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LIBOR Q&A

What you need to know about the changes coming to this short-term interest rate benchmark

What is LIBOR?

LIBOR, short for London Interbank Offered Rate, has served as the benchmark interest rate for short-term unsecured loans between major global banks since the 1970s.

Published each day by the ICE Benchmark Administration (IBA), LIBOR is calculated for five currencies: the U.S. Dollar, the Euro, the British Pound, the Japanese Yen and the Swiss Franc. Rates are issued for seven different terms, ranging from overnight to 12 months.

How is LIBOR used?

In addition to its use on interbank loans, LIBOR underpins interest rates worldwide on everything from credit cards, student loans and variable rate mortgages, to interest rate swaps, floating rate CDs, collateralized debt obligations and syndicated loans.

LIBOR is used by the Federal Reserve and other nations’ central banks to gauge market expectations for interest rates. It is also viewed, among other things, as an indicator of overall banking system health.

Why is it changing – and when?

For years, regulators worldwide have raised concerns that LIBOR is an unreliable benchmark because it is not based on a significant volume of observable transactions. The interbank submissions of just 16 financial institutions, for example, are used to calculate the US Dollar LIBOR. Some of these banks, including Deutsche Bank, Barclays, UBS, Rabobank and the Royal Bank of Scotland, have been accused in the past of colluding to manipulate LIBOR rates.1

In 2017 the U.K. Financial Conduct Authority, stated that it would not compel LIBOR panel banks to make submissions to determine LIBOR rates after 2021. The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board and the New York Federal Reserve Bank to seek alternatives to LIBOR, has recommended a new index – the Secured Overnight Financing Rate (SOFR) – as the new benchmark for U.S. bond and loan market transactions. The New York Federal Reserve Bank now publishes the SOFR daily and the number of SOFR-linked products is slowly growing.

The ARRC’s goal is to assist financial institutions in completing the transition from LIBOR to SOFR by the end of 2021.

How is SOFR calculated?

SOFR is a transaction-based rate that represents the cost of borrowing cash (US Dollars) overnight on a secured basis - calculated from three existing transaction-based indices directly related to overnight Treasury repurchase agreements.

How is SOFR different from LIBOR?

There are at least two important differences between the two benchmarks.

First, because LIBOR is an unsecured interbank lending rate, it is often at least 20 basis points, or .20%, higher than SOFR, which is considered "risk free." The spread between the two rates often expands when credit markets are under pressure.

A direct switch from LIBOR to SOFR, therefore, is inappropriate, as each rate has different underpinnings. When converting interest rates for existing transactions that mature after 2021, creation of a spread adjustment will be necessary to ensure the consistency of rates, and a uniform credit spread adjustment has not yet been adopted.

Second, while LIBOR is calculated for multiple terms, SOFR is currently only available as an overnight rate. While SOFR curves are being developed for additional time frames, it will take time for the market to create them. This process may be complicated by the fact that SOFR is potentially volatile at month, quarter and year-end, given its ties to the securities repurchase market. It may take time for the new benchmarks to become predictable and accepted.

Is the SOFR benchmark being adopted by other countries around the world?

Each of the five currencies that currently rely on LIBOR are in the process of transitioning to alternative risk-free benchmarks. In the United Kingdom, for example, LIBOR is being replaced by the Reformed Sterling Overnight Index Average (SONIA). Japan has chosen the Tokyo Overnight Average Rate (TONA), the EU has selected the Euro Short-Term Rate (ESTER) and Switzerland has chosen the Swiss Average Rate Overnight (SARON). Adjustments and fallbacks are being developed to create continuity between the benchmarks.

What should businesses do to prepare for the transition?

There are several things businesses can do to begin preparing for the switch from LIBOR to an alternative rate:
  1. Existing transactions – Assess your LIBOR exposure in any current loans, bonds, notes, derivatives and other transactions that mature after 2021. The documents for LIBOR-based loans, for example, generally include language that allows for certain “fallbacks" in case LIBOR is not available – but these fallbacks may be incomplete or insufficient in the event that LIBOR no longer exists.

    Contracts for loans and floating-rate bonds tied to LIBOR, for example, will likely require changes. Master agreements for international swaps and derivatives will also need to be amended or replaced, as may others. Your banker can be helpful when reviewing the provisions for amending contract terms and conditions.
  2. New transactions – Before completing any new loans or other major transactions between now and the end of 2021, review your standard transaction documents to see if changes are needed to address the benchmark change. Keep abreast of developments in standard LIBOR fallback and replacement language.
For now, several unknowns await clarification. The methodology for determining the spread between LIBOR and SOFR must be agreed upon. The authority governing interest rate swaps and derivatives has not yet adopted definitions necessary to amend those agreements. Existing contracts must be adjusted and repriced to conform to the new benchmark.

You are likely to have additional questions of your own during this transition period. For answers, your banker is a good place to start.

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