In July 2017 it was announced that LIBOR will be phased out by 2021. Because globally securities of more than $350 trillion are based on the LIBOR reference rate, its discontinuation will be a paradigm shift in the financial industry impacting the whole value chain of banks from retail to treasury to trading. Market participants should adapt to those upcoming changes in an early stage to be prepared and benefit from the new market environment.
What happened so far?
The Chief Executive of the UK’s Financial Conduct Authority (FCA), Andrew Bailey, delivered a speech on 27 July 2017, stating that the London Interbank Offered Rate (LIBOR) will be phased out by 2021. He urged the sector to work in earnest on developing alternative reference rates based on actual transactions. In his speech, Bailey indicated that the FCA wishes to achieve a position by the end of 2021 where transaction-based alternatives are available and “it would no longer be necessary for the FCA to persuade, or compel, banks to submit to LIBOR.” The decision of FCA not to maintain LIBOR any longer is definitely a massive change in the interest rate area that will affect the financial services industry in various areas.
First implications following the announcement to phase out LIBOR at the latest by 2021
Following the lead of the FCA on 21 September 2017 the Financial Services and Markets Authority (FSMA), the European Securities and Markets Authority (ESMA), the European Central Bank (ECB) and the European Commission announced the launch of a new working group tasked with the identification and adoption of a riskfree overnight rate which can serve as a basis for an alternative to current benchmarks used in a variety of financial instruments and contracts in the eurozone.
The discontinuation of LIBOR: a paradigm shift for the banking industry
Since securities of more than $350 trillion are underpinned by LIBOR, its discontinuation will initiate a major change in the banking industry:
- In the short term, it is currently unclear how contracts with an expiry date later than 2021 will be settled when the underlying benchmark does not exist anymore.
- In the long term, choosing OIS curves as a successor to LIBOR could be problematic as the market volume has been steadily shrinking since 2008, making it difficult to use it as a benchmark.
- Considering the large spread between LIBOR and the most probable successor OIS since 2007, there is potential risk of a cliff effect in valuation of mortgages, credits and bonds.
The LIBOR-OIS spread is seen as the level of reluctance of an investor to deposit for an AA-rated bank, in comparison with a risk-free investment, i.e. the LIBOR-OIS spread is a measure of the bank credit spread, term liquidity spread, and term risk premia for interbank loans. This spread is a closely monitored barometer of the health of the banking.
Changing curves: what is the alternative?
Nevertheless, the Overnight Indexed Swaps (OIS) rates are seen as the most appropriate risk-free alternative for LIBOR in practice since the floating payments of an OIS are equivalent to daily compounded overnight investments, i.e. investments that are considered as nearly risk-free due to their extremely short term (less than one day). More explicitly, the most considerable alternatives are:
- Overnight index averages like EONIA, SONIA, SARON, SOFR and TONAR may
serve as adequate, nearly risk-free alternatives. - Switzerland is already replacing its benchmark rate, TOIS, with the overnight
alternative, SARON.
Next steps
Market participants must precociously begin to consider the effects the introduction of new benchmark rates has on their portfolios and systems. Viable interest rates have to be developed and their impact analysed early on to ensure a smooth transition away from LIBOR.
