This post introduces basic concepts around LIBOR and its transition to Alternative Reference Rates by addressing the questions: what is LIBOR and why it started? , what is the current exposure of institutions to LIBOR?, why transitioning to Alternative Reference Rates?, what are the calculation methods for the Alternative Reference Rates?, finally, what are the impacts of the transition, the challenges, and the strategies to overcome them?
What is LIBOR?
The LIBOR, (London Interbank Offered Rate), is a measure of the average rate at which banks are willing to borrow or lend wholesale unsecured funds.
The rate is published in five currencies, GBP, EUR, USD, JPY, and CHF, for a range of maturities which are, overnight, one week, one month, two months, three months, six months, and one year.
Its value is based on submissions from a few number of big banks. Every morning these banks share estimates of the lowest interest rate at which banks can borrow from each other. As there are five currencies and seven maturities, that makes a total of thirty five rates per day.
Origins of LIBOR
Back in the seventies, London was a rapidly growing financial centre and the UK was the country chosen by many countries to secure their funds. The so-called ‘Eurodollars’ market, time deposits market denominated in US dollars in offshore locations, was flourishing because of some countries trying to avoid or escape the rigorous regulations of the Federal Reserve Bank.
Still, there was a market gap to bridge when it came to lending big amounts of these US dollars, especially to countries of doubtful credit worthiness and insufficient foreign currency reserves. At that time, banks did not want to lend big amounts of money long term at a fixed price, due to the unstable market conditions and high interest rates.
Syndicated banks wanting to share borrowing risks decided to lend and charge these doubtful borrowers an interest rate recalculated periodically while ensuring the funding with rolling deposits. They would then share their funding costs prior to loan maturity date, and the price of the loan for the next period would be calculated as the weighted average plus a spread for profit. (See calculation methods section).
And so this rate was called the London Interbank Offered Rate, LIBOR, which de facto became the interest reference rate for the Eurodollars market. The rate was further adopted in the eighties for derivatives products as a way to ensure sustainable growth for this market further backed by the Bank of England and the British Bankers Association.
Currently many financial institutions across the world use LIBOR as the reference rate for a range of financial products such as deposits, loans, derivatives, etc. The rate is embedded in virtually everything from pricing to valuations, modelling, accounting processes, etc. The total exposure is estimated in the region of several trillion USD.
For this reason the transition is not as simple as replacing LIBOR by adopting alternative risk-free or no credit risk rates. It has large impacts across banking operations, governance, policies, contracts, infrastructure… (See transition impacts section).
Why the transition to Alternative Reference Rates?
The UK Financial Conduct Authority, (FCA), published long ago deadlines for LIBOR transition to Alternative Reference Rates. They stated that after 2021 they will no longer compel banks to submit rates used for calculation of LIBOR. Key milestones were fixed as April 2021 for existing contracts migration to Alternative Reference Rates, and December 2021 as the end-date for LIBOR discontinuation.
One of the key reasons for the transition is the LIBOR rigging scandals of the past which raised serious concerns on the credibility and future of this benchmark. These rigging practices were facilitated because of the survey mechanism described in section what is LIBOR for its fixing. Estimates provided by banks do not include any transaction based factors and are not based on their underlying market transactions. These can therefore be easily manipulated.
By manipulation it is meant providing distorted rates instead of actual rates for the purpose of benefiting from trades with other banks. Say for example you as bank may want to understate the rate you pay for borrowing funds, so that you look more creditworthy vis-à-vis other banks.
The investigation into these manipulations brought to light that rigging practices dated back from years. Exemplary fines were imposed further to bringing criminal charges to traders involved in these practices. Nonetheless, LIBOR’s reputation was tarnished from that point on.
Putting rigging practices aside, the main sustainability issue for LIBOR is the current illiquidity of its underlying unsecured funding market. Since the financial crisis, the transaction volumes of unsecured deposits have steeply decreased. These low numbers mean LIBOR is an inefficient reference rate today.
Alternatives Reference Rates
Due to the reasons explained in previous section, there is a market need to switch to Alternative Reference Rates (ARRs).
For each published currency, there is an ARR established by industry groups and financial authorities of each respective country or region. All of these alternative rates share a common set of characteristics which have been summarized in table 1 below.
The fundamental difference is that whereas LIBOR is based on expert judgement from a group of banks, the ARRs are based on actual transactions. Rigging becomes therefore more complicated for these, as they are less vulnerable to manipulation by their own nature.
Industry groups also issue recommendations and help market participants with the transition challenges. The alternative suggested rates per each of the currencies published are the following: (See table 2 below)
- For JPY: Tokyo Overnight Average Rate (TONAR)
- For CHF: Swiss Average Rate Overnight (SARON)
- For GBP: Sterling Overnight Index Average (SONIA)
- For USD: Secured Overnight Financing Rate (SOFR)
- For EUR: Euro Short Term Rate (€STER)
Let’s now focus on one of these rates to explore further details by comparing SONIA, the Sterling Overnight Index Average, vs LIBOR.
ARRs Calculation Methods
The calculation methods for ARRs is relevant because all financial instruments which are currently based on LIBOR will need to take into account these methods. More importantly, current calculation systems have to be modified accordingly during the transition. Please note this section does not elaborate on the arguments to decide upon what calculation method to adopt.
In section Origins of LIBOR, we mentioned interest rate average which is a concept also used in overnight rates, meaning that more than a single reading of the rate is used for the calculation. There are several ways to proceed with this average calculation:
- Daily simple average: the rate is calculated as the arithmetic mean of the daily ARRs
- Daily geometric average: the rate is calculated as the geometric mean of the daily ARRs
- Daily compounding average: the rate is calculated taking into account the principal and the accumulated unpaid interest for the periods.
When the rate is set at the beginning of the period, this is called ‘in advance’, whereas when it is set at the end is called ‘in arrears’ calculation.
In the first case, the rate is fixed before the current interest period begin and in the second, the rate is known at the end of the period. There are different conventions for using ARRs in financial instruments for both ‘in arrears’, ‘in advance’, and ‘hybrid’, briefly introduced below:
- Plain: interest rate is applied over the full period. Interest payment is made when it is due
- Payment delay: interest rate is applied over the full period but interest payment is made a number of days after the start of the next period
- Lockout period: interest rate is applied over the period with the rate no longer updated (frozen) for a number of days prior to the end of the period
- Lookback: the period for the interest rate calculation starts and ends a number of days prior to the interest period.
- Last reset: interest rates for current period are determined on the basis of the average ARRs of the previous period
- Last recent: interests rates for current period are determined on the basis of one or averaged ARRs from a short recent period.
- Principal adjustment: combines an instalment payment known at the beginning of the interest period with an adjustment period known at the end
- Interest rollover: Also combines an instalment payment known at the beginning of the interest period with an adjustment payment known at the end. The difference to principal adjustment is that the adjustment payment is delayed and can be made a few days later or at the end of the next period.
The transition from LIBOR to ARRs is a market driven initiative and different financial institutions are gearing up for it at a different pace. A variety of institutions including retail, commercial, investment, and central banks, are impacted by this transition. Whereas large banks have made good progress already, most of the medium and small institutions impacted are starting to get ready.
There is a wealth of consulting and software vendor companies offering tailored specialist advice to help their banking clients evaluate, prepare, and execute the transition. In some cases, advising and technical capabilities are bundled through market partnerships to strengthen the value proposition offered to their clients.
The strategies and technologies used to support and speed up the transition are similar across the spectrum of vendors and based on the same enablers. (See section transition strategy)
There is however fierce market competition among vendors to execute the fastest and most cost effective transition while ensuring compliance all the way through it. Differentiation strategies call for capabilities to provide end-to-end modular solutions to assist with a staged transition.
In these strategies, banking clients can pick and choose the service/s they want to buy from vendors and providers along the process in a flexible way, and prices are based on expected deliverables or outcomes.
As pointed out in LIBOR exposure section, the transition have impacts across a wide number of streams listed below by categories for reference. Please note the lists are not exhaustive.
Banks, mortgage companies, asset and investment managers, brokers, dealers, trading systems, exchanges, derivatives traders, data providers and regulators
Legal, compliance, operations, finance, treasury, risk, IT
Risk modelling, analytics, accounting, trading and booking, pricing and valuation, post-trade services, data management and reporting
Commercial loans, syndicate loans, mortgage loans, deposits, derivatives, bonds, debt instruments, securitized products.
For financial institutions implementing a LIBOR replacement strategy, Artificial Intelligence, Machine Learning, and Robotic Process Automation, are critical technology enablers. For the effective application of these technologies sizing is very relevant. This includes portfolio size, number of contracts linked to LIBOR, documents and clauses to be reviewed, number of clients, applications and systems impacted, etc.
From a process management point of view, replacement strategies encompass steps described below:
- Define objectives and action plans
Defining a clear set of objectives to achieve during the transition is key. These objectives can be prioritized based on line of business, products, currency, countries, etc. depending on the needs of the institution.
- For line of business for example, first priority could be assigned to trading and sales, treasury, credit risk, market risk. Second priority could be assigned to operations, finance, tax and accounting.
- For products, first priority could be assigned to derivatives, loans, EFTs, funds… Second priority could be assigned to consumer loans, credit cards, mortgages, and insurance …
The objectives are then divided into requirements and action plans are drafted against requirements considering all known dependencies, assumptions, and risks. Responsibilities are allocated and the project manager ensures proper follow-up and monitoring of the plans.
2. Contracts analysis
Contract analysis is the most critical element of the transition due to the likely huge number of contracts in which LIBOR is present.
The institution needs to identify all contracts using LIBOR as the reference rate and eventually modify fallback clauses. These clauses were included to deal with the benchmark not being temporarily available but not indefinitely. It would be extremely inefficient to conduct this process manually even if all contract documentation was standard, reason why tools are needed.
Artificial Intelligence, optical character recognition, and computer vision techniques, can extract contextual information from contracts. Natural language processing can be used to screen contracts and identify those impacted.
Market tools enable business users to quickly and accurately find LIBOR referenced contracts by leveraging these technologies. A user friendly interface and a workflow management tool are featured, while the back-end can process thousands of contracts per hour with a very high accuracy in clause extraction. A series of specific data can be identified, such as currency, contract expiration date, interest calculation method, applicable law, etc.
3. Contracts Repapering and Notification
After analysis, the contracts are fed into a Robotic Process Automation process for repapering. This process creates an alternative contract language and replace LIBOR with a new reference rate in all contracts or agreement documents. Machine Learning algorithms are used here to adjust the new pricing by calculating the applicable spread according to bank requirements. The guiding principle is to minimize changes in contract value from replacing reference rates.
If any particular element of risk is found during the repapering, an exception is thrown and the legal and business experts step in for a manual review after which a remediation process follows.
After repapering is completed, the tools can also notify clients on the new rates and clauses requesting them sign-off. If the client needs help after reception of the contract, inbuilt interactive bots can provide further assistance.
Nonetheless in the European Union, the Global Data Protection Regulation states that there is client’s right not to be subjected to automated decisions. A client may request a human explanation on new rates, clauses, or decisions made with respect to the contract. The institution must then be able to explain any automated decision to clients and regulators alike.