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What will be the future of LIBOR?

LIBOR manipulations consequences

LIBOR (i.e. “London Interbank Offered Rate”) has been a great stabilizing influence in the world’s debt capital markets. It also facilitated the standardization of financial contracts. No one could contest these facts and positive impacts. It was first used in 1969. It was developed into a uniformed and eventually widely used reference rate for the following decades. However, with the financial crisis of 2007 and 2008, it appears that a significant reform of LIBOR was, as for many other markets, products and practices, necessary. The prudential regulators thought it could be a systemic weakness to have only one single reference rate with no credible alternative or back-up. If market liquidity dries up, we could face the issue of what were the basis on which daily rates are set, fixed and submitted. At the peak of the crisis interest rates volatility was noticed and we felt lack of creditworthiness within the interbank market. LIBOR rates were signaling that financial markets were about to possibly collapse. Some finance specialists claimed it was like the canary used into the coal mines. It was dying. Did market players realized it? LIBOR acted well during the crisis. However, a lack of real transaction data backing up the submissions for some currencies or maturities became more obvious to Supervisors.

Then, the so-called “Libor scandal” came. It was a series of fraudulent actions connected to the LIBOR. The “Libor” is an average interest rate calculated through submissions of interest rates by the largest banks across the world. This well-known affair arose when it was discovered that some banks were falsely inflating or deflating their interest rates so as to profit from trades, or to give the impression that they were more creditworthy than they actually were. Libor underpins approximately 350 trillion of USD in derivatives. It is currently administered by Intercontinental Exchange, which took over running the Libor in January 2014.

Financial Institutions are supposed to submit the actual interest rates they are paying, or would expect to pay, for borrowing from other banks. Libor is supposed to be the total assessment of the health and shape of the financial system because if the banks being polled feel confident about the state of things, they should report a low number and if the member banks feel a low degree of confidence in the financial system, they should report a higher interest rate number. In 2012, multiple criminal settlements by a large British Bank revealed significant fraud and collusion by some member banks connected to the rate submissions, leading to this enormous scandal.

Because Libor is used in US derivatives markets, an attempt to manipulate Libor is an attempt to manipulate US derivatives markets. Thus it looks like a violation of American law. Since mortgages, student loans, financial derivatives, and other financial products often rely on Libor as a reference rate, the manipulation of submissions used to calculate interest rates could have significant negative effects on consumers and financial markets across the world.

On 27 July 2012, the FT published an article by a former trader which claimed that benchmark rates manipulation had been common since at least 1991. Could you imagine how long these embezzlements have affected our businesses? Other reports on this have since come from different sources, confirming these manipulations. On 28 November 2012, even the Finance Committee of the Bundestag held a public hearing to learn more about the issue. The British Banker’s Association (BBA) said in September 2012 that it would transfer oversight of Libor to UK regulators, as predicted by bank analysts, proposed by FSA. The famous “Wheatley's review” recommended that banks submitting rates to Libor must base them on actual inter-bank deposit market transactions and keep records of those transactions, that individual banks' LIBOR submissions be published after three months, and recommended criminal sanctions, specifically for manipulation of benchmark interest rates. Financial institution customers could experience higher and more volatile borrowing and hedging costs after implementation of these

recommended reforms. The UK government agreed to accept all of the Wheatley Report's recommendations and press for legislation implementing them.

Fix and reform what you have messed up!

Significant reforms, in line with the Wheatley Review, came into effect in 2013 and a new administrator will take over in early 2014. The UK controls Libor through laws made in the UK Parliament. This report recommended reform rather than replacement of LIBOR, called for strict processes to verify submissions with transaction data and suggested that market participants should play a significant role in LIBOR production and oversight. The transition away from LIBOR benchmarks is important. The deadline has been fixed for end of 2021. The preparation must begin now to be ready on time with an alternative solution that flies. According to regulators, solution must be market-led and would strongly encourage market participants to become involved in shaping the future of alternatives. We should not underestimate the transition which is a huge task that will impact numerous contracts and affect multiple product areas and business lines.

LIBOR or not LIBOR? That’s the question

Since February 2014, ICE Benchmark Administration ltd (IBA, a London subsidiary if the Intercontinental Exchange) has taken over administration of LIBOR. It produced a review of implementation of IOSCO’s principles for financial benchmarks. The idea was to make LIBOR fixing more rigorous, compared to the way it was formerly calculated. One of the main objectives was to reduce the judgmental part in the rate that LIBOR banks submitted in the past. The bank submission should be based on the transactions actually carried out. In case they don’t have the data, the alternative is to explain their judgments. IBA has now moved towards tests since September last year. Banks should use the so-called “waterfall three level methodology” to evolve LIBOR in order to provide an indication of the average rate at which a group of banks could obtain unsecured wholesale funding. IBA has published the “roadmap for ICE LIBOR” about 2 years ago. It is the result of a consultation process which provides us with a uniform submission methodology, based on a clear common definition and eventually fully transaction-based wherever possible. IBA plans to centralize calculation process using a robust algorithm to determine LIBOR level, in different market circumstances. IBA also believes that an increase of number of banks submitting rates would help and enhance the robustness of the benchmark. The aim is also to better supervised rate fixing and to avoid conflicts of interest. They wanted to strengthen existing IBOR’s by anchoring into the transaction and by developing nearly Risk-Free Reference rates (the so-called RFR’s). Unfortunately with reforms and as always with major changes, the transition is not a small task and will impact a large number of existing contracts and multiple products. It is essential to understand and engage with key issues. On its side, the European Money Markets Institute (EMMI) published similar proposals for EURIBOR. We progress with the reform but it will have taken a rather long process before going live.

Is LIBOR used by Corporates and if so for what sort of purposes?

LIBOR rates are used for debt financing and derivatives, to price intercompany loans, for bilateral or syndicated loans, for letters of credit, private placements in the US, securitizations or floating rate notes, for example. It is also used in many derivatives like forwards, swaps or options and even cross-currency swaps to determine payment obligation and for pricing purposes. It is also used in the context of corporate’s portfolio management. It is referred to for commercial contracts e.g. late payment clauses in contracts, gross-up provisions, price adjustment mechanisms, to define investment return hurdle in some context. It can also be used for fair valuing derivative contracts for accounting purposes, to determine hedge effectiveness and to calculate financial disclosures under IFRS 9. In some industries, it is also used by insurers, for risk-free rates used for pension liabilities calculation which are based on LIBOR swap curve. Eventually it is used for regulatory cost of capital reasons. With such a long and not fully comprehensive list, you can easily understand LIBOR is highly referred to for many operations and for years. Having the fairest LIBOR rate is therefore key for corporates. Isn’t it? The LIBOR serves seven different maturities, over-night, one week and 1,2,3,6 and 12 months. There are 35 different Libor rates each business day with the most commonly used being the 3M USD rate (i.e. USD, EUR, GBP, JPY and CHF).

What does it mean in practice?

In practice, all market participants will have to address the issue and to review loan or financial instrument documentation in order to get it updated. It is sound to start discussion now with counterparties in order to get all documents amended before dead-line fixed. We have entered into a transition period of a few years. There is room for negotiation between borrowers and lenders. We should not underestimate these negotiations.

In Europe, many working groups have worked on alternatives to LIBOR and on selecting the RFR (i.e. Risk-Free rate which is the rate of return of a hypothetical investment with no risk of financial loss over a given period of time. In GBP, we named it SONIA (i.e. Sterling Overnight Index Average), in USD SOFR (i.e. Secured Overnight Funding Rate), in Switzerland SARON (i.e. Swiss Average Rate Overnight) or in Japan TONAR (i.e. Tokyo Overnight Average Rate) The LIBOR is forward-looking where RFR is backward-looking overnight rates. Libor includes the premium paid on longer-dated funds where RFR will not include a premium for term. In case you want to get more details about this issue, please consult the ACT website. Please also note that EACT has been in talks with European Central Bank and all stakeholders to express the corporate treasurers’ view and defend their position. It is again a strong and painful adjustment aimed at correcting past abuses and frauds made by some banks. It is interesting to notice that our

Regulators and Supervisors are still fixing some errors of the past. Let’s hope as always with new regulation that it will be for operating in a better financial world. This is a long path and certainly not the last miles. I’m always tempted to remain optimistic and to think that the best is ahead in corporate finance and that a cleaner financial ecosystem is good for all of us and virtuous. Hope it is not wrong impression.

François Masquelier, Chairman of ATEL

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