The beginning & the end of LIBOR

While dollar LIBOR will continue to be quoted after 2021, it will cease to exist after June 2023, regulators everywhere require amending of existing contracts linked to LIBOR as benchmark rate to incorporate the new ARRs, with effect from January 1, 2022.

As the end of LIBOR dawns, it is useful and interesting, to look at its birth. LIBOR was born on January 1, 1986. Its mother was the British Bankers’ Association (BBA), father the Eurodollar market that is, by a wide margin, the largest source of global finance.

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Eurodollars (nothing to do with Euros) are time deposits denominated in dollar at banks outside the US, not under the jurisdiction of the US Fed. The first Eurodollar deposit was made as early as 1957 when the Soviet Union, concerned that its dollar holdings may be frozen in retaliation for some of its Cold War actions, moved some of this to Moscow Narodny Bank in London, Soviet-owned but with a British charter; Moscow Narodny could safely deposit the dollars in US banks, since, given that it was a British bank, the money remained safe from being frozen.

Interest rates on Eurodollars, negotiated between depositor and bank, were generally higher than those on dollar-deposits in the US, since Eurodollar deposits were not protected by the Fed; so, since there was less oversight, Eurodollars could be used more widely. This “opening up” of financial opportunities saw the market grow dramatically, and by 1985, it was estimated at over $1.68 tn, about a third of the US economy.

By this time, with markets rapidly deregulating, global banks were trading in a variety of relatively new market instruments, like IRS, FX options and FRAs; some bankers worried about the risks since each instrument had independently negotiated terms; again, they recognised that growth would be constrained unless there was some uniformity in transaction terms. In October 1984, the BBA—working with other parties, including the Bank of England—began work on creating a standard and LIBOR was born.

A group of globally active banks were asked to quote the interest rate at which each could borrow, if it were to ask for and accept inter-bank offers in reasonable market size, just before 11 am London time. The BBA followed a prescribed process—eliminating extreme values—and announced LIBOR, in different currencies at the different tenors, by 11:30 am. This became the LIBOR fixing. Over time, the number of banks increased (currently at 17).

While LIBOR was quoted out to 12 months, LIBOR derivatives—futures and swaps—enabled the creation of the benchmark out to much longer tenors. All of this accelerated the financialisation of the global economy, leading to an explosion of LIBOR-linked derivatives—outstanding volume of transactions is estimated at $350 tn, more than 15 times the size of today’s US economy!

In 2008, a controversial study suggested that banks might have understated their borrowing costs (reported as LIBOR) during the 2008 credit crunch, to protect creditworthiness. In 2012, a retired trader was quoted as saying that LIBOR was being manipulated as far back as 1991. It became clear that banks had been manipulating LIBOR so they could charge companies higher interest. By 2012, several regulators started probes, and many global banks were fined substantial amounts.

This triggered a period of soul-searching and a focus on reforming the system. Rather than LIBOR, which was not only easy to manipulate but also was not representative of the huge and growing market, US and UK regulators (as also of other jurisdictions) determined that LIBOR would be phased out, and all new lending would use alternate reference rates (ARRs)—for example, SOFR (Secured Overnight Financing Rate) for the dollar. SOFR, computed from actual repo transactions (as opposed to assumed transactions in the case of LIBOR), is published daily by the US Fed.

While dollar LIBOR will continue to be quoted after 2021, it will cease to exist after June 2023, regulators everywhere require amending of existing contracts linked to LIBOR as benchmark rate to incorporate the new ARRs, with effect from January 1, 2022. Companies need to adopt the fall back language of ARRC and sign the ISDA 2020 IBOR Fallback Protocol, amending both the Loan Agreement and the ISDA Master Agreement 2002.

For loans with payments beyond June 2023 and where the interest rate risk is hedged with an IRS, there will be no impact on rupee cost after this documentation, since LIBOR in the loan and in the derivative will automatically convert to SOFR + adjustment spread, and each would be set off against the other. If the lender and derivative counter-party are different, the documentation will need to be more carefully considered.

For unhedged loans, it is trickier since interest payments will be higher as compared to the LIBOR loan—because, even though the SOFR curve will be lower than the LIBOR curve (since SOFR is secured lending), the difference in the two curves will most likely be less than the adjustment spread (between LIBOR and SOFR). Another issue is that SOFR, being an overnight rate, is quoted in arrears, so the actual interest due after, say, three months, won’t be known in advance (as in the case of LIBOR). Payment conventions are developing to address these issues and, indeed, the SOFR market itself will in time become much more liquid and “real”.

The author is CEO, Mecklai Financial, www.mecklai.com