The LIBOR and the scandal
Any replacement for the London Inter-bank Offered Rate (LIBOR) will have serious investment, accounting and legal implications for various global stakeholders (SHs). The LIBOR has been the most widely used interest rate in the world. It has been used to price assets worth more than $370 trillion. The LIBOR has been part of virtually every financial transaction in the developed world. The LIBOR has also affected developing countries because developing countries, including China, rely on the developed world for their financing needs. Therefore, the LIBOR can be considered as having been the central gear in the global financial machine.
The world was shocked to learn that a group of bankers and asset managers were illegally controlling this central lever. The LIBOR was illicitly manipulated via synchronizing the answers to Thomson Reuters’ daily calls. The answers to these calls were used in the determination of the LIBOR. This alleged manipulation allowed a select few bankers to gain in zero-sum financial transactions. In the aftermath, complicit financial institutions were fined up to $10 billion. However, the real fallout of the event came when the United Kingdom’s Financial Conduct Authority’s (FCA) announced that banks will not be liable to publish the LIBOR rates after 2021. This opens the possibility of a world without ample observation of the LIBOR figure.
Implications for the LIBOR replacement
The LIBOR’s exit will leave massive shoes that the LIBOR replacement (LR) will have to fill. The size of these shoes can best be determined by the usage of the LIBOR. The LIBOR has been used as the global baseline for risk-free investments. This baseline has been actively employed in judging the risk-adjusted performance of investments. Furthermore, the LIBOR has also acted as an important component in the calculation of risk premiums, valuations and many other variables. Its users have included public bodies such as government holding companies and finance ministries. In addition, powerful private bodies, the ranks of which have included pension funds and insurance companies, have used the LIBOR to assess their balance sheets. All of these users will now have to turn to new measures.
Replacements for the LIBOR
There are many potential LRs, and they share common features. First, they emanate from various economic and financial centers of the world. Second, they are not mutually exclusive. It is possible that many of these replacements could be used simultaneously by stakeholders (SHs). The LRs include rates that are governed by private bodies and state banks of the respective countries. Moreover, the LRs are secured and non-secured in nature. All of these new measures come from countries in the developed world, which include the European Union (EU), Japan, Switzerland, Japan, the United States and even the United Kingdom. The following discussion will elaborate on each of these LRs.
The first LR is a new, reformed LIBOR that hopes to correct methodological mistakes ignored by the old scandal-ridden version. This cleaner LIBOR will be operated by an independent agency named ICE Benchmark Administration (IBA). Apart from the LIBOR, the United Kingdom is also promoting the SONIA, which stands for Sterling Overnight Index Average. The SONIA has the advantage of being unsecured. This increases the chances that it will behave similarly to the LIBOR. However, unlike the LIBOR, it is governed by the Bank of England (BOE). As the name suggests, the SONIA is for overnight rates only. Working groups on further development of term rates for the SONIA have been established. The term rates of all of the other LRs are under development.
Within Europe, there are two other possible LRs. They are the SARON (Swiss Average Rate) and the €STR (Euro Short-Term Rate). The SARON will be administered by the SIX Swiss Exchange, which is the principal stock exchange for Switzerland. While the SARON will be privately operated, the EU has given its LR-establishment task to the European Central Bank (ECB). The ECB is developing the Euro Short-Term Rate (€STR). The €STR is non-secured, while the SARON is secured. All of this activity has roused the EU’s allies across the Atlantic.
The US Federal Reserve has been pushing the SOFR (Secured Overnight Financing Rate) as a LR. Unlike the SONIA, the SOFR is a secured rate, which means that it is collateral-dependent. Currently, the Alternative Reference Rate Committee (ARRC) is engaged in further development of the SOFR. Moving further across to the Pacific, the Japanese have also tasked their central bank with LR creation. The Bank of Japan (BOJ) is working on adding term rates to the TONAR (Tokyo Overnight Average Rate).
All of these LRs are different from the original LIBOR. These differences will raise legal-, investment- and accounting-related issues for SHs.
Fallout from the LIBOR
The effects of the LR on SHs will not be “black swan” in nature. The 2021 phase out of the LIBOR is a planned event, and an organized reaction from all SHs will help to ensure a smooth transition towards a single LR or multiple LRs.
The legal effects of the LR will depend upon the reaction of governments and other parties to the contracts. Most contracts will have fall-back conditions related to the replacement of the LIBOR. However, most of these provisions will be temporary in nature. According to Allen & Overy, long-term legal replacements will have to be agreed upon by the parties to the agreements. The government can save SHs a lot of legal headaches by issuing legislation that will allow the word LIBOR to be interpreted as a different interest rate. However, such blanket legislation would be a poor fit for some industries in the economy. Therefore, general and specific legal solutions also need to be agreed upon by SHs. This newly agreed LR will have to guard planned rates of return because all legal agreements aim to protect SH investments.
The LIBOR affects the investment world in many ways. To start, Mark Unferth, who is a portfolio manager at ACR Alpine Capital Research LLC, explained that spreads for fixed-income products were always valued in terms of “LIBOR plus the spread of a fund”. Using any other rate would tilt the balance in favor of the borrower or the lender. This reduces the chances of agreement on the LR by SHs.
It also does not help that all the LRs are country-specific and would not allow comparison between investments in different countries. Furthermore, the LIBOR was available in multiple currencies, while its replacements are denominated in local currencies. Having an interest rate denoted in a single currency increases the exposure of investors to currency swings. To make matters more complicated, LRs often have a smaller range of term-rate offerings. This implies that apart from investing, LRs will also affect planning and forecasting for SHs.
According to Eric Bernstein of Broadridge Asset Management Solutions, asset owners and money managers that had the LIBOR as a deep part of their investment system will have to incur significant costs of recalculating their investment data. Apart from recalculating old data, calculation of future projections will also be problematic. That is because future projections use regression, which in turn requires more observation. Some replacements such as the SOFOR started publishing data only in 2018. This means that for the next two decades, investors will have to rely more on informal measures of long-term forecasting.
Apart from forecasting, global accounting will also have to adjust to the changing LIBOR situation. According to PricewaterhouseCoopers(PwC), global financial reporting will have to find an alternate mechanism for discounting income and other figures on financial statements. It is important that a global consensus on the LR for financial reporting takes place. Otherwise, SHs would face impediments because of the need to create multiple financial reports for the same firm.
Conclusion
The LIBOR was the “holiest” number in the history of global finance. Therefore, the global legal, financial and investing communities were aghast when the LIBOR fudging came to light. Now, after the FCA announcement, stakeholders will have to find the LIBOR’s replacement. There are many possible replacements, and the implementation of these replacements will raise many issues. These problems will be legal, accounting and investment related in nature. The final impact of these problems depends on the preparation of local and international stakeholders for the 2021 replacement of the LIBOR.
References
- https://www.isda.org/2018/02/05/the-370-trillion-benchmark-challenge/
- https://www.cnbc.com/2019/01/09/china-no-longer-a-poor-nation-still-borrows-billions-from-world-bank.html
- https://www.cfr.org/backgrounder/understanding-libor-scandal
- https://www.brinknews.com/why-libor-will-disappear-and-what-it-means-for-you/
- https://www.oliverwyman.com/our-expertise/insights/2018/feb/libor-rate-transition.html
- http://www.marketswiki.com/wiki/Wholesale_Markets_Brokers%27_Association
- https://www.bankofengland.co.uk/paper/2018/consultation-paper-on-term-sonia-reference-rates
- https://www.businessinsider.com/a-new-benchmark-rate-is-replacing-libor-heres-what-you-need-to-know-2018-4
- http://www.allenovery.com/publications/en-gb/lrrfs/cross-border/Pages/No-more-LIBOR-%E2%80%93-impact-on-finance-agreements.aspx
- https://www.nortonrosefulbright.com/en/knowledge/publications/e0a200ea/retirement-of-libor—contractual-consequences
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- https://www.bankofengland.co.uk/markets/sonia-benchmark
- https://www.tandfonline.com/doi/abs/10.1207/s15327906mbr2603_7
- https://www.reuters.com/article/us-usa-bonds-sofr-explainer/what-is-sofr-the-new-u-s-libor-alternative-idUSKCN1HA0H1
- https://www.pwc.com/gx/en/audit-services/ifrs/publications/pwc-financial-reporting-impacts-from-replacement-of-libor-and-other-interbank-offered-rates-pwc-in-depth.pdf