Controversial interest rate deal LIBOR faces the axe

The UK’s Financial Conduct Authority (FCA) concluded back in 2017 that LIBOR - a key benchmark rate-setting mechanism used between global banks for financial transactions is no longer robust enough for international benchmarks and announced in 2017 that it would be abolished.

That followed one of the biggest scandals to emerge from the financial crash of 2008 – traders were almost routinely fixing the rate to their own advantage.

It was key to the financial world. Whether it’s a credit card rate, adjustable rate mortgages, a whole range of investment and debt products, including floating-rate bank loans and interest rate swaps, LIBOR is used as a reference rate for financial contracts and also as a benchmark to gauge funding costs and investment returns across financial products.

So it’s a big deal for financial firms to comply and businesses using debt to transition to the replacement benchmarks.

Today the FCA and the Bank of England drew a firm line in the sand, confirming that banks have until December 2021 to cease submitting rates for the calculation of LIBOR – they will now need to base their transactions and products instead upon one of the Risk-Free Rates (RFRs), administered from the global financial centres of London, New York, Frankfurt, Zurich and Tokyo.

What is it and why is LIBOR now such a pressing issue?

LIBOR is the London Inter-Bank Offered Rate.

Its future has been under scrutiny since the 2008 financial crisis, increasingly viewed by regulators as outdated, particularly as international financial markets have become more complex. The underlying mechanism that enabled manipulation of LIBOR (which was uncovered in 2012 and saw a global investigation resulting in criminal convictions and heavy regulatory fines) is one of the reasons that it is being phased out.

So what’s the difference between the old benchmark and the new?

LIBOR, which has been in use for well over 40 years, is not entirely based upon pure transaction data alone – it is partly based on a subjective judgement, producing seven varying rates on benchmarks for one-year rates through to a one-day rate.

David Hetling,a director of Regulated Industries at SDL, which is part of RWS Holdings, says: “The new RFRs are based purely on overnight transactional data referencing that currency’s Treasuries which have been borrowed or lent overnight.  This makes RFRs more robust and less open to manipulation, with a corresponding risk reduction for transacting parties as well as the wider financial markets.”

What’s the timeframe and what does the transition mean in reality for banks, businesses and consumers of credit?

With estimates at more than $400 trillion in loans, securities and derivatives contracts globally exposed to LIBOR, the clock is ticking. The greatest onus sits squarely on the shoulders of financial institutions to remove their reliance on LIBOR in all new business, and in legacy contracts where it is feasible to do so by the end of 2021. The BoE said in January that it expects all businesses with existing loans in Sterling to have already heard from their lenders about the transition, and those seeking a new or refinanced loan to be offered a non-LIBOR alternative. The FCA’s announcement today makes it clear that this expectation remains,regardless of the prevailing pandemic conditions.