By the end of 2021, the Financial Conduct Authority (FCA) of the United Kingdom plans to phase-out the London Interbank Offered Rate, or LIBOR, which is the benchmark rate that many banks use to set interest rates in loan documents. What does this mean for businesses? We explore here.

What is LIBOR?

The London Interbank Offered Rate, or LIBOR, is a global benchmark interest rate, which is calculated in five different currencies.

Here are a few fast facts about LIBOR:

• LIBOR has played a central role in global finance for more than 30 years
• LIBOR is the average interest rate at which major global banks borrow from one another.
• The Intercontinental Exchange administers the LIBOR. They ask major global banks how much they would charge other banks for short term loans.
• The rate is calculated through the Waterfall Methodology, a standardized, transaction-based, data-driven and layered method.

Why is LIBOR being phased out?

A “rigging scandal” came to light in 2012, revealing that some banks were reporting artificially low or high interest rates to benefit their derivatives traders, undermining a major benchmark for interest rates and financial products. Due to the realization that this benchmark is susceptible to manipulation, British regulators decided to phase LIBOR out, with plans to seek alternative rate-setting systems in the future.

Is anything replacing LIBOR?

The New York Federal Reserve launched a possible LIBOR replacement in April 2018 called the Secured Overnight Financing Rate (SOFR). SOFR is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight.

Potential impact of LIBOR phaseout

There are a few hurdles that businesses may face when transitioning away from LIBOR. This includes..

Added cost- Being that proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR, which could bring higher costs to businesses.

Change to firms market risk profiles- This may require changes to risk models, valuation tools, product design and hedging strategies.

Will require significant operational and legal work- According to the Bank of International Settlements (BIS), there are hundreds of trillions of dollars of interest rate derivative contracts that reference LIBOR. Reworking these contracts is expected to put a significant burden on legal resources.

Fixed income markets could take years to accept SOFR as replacement- It’s also expected that the Financial Accounting Standards Board (FASB) will need to designate SOFR as a benchmark interest rate in the U.S.

What does this mean for businesses?

Seeing that LIBOR may not exist beyond 2021, it is crucial for companies, financial firms, consumers, and other stakeholders to discuss what must be done to make a smooth transition away from LIBOR. Each company’s transition will vary depending on the type of market participation and their exposure to LIBOR. Hence the first step is to get a better understanding of where your business is exposed to the transition from LIBOR, the impact of the transition and the scale of the risks.

A “wait-and-see” approach is not recommended, businesses need to start planning now!

Questions on the LIBOR phase-out? Contact us, we can help.