financial Conduct Authority (FCA), the UK’s financial regulatory body, encourages the world to stop using this rate from now on, after some doubts about its governance and its current relevance to represent the up-to-date funding costs emerged.
There are still many things to determine and time is our tyrant: LIBOR could disappear as soon as December 2021 if regulators so decide (there are consultations to extend the life of some tenors of the US dollar LIBOR). Working groups in financial markets have taken the first steps, but many elements must be decided and defined. Experts have been studying the key structural differences between LIBOR and possible new benchmarks. To account for them, spreads and adjustments are added to the replacement rate, such as credit and term premiums.
Questions remain about how to implement changes, how all players will adapt to them, and how they will impact sovereign, corporate, and retail borrowing and lending markets. Transitioning to alternative rates will affect how the prices of existing and new contracts are determined, and financial institutions will have to update their operating models. Some institutions are getting ready to proactively transition months before a hard end of LIBOR.
Three Sources of Uncertainty Surrounding New Reference Rates
Uncertainties around the transition can be grouped into three driving factors. The first is how the new rates will be calculated. As mentioned above, the new reference rates are different than LIBOR. How to adjust them and how new financial products will be priced is yet to be defined.
The second factor is the level and speed of financial markets’ acceptance of the new reference rates, reflected in the number of contracts (or level of ‘liquidity’) that adopt the new alternatives. For example, a rapid increase in the number of new loans linked to new rates means a quick acceptance by banks and clients. Moderate growth can mean the participants are not convinced the proposed replacement rate is the best option.
The third and last factor is the behavior of the borrowers. Retailer clients, governments, and smaller banks could adopt a receptive attitude towards the reform, or a wave of litigations could come. For example, clients could sue the banks after the rate of their current mortgage has changed.
Given the complex web of interactions and the vast number of contracts, LIBOR’s replacement represents a considerable challenge in many dimensions, and it constitutes an immense challenge for the global financial market. Lack of preparation across the world could lead to considerable disruption in the financial markets.
Scenarios for a World after LIBOR
To prepare for the transition to a new reference rate, the IDB has built a set of possible scenarios based on the three driving factors described above. These are aimed at aiding decision-making and can help address questions on the timing of the transition, how regulators could speed up the process, and how the IDB should respond if the market does not converge into a single replacement rate for LIBOR. As these questions play out, the institutional plan for transitioning out of LIBOR can be tested under the scenarios, and adjustments can be made. As we move into uncharted territory, scenario planning can be a powerful tool to prepare for the unknown.
The move away from LIBOR represents a paradigm shift for the financial industry, and it is happening now.
The demise of Libor lies with the divisional managers. Managers of markets particularly financial markets must be fully aware of marked changes, be sagacious in their decisions, follow market trends and act with alacrity when financial flows are interrupted along the money supply chain. Supplier and consumers needs to be informed through interconnected network and quickly respond to any unethical deviation from the policy guidelines. Ethical codes of conduct must be followed precision..