The end of Libor

Le Temps (23.12.2019) - LIBOR (the London InterBank Offered Rate) is for investors what a compass is for sailors: a vital instrument that helps them set their course.

This benchmark interest rate has been published daily in London since 1986 and USD 300,000 billion dollars of financial contracts are linked to it. However, it is set to disappear at the end of 2021, along with other interbank rates (IBORs). From 1 January 2022, LIBOR and other IBORs will be replaced by indices that reflect risk-free overnight interest rates and deemed more transparent and “robust” according to the Financial Stability Board’s terminology. In Switzerland’s case, the new credit market benchmark will be SARON (the Swiss Average Rate Overnight).

This reform, which appears to be the main challenge currently facing the finance industry, is driven by both political and technical factors.

It is the direct result of LIBOR’s manipulation by certain market participants, which was dramatically uncovered in 2011. The national groups that worked on the matter could have decided to maintain the existing indices, while strengthening oversight of the banks that set IBORs. However, maintaining the status quo would not have had the desired effect in terms of image: since the 2008 financial crisis, the public has been demanding more transparency from regulators.

As well as being politically justified, the scrapping of LIBOR is also technically necessary. The 2008 crisis showed that, in extreme conditions, the unsecured interbank lending market can dry up almost without warning, making it impossible to determine IBORs. SARON and other IBOR alternatives adopted in other countries are intended to address such situations.

However, none of them are a magic bullet: switching to this new model will be a complex and costly process.

LIBOR’s main weakness is that it requires banks to estimate the rates at which they might be able to borrow in the interbank market. This results in a degree of uncertainty that allowed large-scale manipulation between 2005 and 2009.

Conversely, the new model, which is the result of work overseen by regulators including the Swiss National Bank, is based on rates actually observed in the market in the last 24 hours. This backward-looking method aims to provide an objective estimate of risk-free rates in each financial centre. By putting independent institutions – such as SIX in the case of SARON – in charge of collecting and collating rates applied between market participants, regulators can be sure that Alternative Reference Rates (or ARRs) will not be distorted by incorrect estimates.

The reform looks set to have a considerable impact. It will affect both credit institutions and borrowers, because all credit agreements currently in use will have to be amended to adjust to the new requirements. In addition, those requirements have not yet been fully determined. Since the new indices only take into account past events, they do not reflect counterparty risk, liquidity risk, volatility risk or market direction risk, which are nevertheless vital factors when setting interest rates.

At the moment, each national working group is striving to integrate all of these parameters into a relatively simple formula. They are trying not only to define a new ARR but also to develop a way of assessing the factors that need to be taken into account and calculating the necessary rate adjustments during the transition, which will happen on the night of 31 December 2021.

The Static Credit Spread Adjustment (SCSA) will be calculated for each standard maturity and will have to be taken into account by the new indices. This spread adjustment has been the subject of broad consultation between international banks as part of the US Federal Reserve’s ARRC (Alternative Reference Rates Committee). The ISDA (International Swaps and Derivatives Association) also published a report on this subject in November 2019. These two authorities have promised to make operational recommendations in the first quarter of next year.

The adopted solution is likely to be the one that calculates the cost of liquidity made available by banks in the most objective way possible, i.e. a rate based on the new market index, and adds in the SCSA, the liquidity premium, the counterparty risk premium and, finally, the credit margin.

Although the reform stems from the regulators’ best intentions, it will result in a system that is extremely complex and will therefore be costly for banks in terms of documentation and changes to IT systems. However, that is the price of transparency, and there can be no going back.