The end of LIBOR – and the need to be ready for its replacement
LIBOR will have been phased out by the end of next year. Nicola Sharp, of corporate crime solicitors Rahman Ravelli, tells Business Leader why those working in the financial industry should already be making firm arrangements for dealing with what succeeds it…
LIBOR has been lurching in and out of the news for years. From the initial 2012 reports of the scandal, through the measures proposed to reform the system and then the investigations that led to one conviction and six acquittals in the UK, LIBOR has rarely been away from the headlines.
And then there was the Serious Fraud Office’s decision in October 2019 to call time on LIBOR and officially close its investigation.
So, is that the end of LIBOR as a live issue? Far from it.
If ever there was a time when those in the financial world need to be paying extra attention to LIBOR, it is now.
Ironically, that is because LIBOR will soon be history. And because its departure is significant, to put it mildly.
As the benchmark for short-term interest rates, LIBOR has up to $300trn in consumer loans, mortgages, corporate debt and other finance tied to it.
It is set to be phased out by the end of 2021. By then, the Financial Conduct Authority (FCA) will no longer seek to compel or persuade panel banks to submit quotes for LIBOR.
Reliance on LIBOR will not, therefore, be a safe course of action beyond this date.
The FCA has made it clear that the best way to avoid LIBOR-related risks is to move off LIBOR altogether.
As you would expect, replacements are in the offing.
From a US perspective, all dollar-denominated loans, derivatives and debt will be referencing a new rate known as the Secured Overnight Funding Rate (SOFR).
This is no sudden transformation – it is more of a recognition that LIBOR was outdated and no longer suitable for the increased size and complexity of world markets.
But it is a major change. SOFR relies on transaction data and is a daily rate whereas LIBOR was based on market data judgement and had seven rates on terms of one day to one year.
LIBOR contained an in-built credit-risk element as it represents the average cost of borrowing by a bank whereas SOFR will represent a risk-free rate as it is based on the US Treasury repurchase market.
In the UK, LIBOR is set to be superseded by the Sterling Overnight Indexed Average (SONIA). Run by the Bank of England and based on actual transactions, SONIA reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. It is currently being used to value assets worth a total of £30trn each year.
The Bank of England and the Financial Conduct Authority (FCA) have written to the major banks and insurers detailing what the FCA and Prudential Regulation Authority (PRA) expect this year in terms of progress regarding transition. They are encouraging those involved in the financial markets to switch the convention for sterling interest rate swaps from LIBOR to SONIA from this month onwards.
Make no mistake, those working in the financial markets have to ensure they are up to speed with what is a major development.
The transition from LIBOR is not a simple case of switching over when the time is right. It takes time, preparation and an in-depth knowledge of the changes that the transition represents.
This was never going to be easy: the move to using SONIA or SOFR cannot suddenly be carried out like the changing of a lightbulb.
This may be the last time that LIBOR appears in the news cycle but arguably, for those who have come to rely on it, this could be the most critical moment in its history.
Firms have to take the time and seek the right advice to make sure they are prepared for LIBOR’s demise. This places a great need on firms to understand the situation, the risks associated with it and the need to actively engage with transition efforts.
There is a clear obligation on banks, insurers, asset managers and any other firms to ensure they are ready for a post-LIBOR world. A failure to meet this obligation – or even a mismanaged attempt at meeting it – could mean costly disruption, if not disaster.
Firms should not be surprised if regulators are checking on their transition preparations. After all, they have been told clearly what is expected of them. Which is why they have to be making full use of the advice and assistance offered by the FCA and PRA.
The end of 2021 and the farewell to LIBOR may, at this time, seem a long way off. But the scale of the change means that transition efforts cannot start early enough.