LIBOR, the London Interbank Offered Rate, has been called “the most important number in finance” but it is scheduled to sunset next year. Your clients are likely to be affected by the coming change. Here is what you should know about LIBOR and its alternative and what you and your clients should expect during the transition period. Most important to remember is the moving from LIBOR will make for better markets for investors.
LIBOR serves as a reference rate for many bond investments and securities with floating coupon rates such as investment-grade floating-rate notes and bank loans. It also is a benchmark for a multitude of consumer loans including adjustable-rate mortgages; home equity loans and lines of credit; auto loans; student loans; credit cards; margin loans; pledged-asset lines; and variable-rate mortgages.
Most financial professionals know what LIBOR is but even experts don’t focus on how it came to be the benchmark affecting trillions in loan obligations. It’s a curious story. In 1969, a consortium of banks led by Manufacturers Hanover organized an $80 million syndicated loan for the Shah of Iran. It was a variable rate loan, and the lenders had to decide how to reset the rate as interest rates changed. They decided they would call each other and each would say what he thought the rate should be. That is how LIBOR was born.
The system for determining LIBOR was formalized during the mid-1980s by the British Bankers Association. It remained more or less unchanged until 2012, when a rate-fixing scandal cast a pall on LIBOR. In 2021, when the U.K.’s Financial Conduct Authority stops requiring banks to submit the daily rates used to calculate the benchmark, LIBOR will become less important as one of several benchmark interest rates.
The Alternative Reference Rate Committee (ARRC) was convened by the Federal Reserve Board and the Federal Reserve Board to assure a smooth transition from LIBOR to ARRC’s recommended alternative, the Secured Overnight Financing Rate (SOFR). SOFR is derived from borrowing and lending activity in Treasuries, The ARRC has been working to address risks in products still tied to LIBOR in the event LIBOR is no longer usable.
A number of alternative benchmark rates have emerged in addition to SOFR, giving financial markets participants the time to find the benchmarks that are best for them depending on the kind of loans they are making. When it comes to alternative rates, choice is critical. It enables lenders and other participants to pick the appropriate rate for their circumstances and it helps lower systemic risk. In times of volatility, it is better to have a choice of rates than a single benchmark. The new benchmarks include:
• the British government’s SONIA (Sterling Overnight Interest Average rate),
• the Japanese TONAR,
• the Swiss SARON; and
• In the U.S., Ameribor, a benchmark rate that reflects the actual market-based cost of borrowing for U.S. financial institutional based on overnight unsecured loans they have transacted on the American Financial Exchange ("AFX"), a regulated electronic exchange based in Chicago.