LIBOR: What it is, Why it’s Ending and What Will Replace It

By The ArborCrowd Team
Dec 2, 2020

While many investors and consumers are familiar with the term LIBOR, they may not know exactly what it is. Officially known as the London Interbank Offered Rate, LIBOR is widely used as a reference rate for financial contracts and as a benchmark to gauge funding costs and investment returns for adjustable-rate mortgages, credit cards, floating-rate bank loans, interest-rate swaps and other investments. The bank rate, consumed by scandal during the 2008-2009 financial crisis, will be phased out in 2021 with broad implications. Here’s what you need to know about the rate, and what will replace it.

Thirty-five different London Interbank Offered Rates are administered in five different currencies by the Intercontinental Exchange, which operates global exchanges. Simply put, these are rates that banks charge each other for short-term loans. LIBOR’s history dates back to 1969, when a Greek banker arranged a syndicated loan linked to the reported funding costs of banks. Over the next half century, the rate grew to play a critical role in global markets, with LIBOR representing benchmarks for trillions of dollars in securities across the globe.

Next year, LIBOR will be ending after several years of scandal. Because LIBOR rates are set by banks submitting their own estimates of their borrowing costs, they can easily be manipulated by the banks themselves.

During the Great Recession, some banks submitted low LIBOR numbers to make it appear as if they were in good financial shape, masking liquidity problems many were experiencing at the time. Other banks manipulated LIBOR rates to benefit their own LIBOR-linked investments. These practices were wide ranging: according to the Council on Foreign Relations, banks have been fined over $9 billion for LIBOR-rigging schemes since 2012.

While this diminished the credibility of LIBOR, it continued as the primary benchmark for global lending rates. But in 2017, the Financial Conduct Authority (FCA), a conduct regulator for financial services firms and financial markets, announced LIBOR would be discontinued in 2021. The phase-out reflects a growing desire from regulators who prefer to see reference rates based on actual transactions as opposed to subjective judgments from banks.

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This March, a group of private-market participants and regulators known as the Alternative Reference Rates Committee (ARRC) proposed legislation in New York that would protect parties in adopting a new benchmark known as the secured overnight financing rate, or SOFR. SOFR is based on transactions in the U.S. Treasury repurchase market, where banks and investors borrow or lend Treasuries overnight. Since it references actual transactions, it is expected to be more accurate and difficult to manipulate than LIBOR.

SOFR, like LIBOR, reflects short-term borrowing costs and is expected to become the dominant global benchmark rate. However, it’s a complex, uncertain replacement due to key differences that mean the two cannot easily be swapped. For example, LIBOR rates could be used for a range of borrowing periods, from one day to 12 months, which makes it easier to predict future payments. Since SOFR is based on daily overnight transactions, it is not forward looking and could be challenging to calculate payments in advance. Another difference is that SOFR rates are expected to be lower than those using LIBOR because SOFR is based on overnight Treasury transactions, so it is a risk-free rate, while contracts that reference LIBOR typically include credit risk.

To account for the disparities, regulators are encouraging institutions to proactively include detailed “fallback provisions” in new contracts, which outline exactly how differences in SOFR and LIBOR will be calculated after the phase out. The main challenge rests with amending the liability interest rate language of older, legacy transactions that haven’t taken the end of LIBOR into account. ARRC’s proposed legislation includes language that would allow existing contracts without fallback provisions to use a rate based on SOFR, while not affecting contracts that have certain fallbacks.

The ARRC proposed legislation hasn’t passed yet, but it will provide more clarity and protection in the transition toward SOFR. There remain uncertainties, including potential litigation (as this article points out, U.S. legislation may differ from fixes adopted by the U.K., the EU or other jurisdictions, resulting in disputes around the choice of law to apply) as well as how the transition will impact earnings for U.S. banks.

For the real estate industry, there’s less worry as 83% of outstanding commercial real estate contracts are expected to expire in 2021. Therefore, the industry is mostly well positioned for the change, according to a 2019 report by Voya Investment Management.

The ideal outcome is to have a gradual, measured switch from LIBOR to SOFR. Despite delays from COVID-19, the process is returning to focus as there is still significant work needed for a seamless transition. The upcoming year will prove crucial for real estate investors as newer property loans will start to see floating rate loans keyed off a SOFR-based rate instead of LIBOR. While in the short term there may be some confusion and risk associated with this change, there are clear long-term benefits to a benchmark that is less open to manipulation.

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