The last remaining London interbank offered rate (Libor) panel ceased on June 30 2023 – and though it is not quite the end for what was famously described as “the world’s most important number”, there is no mistaking that a new era of interest rate benchmarks is underway.
Alternative Reference Rates (ARRs) – such as the Secured Overnight Financing Rate Data (SOFR) in the US, and the Sterling Overnight Index Average (SONIA) in the UK – are the future. In our view, global financial markets will be better off for it. Unlike the legacy rates they are superseding, which were determined subjectively and thus vulnerable to manipulation, ARRs are based on actual financial transactions. They make use of more transparent calculation methodologies, and also tend to be much more liquid than their predecessors.
Yet the transition has not been seamless. That is perhaps unsurprising: as recently as 2021, estimates suggested that $200-300 trillion (£158 - £237tn) in financial contracts depended on Libor worldwide. As of the end of May 2023, just a month before the cessation of USD Libor, Barclays noted that about 55% of US loans in collateralised loan obligations were tied to Libors, with 44% tied to SOFR. That ratio is swiftly changing in SOFR’s favour, but it does underline Libor’s lingering influence in certain financial markets.
The caution some financial institutions have shown in making the switch is understandable. It tends not to be rooted in resistance to the idea of adopting ARRs, but rather the expected costs of transition – for example, of upgrading IT systems and processes to reflect the new benchmarks, modifying contractual fallback language and basis risk between the old and new reference rates – especially in the midst of focusing on other priorities, such as the inflationary macroeconomic climate.
Regulators have recognised this can be a significant challenge, and provided some breathing space for institutions that were unable to meet the June 2023 deadline. In response to a recent public consultation, the UK’s Financial Conduct Authority (FCA) ruled that Libor’s administrator, ICE Benchmark Administration, would be required to continue to publish the 1-, 3- and 6-month US dollar Libor settings under a “synthetic” methodology until September 2024. Meanwhile, a 3-month synthetic sterling Libor setting will be published until March 2024; and in Singapore, the 1-month and 3-month synthetic Singapore Interbank Offered Rate (SIBOR) will run the end of next year.
But this seems to be the final deadline: further extensions are unlikely to be forthcoming. Regulators have also made clear that synthetic Libor is only intended for use in certain legacy contracts – and not for new contracts. In the FCA’s words: “Synthetic Libor is only a temporary bridge, and synthetic settings will not continue simply for the convenience of those who could have transitioned their contracts but have not done so”. Nor, it points out, are these rates intended to be representative of the underlying markets they previously sought to measure.
In most jurisdictions, financial market participants are not restricted by regulators to switch over to a single mandatory ARR. In the US syndicated loan market, for example, many banks have opted to use the forward-looking ‘Term SOFR’ – which more closely resembles the term structure of Libor – rather than retroactive overnight SOFR benchmarks which potentially create uncertainties around interest rate payments.
Some smaller and regional banks had indicated they will bypass SOFR altogether in favour of credit sensitive rates, such as the American Interbank Offered Rate (Ameribor) or Bloomberg’s Short-Term Bank Yield Index (BSBY). However, the prudence of using credit sensitive rates has been called into question by authorities such as the FCA. Most recently, on July 3rd, the Board of the International Organisation of Securities Commissions (IOSCO) released a review concluding that two credit sensitive rates (not named, but widely acknowledged to be Ameribor and BSBY) exhibit some of the same inherent “inverted pyramid” weaknesses as Libor. Without modification, their use “may threaten market integrity and financial stability”, IOSCO warned. Two Term SOFR rates also reviewed by IOSCO were rated better than the credit sensitive rates, but nevertheless were deemed “suitable for limited use only” – risking being undermined if they become too widely available.
What seems clear is that however financial market participants choose to navigate this landscape, they cannot afford to wait until the last moment. Institutions which use the runway afforded by synthetic Libor to postpone the switch are likely to face higher borrowing costs and operational risks in the meantime – on top of the eventual costs of transition they will have to bear.
The Alternative Reference Rates Committee (ARRC) – a group convened by the US Federal Reserve Board to help guide the changeover to SOFR – recently released a statement urging market participants with remaining Libor exposures to complete the transition. “Those that are not prepared risk significant ramifications, including uncertain and potentially unfavorable outcomes regarding their legacy Libor contracts along with operational disruptions”, the ARRC warned.
Now the June 2023 deadline has passed, and with a final end date for synthetic Libor impending next year, this advice is more important than ever for firms that haven’t yet switched over. And a crucial prerequisite for financial firms making the transition is to have access to data that will allow them to continue to do business and unlock insights into these new benchmark rates.
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