Heated debate surrounding the widespread transition away from Libor (London Interbank Offered Rate) as an interest-rate benchmark has been brewing for years. But several working groups have begun issuing guidance and making serious moves toward Libor’s disappearance as the deadline quickly approaches.
A subcommittee of the Commodity Futures Trading Commission’s (CFTC) Market Risk Advisory Committee (MRAC) recommends replacing Libor with the secured overnight financing rate (SOFR), which is a benchmark interest rate used for dollar-denominated derivatives and loans. The initiative, SOFR First, is a best practice modeled after the U.K.’s SONIAFirst and would replace Libor at the end of July, one of the earliest dates suggested.
“SOFR First’s milestone date of July 26, 2021, is consistent with, and is designed to complement, U.S. banking regulators supervisory guidance that banks should cease entering into new contracts that use USD LIBOR as a reference rate at the end of 2021,” said Rostin Behnam, acting MRAC chairman, in a recent CFTC press release.
The Financial Stability Board also recently published guidance for a smooth transition away from Libor by the end of 2021. The U.K. Financial Conduct Authority announced that the majority of Libor panels will be discontinued at the end of this year.
Libor has been used globally for several decades as the index for interest rates. So why the big push for its disappearance? Libor has been controversial since 2012, when bankers from multiple financial institutions were caught manipulating the rates to their advantage, according to several news reports. The scandal revealed major flaws with Libor and raised questions about its credibility.
As financial institutions begin making this transition, creditors will want to double check that their bank lending agreements have been updated and no longer base interest rates on Libor. “Any contract or agreement we’ve had with the bank for borrowing or our discounting programs for letters of credit and drafts will have to be amended to find a new index,” said Val Venable, CCE, ICCE, FCIB’s International Credit & Risk Management instructor.
Banks will need to replace the traditional interest rate benchmark with alternative index rates. These will be different for each currency that uses its own index. Some examples of Libor replacements include SOFR (USD), SONIA (Sterling), ESTER (Euro), SARON (Swiss Franc) and TONA (Japanese Yen).
Instead of setting interest at a fixed rate, Libor offered protections to lenders by being adjustable, Venable said. Any creditor (or debtor) that has lending or borrowing agreements that use Libor as the index at which to set rates will need to have the agreements amended to reflect the new index.
“It is yet to be seen if the new index, or indexes, that replace what is now Libor will substantially change borrowing rates,” she explained.
This article first appeared in the July 8 issue of NACM e-News. It is used with permission.