The London Inter-Bank Offered Rate (LIBOR) has long been the workhorse of the financial sector, the backbone of hundreds of financial contracts and a key tool in the art of financial institutions. But now, after decades of service, its time has come, and come June this year, it will be switched off for good.
1. LIBOR: The End of an Era
On 31st December 2021, the London Inter-Bank Offered Rate (LIBOR) will no longer exist. Since its launch in 1984, LIBOR has been one of the primary benchmarks for interest rates in the global financial markets, and its impending demise marks the end of an era.
The demise of LIBOR will have far-reaching implications for financial markets. Crucially, financial contracts worth up to $400 trillion are linked to LIBOR, and must now be reworked. Every party must agree upon what comes after LIBOR. This must be done quickly, as the transition costs for finance companies, such as banks and insurance companies, in terms of new systems and operations can be substantial.
To address this issue, many countries have adopted alternative reference rates. These often vary by country and currency, but have a few key elements in common. These include:
- Transparency: The rate must be clear to all users.
- Stability: The rate must remain consistent over time.
- Reliability: The rate must be backed by a substantial amount of data.
LIBOR’s demise means that financial markets must continue to develop to ensure the security and sustainability of financial contracts. In the wake of its disappearance, financial markets will continue to change and evolve.
2. What the Decommissioning of LIBOR Means
The potential decommission of LIBOR, the London Interbank Offered Rate, is on the horizon. This benchmark, which has governed inter-bank loan agreement since the 1970s, is set for phased retirement by the end of 2021. There are a number of essential points to understand with regards to this decommissioning and its possible implications for businesses and individuals.
Firstly, the effect of LIBOR’s decommissioning extends far beyond the banking realm. LIBOR is an applicable index for calculating interest rates in many of the world’s financial instruments, including:
- Certificates of deposit
- Business loans
- Treasury notes
Virtually every global sector has some form of exposure to LIBOR. As such, its direct impact will be felt on a global scale.
3. Alternative Benchmark Rates Prepare for LIBOR’s Departure
As LIBOR is set for retirement, there are several alternative benchmark interest rates that banks and other financial institutions must prepare for. Here are the most important ones to be aware of:
- Secured Overnight Financing Rate (SOFR): SOFR was developed with the aim of replacing the U.S dollar LIBOR. It is an overnight rate based on the cost of funding for the secured loans in the U.S. Treasury market and other money market securities.
- Euro Short Term Rate (€STR): €STR was introduced by the European Central Bank to replace EURIBOR. It is an overnight rate that is a compilation of the rates on single count euro unsecured borrowing operations of different maturities.
- Sterling Overnight Index Average (SONIA): SONIA is the replacement of the British Pound Sterling LIBOR and is based on the prevailing rate for unsecured transactions on the London interbank market.
While the entire financial sector will be impact by the new benchmark rates, it’s especially key for credit managers, lenders, and other financial players impacted by the transition to prepare ahead. Understanding the different features and implications of each alternative benchmark rate is essential for business continuity and risk management.
4. The Challenges Ahead for Firms Without LIBOR
Although much of the focus in the aftermath of the LIBOR retirement has been on the industry’s efforts to prepare and transition, there remain entrenched challenges that many organizations face as the benchmark reaches its end in 2021. Businesses still need to identify accurate later-day rate replacements in the EU and worldwide, which might require them consulting outside experts to assist them in mapping out a viable plan for the future.
On top of this, firms that don’t have enough LIBOR-based instruments will also have to shoulder extra planning in order to find effective replacements that meet their specific requirements. It’s important for businesses to employ a comprehensive approach to addressing their LIBOR-related needs. This includes examining customer requirements, evaluating the proper reference rate, addressing any technical integration aspects, and considering the relevant legal implications.
- Identifying accurate rate replacements
- Finding effective LIBOR replacements
- Conducting comprehensive approach to LIBOR-related needs
- Examining customer requirements
- Evaluating proper reference rate
- Addressing technical integration aspects
- Considering legal implications
The sun may be setting on LIBOR in June, but there are many exciting new possibilities to explore with the new benchmark. With careful preparations and innovations, the financial industry can ensure a smooth transition to the new era of borrowing.