Saturday, July 11, 2020

LIBOR to be replaced by SOFR - December 31, 2021


Understanding LIBOR

LIBOR is the average interest rate at which major global banks borrow from one another. It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day. The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.
Each day, ICE asks major global banks how much they would charge other banks for short-term loans. The association takes out the highest and lowest figures, then calculates the average from the remaining numbers. This is known as the trimmed average. This rate is posted each morning as the daily rate, so it's not a static figure. Once the rates for each maturity and currency are calculated and finalized, they are announced and published once a day at around 11:55 a.m. London time by IBA.
LIBOR is also the basis for consumer loans in countries around the world, so it impacts consumers just as much as it does financial institutions. The interest rates on various credit products such as credit cards, car loans, and adjustable-rate mortgages fluctuate based on the interbank rate. This change in rate helps determine the ease of borrowing between banks and consumers.
But there is a downside to using the LIBOR rate. Even though lower borrowing costs may be attractive to consumers, it does also affect the returns on certain securities. Some mutual funds may be attached to LIBOR, so their yields may drop as LIBOR fluctuates.

How Is LIBOR Calculated?

The ICE Benchmark Administration (IBA) has constituted a designated panel of global banks for each currency and tenor pair. For example, 16 major banks, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS constitute the panel for U.S. dollar LIBOR. Only those banks that have a significant role in the London market are considered eligible for membership on the ICE LIBOR panel, and the selection process is held annually.
As of April 2018, the IBA submitted a new proposal to strengthen the LIBOR calculation methodology. It suggested using a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology for determining LIBOR.
  • The first transaction-based level involves taking a volume-weighted average price (VWAP) of all eligible transactions a panel bank may have assigned a higher weighting for transactions booked closer to 11:00 a.m. London time.
  • The second transaction-derived level involved taking submissions based on transaction-derived data from a panel bank if it does not have a sufficient number of eligible transactions to make a Level 1 submission.
  • The third level—expert judgment—comes into play when a panel bank fails to make a Level 1 or a Level 2 submission. It submits the rate at which it could finance itself at 11:00 a.m. London time with reference to the unsecured, wholesale funding market.
 
The Waterfall Methodology retains the trimmed average calculation.
The IBA calculates the LIBOR rate using a trimmed mean approach applied to all the responses received. Trimmed mean is a method of averaging, which eliminates a small specified percentage of the largest and smallest values before calculating the mean. For LIBOR, figures in the highest and lowest quartile are thrown out, and averaging is performed on the remaining numbers.

Uses of LIBOR

LIBOR is used worldwide in a wide variety of financial products. They include the following:
  • Standard interbank products like the forward rate agreements (FRA), interest rate swaps, interest rate futuresoptions, and swaptions, whereby options provide buyers with the right, but not the obligation, to purchase a security or interest rate product
  • Commercial products like floating rate certificate of deposits and notes, variable rate mortgages, and syndicated loans, which are loans offered by a group of lenders
  • Hybrid products like collateralized debt obligations (CDO), collateralized mortgage obligations (CMO), and a wide variety of accrual notes, callable notes, and perpetual notes
  • Consumer loan-related products like individual mortgages and student loans

LIBOR is also used as a standard gauge of market expectation for interest rates finalized by central banks. It accounts for the liquidity premiums for various instruments traded in the money markets, as well as an indicator of the health of the overall banking system. A lot of derivative products are created, launched and traded in reference to LIBOR. LIBOR is also used as a reference rate for other standard processes like clearing, price discovery, and product valuation.
LIBOR is retiring at the end of 2021 and SOFR is the replacement.
What once could have been argued as being one of the most important benchmarks in banking, LIBOR, is coming to an end. With a shelf life expiring at the end of 2021, what does this mean for investors and borrowers?
First, it is important to understand why the LIBOR is ending in 2021. LIBOR (London InterBank Offered Rate) is meant to represent the interest rate banks lend to one another. However, in July of 2012 it came to light that banks were manipulating the LIBOR for the purpose of profit. Banks had been falsely reporting interest rates, therefore impacting the LIBOR benchmark, and, in turn, borrowers overpaid on interest. The manipulation was easy for the banks because they were asked to report a hypothetical rate at which they could borrow, not the rate they actually borrowed.
In 2014 the Federal Reserve Board and the New York Fed created the Alternative Reference Rates Committee (ARRC), and tasked them with finding a more transparent and robust replacement for LIBOR as well as creating an orderly transition plan. In 2017, ARRC identified the Secured Overnight Financing Rate (SOFR) as the recommended replacement for US denominated transactions. SOFR is based on overnight transactions secured by the US Treasury securities and represents a risk-free interest rate.

Transitioning from LIBOR to SOFR: Potential challenges

The transition from LIBOR to SOFR will not be without some speed bumps. The first being that SOFR is quoted at a lower rate than LIBOR due to how it is derived, which means a straight transition from LIBOR to SOFR would result in a lower interest rate. LIBOR was based on unsecured transactions and therefore included a bank funding risk. To ensure compatibility, an adjustment spread will be required on SOFR.
Second, the majority of contracts use a forward looking index as the benchmark. For example, on mortgage loans the one-year LIBOR is typically used. A one-year LIBOR is an average of rates anticipated over the coming year based on a yield curve. SOFR is an overnight rate (backward looking) and a forward looking term SOFR is still in development. ARRC plans to publish a forward looking term rate at the end of 2021.
The third potential speed bump is preparing written contracts for the transition. Any new contract that extends past the retirement of LIBOR is recommended to use another benchmark or have fallback language if the LIBOR ceases to exist. Legacy contracts tied to LIBOR without fallback language that extend past 2021 will be more complicated. It is recommended to check the language of these legacy contracts to understand and quantify the exposure if LIBOR retires. Amending these contracts now will reduce litigation, but not without costs as well as the potential for the borrowers to disagree with the new terms.

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