Do you know that according to LIBOR, organizations, institutions, and associated parties have drafted contracts worth USD 350 trillion worldwide? LIBOR (London Interbank Offered Rate) has been the benchmark interest rate for financial firms across the globe.
LIBOR has been around for many years but is now ending. According to reports, LIBOR will be completely phased out by the 30th of June, 2023. Organizations might have to look for an alternative for deciding interest rates in such a case. Also, organizations must understand how to make a transition from LIBOR immediately.
Read on to understand the LIBOR legislation and how to transition successfully.
What exactly is LIBOR?
As discussed, LIBOR is a benchmark interest rate for financial institutions worldwide. Financial institutions use LIBOR as a reference interest rate for financial instruments like bonds and derivatives. Even NBFCs offering loan services rely on LIBOR to decide the appropriate interest rate. A selected group of financial institutions report their interest rates to ICE (Intercontinental Exchange) daily.
Based on daily reporting by financial institutions, LIBOR is determined. In addition, banks report the interest rates they think will be applied for borrowing money from other banks within the market. The group of financial institutions has stopped reporting, as LIBOR is about to be discontinued.
Banks cannot rely on various benchmarks for lending, borrowing, loans, or other financial activities. LIBOR was a reliable and trusted benchmark for deciding the interest rate for financial instruments. It was a transparent benchmark rate to determine the cost of borrowing for financial institutions.
Even though it was a trusted benchmark, concerned regulatory authorities have decided to move away to a new benchmark. Financial institutions worldwide have been asked not to rely on LIBOR for contracts after 2021. The LIBOR legislation is about to expire, and companies must prepare for the transition now.
Why is LIBOR being discontinued in 2023?
It is hard to explain in words the reason for LIBOR discontinuation even after being a reliable benchmark for years. Even though LIBOR has been around for many years, a few controversies have surrounded it of late.
Accusations of some banks manipulating their interest rates and toying with interest rate submissions for personal benefits came to attention, the same being brought to the ICE’s notice in 2012. Subsequently, several banks were penalized in the USA. LIBOR’s credibility came under scrutiny. Also, the interbank market has changed with time, and LIBOR is no more reliable for organizations.
Over the years, liquidity in the interbank market has decreased. In addition, the use of government-backed securities as collateral has also increased in the interbank market. All these things have made it hard to accurately determine the borrowing cost for a financial institution in the interbank market.
After several allegations and complications, FCA (Financial Conduct Authority) decided to phase out LIBOR. FCA has been responsible for regulating LIBOR for many years. FCA also asked financial institutions to transition to alternate interest rate benchmarks with higher reliability.
Understanding the Alternatives to LIBOR
Since the LIBOR legislation is about to phase out, financial institutions must be familiar with the alternative. Alternative Reference Rates (ARR), also known as risk-free rates, will be used by financial institutions in the coming years. There are several alternate rates, and financial institutions must start the transition now.
SOFR (Secured Overnight Financing Rate) is the most popular alternative to LIBOR in 2023. Transactions and deals within the overnight repurchase agreement market help determine SOFR. SOFR relies on original transactions, not estimates, and will likely replace LIBOR. SONIA (Sterling Overnight Index Average), Euro Short-Term Rate (€STR), and TONAR (Tokyo Overnight Average Rate) are some other alternatives to LIBOR. Organizations must start their transition to an Alternative Reference Rate now.
Is the transition from LIBOR easy?
Transitioning from LIBOR will take work. Financial intuitions have relied on LIBOR legislation for years and must suddenly transition. There are going to be many challenges in a shift away from LIBOR. The biggest challenge is transitioning financial instruments, such as mortgages, bonds, and loans, linked to LIBOR in the past.
Financial institutions should renegotiate the contract according to a new reference rate. The internal processes of a financial institution might go through changes due to the transition to a new reference rate. Finding a reliable reference rate is also a challenge for financial institutions worldwide.
In Conclusion
LIBOR has been a reliable benchmark for years but is now going. For a successful transition from LIBOR, financial institutions can seek third-party support. A reputed third party can help financial institutions change internal processes according to a new reference rate. Prepare for the LIBOR transition now!