Preparing for 2022: What you need to know about the LIBOR transition

The interest rate benchmark London Interbank Offered Rate (LIBOR) is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds. It is a major interest rate benchmark which underpins c.$300tn ($30tn in GBP markets) of financial contracts including, derivatives, bonds and loans. It is expected to cease after end-2021. Firms must transition to alternative rates before this date. LIBOR is currently produced in 7 tenors (overnight/spot next, one week, one month, two months, three months, six months and 12 months) across 5 currencies. It is based on submissions provided by a panel of 20 banks. These submissions are intended to reflect the interest rate at which banks could borrow money on unsecured terms in wholesale markets.

What are the problems? On 27 July 2012, the Financial Times published an article by a former trader which stated that LIBOR manipulation had been common since at least 1991. Further reports on this have since come from the BBC and Reuters. On 28 November 2012, the Finance Committee of the German Bundestag held a hearing to learn more about the issue. In court documents filed in Singapore, RBS trader Tan Chi Min told colleagues that his bank could move global interest rates and that the LIBOR fixing process in London had become a cartel. Tan in his court affidavit stated that the Royal Bank of Scotland knew of the LIBOR rates manipulation and that it supported such actions. In instant messages, traders at RBS extensively discussed manipulating LIBOR rates. In a released transcript of a 21 August 2007 chat, Jezri Mohideen, who was the head of yen products in Singapore, asked to have the LIBOR fixed in a conversation with other traders. The banks earned hundreds of millions, if not billions of dollars, in wrongful profits as a result of artificially inflating LIBOR rates on the first day of each month during the complaint period.

The entire global financial system is riddled with systemic fraud and key players in the gatekeeper roles, both in finance and in government, including regulatory bodies, know it and choose to quietly sustain this reality.

LIBOR is often used to hedge the general level of interest rates, for which it is inefficient given it includes a term bank credit component. The FCA has secured panel bank support to continue submitting to LIBOR, but only until 2021. Beyond this date the future of LIBOR is not guaranteed. 

Why should we care? LIBOR is embedded in firms’ operating models. Transitioning to alternative rates will affect how your contracts are priced and how you manage risk. Contractual fallback provisions in existing transactions may put you at risk of economic value transfer or contract frustration. There are conduct and legal risks associated with writing long-dated business referencing LIBOR.

What is the alternative? The Sterling Overnight Indexed Average (SONIA) measures the rate paid by banks on overnight funds. It is calculated as a trimmed mean of rates paid on overnight unsecured wholesale funds What makes SONIA robust? SONIA is robust because it is anchored in active, liquid underlying markets. Since April 2018, SONIA has been administered and published by the Bank of England. 

Why use SONIA? SONIA is robust and sustainable given the volume of transactions underpinning it. SONIA does not include a term bank credit risk component so is a better measure of the general level of interest rates than LIBOR. SONIA can be compounded to be used in term contracts. Compounded SONIA tends to be relatively predictable. Referencing alternatives such as SONIA is the most effective way of avoiding risks related to LIBOR discontinuation. 

Sources: Bank of England and FCA