The London Interbank Offered Rate (LIBOR) has served as the primary reference rate for various types of adjustable-rate financial products for decades. However, its role as the finance industry's reference rate may soon diminish in favor of a U.S.-based alternative. What is LIBOR, and why might it disappear?
Unlike fixed interest rates, adjustable rates vary depending on market conditions. These rates are commonly charged to individuals who buy homes, businesses that borrow from retail banks and even banks that enter complex derivative contracts. The market interest rate for these arrangements is typically a function of LIBOR, plus a risk premium.
There are many variations of LIBOR. In its simplest form, LIBOR provides a theoretical rate that a major bank might charge a competitor to borrow funds overnight.
It's theoretical because, in the aftermath of the Great Recession, interbank borrowing is rare due to increasingly stringent capital requirements. So, LIBOR approximates the risk-free cost of borrowing, which serves as the foundation of variable interest rate financial products.
An Uncertain Future
LIBOR is compiled from voluntary submissions by banks. It's not tied to real transactions. So, there's a risk that it can be manipulated. In fact, in 2008, regulators uncovered collusion between banks to manipulate LIBOR to profit on the financial instruments supported by LIBOR.
Given the potential for abuse, the United Kingdom's Financial Conduct Authority (FCA) recently announced its intention to make the submission of quotes to calculate LIBOR optional beginning in 2021.
But LIBOR may continue to be used as a market reference rate. While the FCA won't require bank participation in deriving a rate, leading many to opt out of the process, some banks may continue to provide input.
One possible alternative to LIBOR comes from the Federal Reserve Bank of New York. The Secured Overnight Financing Rate (SOFR) addresses the shortcomings of LIBOR by using interest rates associated with repurchasing agreements, which involves a large volume of overnight lending activity.
These repurchasing agreements are secured by U.S. government securities, such as Treasury bills and bonds. So, SOFR closely approximates the risk-free rate.
Swapping SOFR for LIBOR minimizes the potential for market manipulation because, with SOFR, the Federal Reserve assumes responsibility for its aggregation and reporting, not a corporation. By comparison, individual companies assume responsibility for aggregation and reporting LIBOR.
Impact of Market Conditions
Using SOFR does have a potential downside: Because it involves the collation of real-world transactions, any volatility in the economy and the market for repurchase agreements could result in SOFR fluctuations. In turn, this volatility could cause frequent changes in the rates charged to consumers for variable-rate financial products. Right now, the use of SOFR as a reference rate is in its infancy. So, only time will tell how much market volatility will affect the rate.
If consumers experience frequent changes in interest rates and their associated debt payments, the market may shift to a market-adjusted SOFR. This alternative would reflect real-world rates while removing some of the market volatility.
Making the Switch
How can lenders and borrowers that currently use LIBOR prepare for the probable adoption of SOFR?
You'll need to identify loans and other contracts that refer to LIBOR and revise them to reference the alternative market reference rate. In addition to updating documents, a robust communication plan must exist to explain the change in market reference rates and the implications for parties to a transaction. This process needs to be completed before the anticipated demise of LIBOR in 2022.
This isn't as simple as finding and replacing one word in a contract. In some cases, it may also be necessary to adjust the risk premium that's added to the new-and-improved market reference rate. LIBOR and SOFR (or another reference rate) may not be completely equivalent, so it's important to make sure that the risk premium isn't too high or low to compensate a financial institution for its risk.
To illustrate this point, let's assume that the three-month LIBOR rate, expressed as an annual percentage, stands at 2.69%, and SOFR equals 2.39%. To arrive at the current rate for a traditional 30-year mortgage of 4.375%, an institution would need to add 1.685% to LIBOR and 1.985% to SOFR. While the end rate is the same, the risk premium differs.
For More Information
At this point, it's unclear exactly which reference rate will replace LIBOR — or if LIBOR will somehow survive the FCA changes. Contact your financial advisor if you have questions about how these recent developments are likely to affect your organization and to devise a game plan to modify any existing or future market-based financial arrangements.