What you need to know about the changes coming to this short-term interest rate benchmark.
What is LIBOR?
The London Interbank Offered Rate, also known as LIBOR, has served as a widely accepted, short-term benchmark interest rate for loans around the world. LIBOR is set each day by collecting and averaging estimates from global banks (“panel banks”) on the interest rates they would be charged in the interbank market for borrowing in different loan tenors and currencies. It is an unsecured, interbank rate, meaning it is the estimated rate they would be charged for borrowing from another bank. However, USD LIBOR will in effect be discontinued for some tenors on December 31, 2021 and the remaining, more common tenors on June 30, 2023.
Why is LIBOR ceasing?
For decades, LIBOR was a convenient way to determine the cost of floating-rate debt around the world. The integrity of LIBOR was questioned following the 2008 financial crisis due to manipulation concerns. A contraction in the unsecured interbank lending market has also occurred since the financial crisis, substantially reducing the volume of actual transactions on which to base panel bank estimates. These factors have led the U.K. Financial Conduct Authority (FCA) to encourage a transition away from LIBOR.
When is LIBOR ceasing?
In 2017, the FCA stated it would not compel LIBOR panel banks to make submissions to determine LIBOR rates after 2021. In March 2021, the ICE Benchmark Administration (IBA), the administrator of LIBOR, announced that 1-week and 2-month USD LIBOR rate quotes will cease at the end of 2021, and that USD LIBOR overnight, 1-month, 3-month, 6-month, and 12-month rate quotes will cease at the end of June 2023. At the same time, the FCA indicated that it supported the IBA’s timetable for USD LIBOR cessation (although the FCA may permit a few tenors to continue on a non-representative basis). As a result, USD LIBOR will in effect be fully discontinued under the IBA’s timetable, after June 30, 2023.
The Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency have issued supervisory guidance encouraging financial institutions to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021.
Who oversees the transition away from LIBOR?
The Alternative Reference Rates Committee (ARRC), is a group of private-market participants that was convened by the Federal Reserve Board and the New York Federal Reserve Bank to seek alternatives to LIBOR and lead the transition in the U.S. The ARRC is responsible for publishing recommended best practices to outline important transition activities and milestones.
Additionally, the International Swaps & Derivatives Association (ISDA) is leading the transition of the USD LIBOR derivatives (e.g., interest rate swaps) markets away from LIBOR. ISDA and the ARRC work closely together to confirm alignment in their objectives.
What will be the replacement rate for LIBOR?
The ARRC has recommended a new benchmark– the Secured Overnight Financing Rate (SOFR) –for U.S. bond and loan market transactions. The New York Federal Reserve Bank now publishes SOFR daily, as well as SOFR Averages and a SOFR Index. In addition, on July 29, 2021, the ARRC formally recommended the CME Group’s forward looking 1-month, 3-month and 6-month term SOFR rates[PDF]. The number of SOFR-linked products is gradually growing.
Although the ARRC has recommended and is focusing exclusively on SOFR as LIBOR’s successor, some market participants and industry groups are advocating for, and in some cases already employing, other established benchmarks such as Prime and the Effective Federal Funds rate, as well as new benchmarks such as the American Interbank Offered Rate (AMERIBOR), Bloomberg Short-Term Bank Yield Index (BSBY), or ICE Bank Yield Index (BYI).
Commerce Bank will plan to offer Daily Simple SOFR and 30-Day Average SOFR in Advance for new loans and renewed LIBOR-linked loans, and SOFR Compounded in Arrears for commercial swap-linked products.
What will happen to existing LIBOR linked contracts?
Existing contracts with interest rates based on LIBOR that mature past the June 30, 2023 cessation date must be examined to ensure that the contract contains adequate fallback language. If not, the contract will need to be amended to add fallback language or to convert the base rate of the contract to a SOFR based rate or another rate or index offered by Commerce.
Fallback language refers to the legal provisions in a contract that specify the replacement rate that will be used if the underlying benchmark (LIBOR) is unavailable, how the replacement rate will be implemented, as well as the specific conditions that would lead to the benchmark being deemed unavailable.
How is Commerce participating in the industry-wide cessation of LIBOR?
Commerce is actively participating in industry discussions and monitoring market responses regarding the transition away from LIBOR. Commerce is collaborating with peer institutions to track the development of various alternative benchmarks to ensure that the bank remains competitive across applicable markets and products.
What can customers do today to prepare for the LIBOR transition?
Commerce encourages customers to stay informed about how the LIBOR transition will affect their contracts.
In addition, Commerce encourages customers to consider working with their Relationship Manager to proactively transition their LIBOR-based contract to a SOFR-based or other alternative rate in advance of the cessation.
Where can I find more information about the LIBOR transition?
Customers may find relevant market and industry-related information at the following websites: