LIBOR is Flawed, and We Need a New, Better, Benchmark Soon
But, it is also important to make it zero mistake in transition
In finance, LIBOR (London Interbank Offered Rate) is like the speed of light in quantum physics: it is used as a benchmark of (almost) everything. It was the an average value of the submitted interest-rate by the leading global banks on a daily basis. It is supposedly represent the interest rate at which banks offer to lend funds to one another. It is the reference interest rate for millions of USD 240 trillion of derivatives, fixed income, mortgage and so on. It is a very important number to determine risk and valuation of an asset. However, UK financial regulator plans to replace LIBOR with something else in 2021.
The “invention” of the new LIBOR is urgently needed since the volumes of interbank unsecured term borrowing is significantly reduced, not to mention a “LIBOR Scandal” that shook up the world in 2012. Those two reasons are strong enough to bring us one conclusion: LIBOR had to go.
The Contenders
LIBOR is not easy to replace, but some bank centrals are already have contenders in play. The Fed decided SOFR (Secured Overnight Financing Rate) as the replacement for the dollar LIBOR. The U.K. selected Sonia (Sterling Overnight Index Average). Japan had TONA (Tokyo Overnight Average) and Switzerland proposed Saron (Swiss Average Rate Overnight). All of them has different mechanism but one thing for sure, they are based on actual overnight money market transactions, not bankers’ estimation.
The thing is LIBOR won’t going away anytime soon. There is too much risk at stake but it will be changed gradually.
Potentially Creating Chaos and Confusion
LIBOR is definitely the most important number in the world. Majority of financial assets are referenced to it and replacing the reference in one swoop would be a headache.
Renegotiating tens of millions worth of financial contracts is difficult and risky. LIBOR replacement like SOFR or TONA had different approaches between rates create inconsistencies and complexity. Also, the replacement is still untested to prevent rate manipulation like before.
Another thing to consider is LIBOR replacements like above does not take into account banks’ cost of funds or credit risk. It makes the bank treasurer can’t be so certain about the cash flow management since there will be a mismatch between LIBOR and the new benchmark.
“If they replace it, the expectation is that there will be ‘winners’ and ‘losers.’ If they have a contract with LIBOR and replace it with something else, even if it’s close to LIBOR, it won’t match. LIBOR is based on a certain methodology. If it’s replaced by SOFR or another rate, if you compare the two over time, it won’t be the same. If the contract says LIBOR and you substitute SOFR, the economics of that is that some will end up ahead and some behind. They’ll either get more or pay more.” — Willa Cohen Bruckner, partner, financial services, Alston & Bird LLP
Whatever It Is, LIBOR Should be Replaced
Changing LIBOR is certainly a headache for people working inside or outside financial world. It would impact everything, from the student loan, mortgage loan, assets worth, project valuation and so on.
For decades, LIBOR creates certainty since bank’s treasurers already estimated the rate for one, three, six and 12-month contracts in advance. But, this methodology is the exact reason why the world need to shift away from LIBOR.
It does not reflect the real transactions. It is easy to be “fixed” by group of leading bankers. The benchmark needs to be replaced even when the question of who bears the cost of the amendments remains unanswered.
“No one likes LIBOR. The bigger issue is the credibility and materiality of the benchmark, and that we don’t have to think about it. We need to focus on the underlying risk of the borrower, not whether the risk of the benchmark should be a concern.” — Mark Unferth, ACR Alpine Capital Research LLC.
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