The end of the year 2021 will mark a memorable event in the history of international finance. Beginning in 2022, the London Interbank Offered Rates (LIBOR)— having been used as benchmarks to price loans, mortgages and other financial contracts in international financial markets for more than half a century — will be abandoned. They will be replaced by national reference rates developed by national alternative reference rate committees comprised of representatives from regulatory bodies and private sector financial firms in the United States, United Kingdom, the Euro Area, Switzerland, and Japan. The changeover has been carefully prepared over the past five years, and will address the problems that led to the demise of LIBOR. However, the national reference rates will also introduce new problems which will need to be assessed and resolved.
LIBOR and its demise
LIBOR was formalized and administered by the British Bankers Association in 1986, having already been in use in the 1960s and 1970s. This remained the case until the rate fixing scandals came to light in 2012; afterwards LIBOR rates have been calculated and published by the Intercontinental Exchange (ICE) Benchmark Administration (IBA) in London, under supervision of the UK Financial Conduct Authority (FCA). Every day, the IBA asks a panel of up to 18 international banks to submit the rates at which they think they would pay to borrow money in the interbank markets; in five currencies—the US dollar, the British Pound Sterling, the euro, Swiss franc and the Japanese yen—and in seven maturities ranging from overnight to one week; then one, two, three, six and twelve months—for a total of 35 LIBOR rates. Every day, the new LIBOR rates are reported to the public at 11:55 am GMT. These become the benchmark rates used to price financial transactions among international financial market participants. These rates have been used as pricing bases for up to $300 trillion of financial derivatives and other contracts worldwide, including $200 trillion in the United States. LIBOR has been used for about $5 trillion of US consumer loans, including residential adjustable-rate mortgages, personal loans, student loans, and car loans.
During the 2008 Global Financial Crisis, there were concerns that some banks had submitted unrealistically low rates to the LIBOR panel to hide their funding difficulties. Then, in 2012 several incidences of manipulation of LIBOR were reported. Some members of the rate fixing panel had colluded to submit rates slightly different from transactionable rates to tilt the published rates in favor of their market positions. Several bankers were tried and convicted of the rate fixing charges.
These scandals undermined the integrity and credibility of LIBOR as benchmarks. Moreover, by that time, the volume of transactions in the interbank markets had fallen, especially for long maturities — making LIBOR less representative of market conditions. Consequently, the UK Financial Conduct Authority announced in 2017 that LIBOR would be phased out after 2021. No banks will be compelled to submit rates after that date, and no new financial transactions should reference LIBOR. In March 2021, the FCA confirmed that one-week and two-month LIBOR for USD, as well as LIBOR for all other currencies of all maturities, will be dropped after 2021. Other maturity settings for USD will be allowed until June 30, 2023 to accommodate the maturity of most legacy LIBOR-based financial contracts. In the place of LIBOR, national authorities and industry representatives have worked together to develop alternative reference rates.
The US solution and its problems
In the United States, the Alternative Reference Rate Committee (ARRC) was launched in 2014. It comprises representatives from a wide range of banks, asset management companies, and other financial institutions, as well as supervisory authorities as ex-officio members. The ARRC selected the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR. SOFR is calculated daily based on the overnight cost of borrowing and lending in the US Treasury repo market, which is active, deep, and liquid —its daily average transaction volume is about $1 trillion. SOFR is published daily by the Federal Reserve Bank of New York in collaboration with the US Treasury’s Office for Financial Research as a public goods. As the transition date approaches, legislations from New York state and at the federal level have been passed or prepared to provide legal certainty for the change from LIBOR to alternative reference rates in financial contracts.
With sufficient time for preparation, the changeover should proceed smoothly. Nevertheless, the US choice of SOFR presents several problems. Long-term use will tell how serious they are, and if additional benchmark rates are needed to meet market demand.
Because it is collateralized with US Treasury securities, SOFR is considered almost risk free and consequently trades below LIBOR, which incorporates credit risks of the counterparties. To account for this difference in the credit quality behind the two rates, a credit spread was determined by the International Swap And Derivatives Association (ISDA) and endorsed by the ARRC to be used in switching from LIBOR to fallback rates such as SOFR and other national reference rates in financial contracts, including swaps and derivatives. This adjustment goes a long way in reconciling the two rates, but can still be problematic if the credit spread changes over time.
Furthermore, SOFR has been more volatile than LIBOR reflecting the way each is being calculated. SOFR are determined by the rapidly changing averages of actual transaction rates, whereas LIBOR are determined by the more stable trimmed averages of rates submitted by banks. The volatility of SOFR could pose a problem for hedging operations and other financial calculations. In a financial crisis, LIBOR could rise in response to worsening credit conditions facing market participants. SOFR could fall due to a safe-haven flight to US Treasury securities — in this case, SOFR may not be useful for private sector lenders and borrowers of funds in unsecured financial markets.
More importantly, SOFR is open to potential disruptions in the Treasury repo market driven by sudden and technical changes in the supply or demand of US Treasury securities collateral—not triggered by changes in general economic and financial conditions. Such changes triggered the sharp spike in the SOFR in September 2019, and a noticeable decline in October 2021 while other interest rates rose in anticipation of the Federal Reserve’s rate hikes. Volatility of the SOFR could prove problematic for financial contracts and products based on its benchmark, such as floating rate notes or adjustable-rate mortgages.
To address this problem, the ARRC recommended that market participants use longer-term averages, such as one or three-month averages, instead of overnight rates. However, while the longer-term averages are less volatile than the overnight rate, they are retrospective and don’t necessarily reflect financing conditions going forward. A better solution is to increase the availability of forward-looking term SOFR-based futures and swap contracts. These have been introduced on the Chicago Mercantile Exchange (CME), but need time to mature and attain sufficient liquidity to be useful.
Finally, SOFR lacks the credit risk dimension—i.e. counterparty credit risks—inherent in LIBOR. As a result, market participants may need and search for a credit sensitive benchmark rate more suitable for some financial transactions. However, US financial regulators have warned against the use of other rates, such as the Bloomberg Short Term Bank Yield Index (BSBY) ,which are based on low transactions volumes and less robust than SOFR. The question of how to address the market need for a credit sensitive benchmark remains.
Other national alternative reference rates
Similarly to the United States, the Swiss Average Rate Overnight (SARON) represents the overnight interest rates based on transactions and quotes posted in the Swiss repo market — using Swiss National Bank bills as collateral. By contrast, the alternative reference rates selected by the UK (Sterling Overnight Index Average SONIA), the Euro Area (Euro Short Term Rate €STR) and Japan (Tokyo Overnight Average Rate TONAR) are unsecured borrowing and lending rates among banks and other market participants. The differences between secured and unsecured benchmark rates would result in bilateral credit spreads between those rates. These spreads will be accounted for by market participants and are usually unproblematic. However, when secured benchmark rates like SOFR and SARON are impacted by sudden changes in the underlying repo markets in the United States and Switzerland, that could cause uncertainties for cross currency swap and forward markets.
In short, the great LIBOR transition will address the rate fixing scandals by basing the reference rates on a large volume of real transactions and not submissions by bankers. This will restore legitimacy and credibility to the benchmark rates essential for international finance. However, the successor reference rates lack the uniformity and consistency of LIBOR—thanks to using the same methodology in calculating various LIBOR rates. They introduce new practical problems which will require ongoing market adjustments and innovations to preserve and enhance efficient international financial markets.
Hung Tran is a nonresident senior fellow at the Atlantic Council; a former executive managing director at the International Institute of Finance and former deputy director at the International Monetary Fund.
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