5 Things You Need to Know about the LIBOR Transition
LIBOR has often been regarded as the world’s most important number. It’s one of the most widely utilized interest rates in the world used for tens of millions of financial contracts worth more than USD 300 trillion globally. Its cessation December 31, 2021 will alter financial markets around the globe and require banks and other financial institutions to phase out any agreements that utilize LIBOR as a benchmark and transition to an alternative reference rate. While this may seem like a long time from now, the process will be lengthy and complex. To ensure a smooth transition, banks and other impacted organizations will need to begin preparing now.
For many financial institutions, the transition process will involve creating task forces, sorting through immense volumes of documents, adopting new technologies, renegotiating current agreements and developing entirely new financial products. Preparing early and thoroughly is critical for minimizing risk from every angle – financial risk, legal and compliance exposure, and operational disruption. Planning ahead will also facilitate a smooth process for customers, helping maintain – even increase – client satisfaction and retention. While the transition may seem overwhelming, it doesn’t have to be. The best way to begin preparing is to understand what LIBOR is and how it will affect your business, including which products will be impacted, what the replacement options are, and what exactly the complex transition process will involve.
Here are five things you need to know now about the LIBOR transition before you start to create an action plan:
Why is it going away?
LIBOR, which stands for London Interbank Offered Rate, is embedded into almost every type of variable financial product in the market. It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day. The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.
According to the Consumer Financial Protection Bureau, the LIBOR rate is based on specific types of transactions between banks which now do not occur as frequently as they used to, making the rate less reliable. The governing bodies that oversee this index have stated that they cannot guarantee the rate will be available after 2021. Certain private-sector banks which are currently required to submit information that is then utilized to set the LIBOR rate will stop being required to do so after next year, which means the rate will subsequently not be an accurate reflection of its underlying market. At this point, the quality of the rate will likely degrade to a degree it’s no longer credible, which could cause LIBOR to stop publication immediately.
Will you be affected?
All types of banks and financial institutions will be impacted, from the small regional banks serving local consumers to large global financial institutions providing commercial services to multinational enterprises. In addition, related industries, such as insurance, will also be impacted by the discontinuation of LIBOR. Even industries that are completely outside of the financial sector will feel a ripple effect from the transition.
Below are a few types of businesses that will be directly affected by the LIBOR transition:
- Investment banks
- Retail banks
- Insurance and reinsurance organizations
- Commercial banks
- Asset managers
- Pension funds
- Hedge funds
- Regulated funds
- Non-bank lenders
The list is by no means exhaustive. All businesses utilizing the LIBOR rate in any type of financial offering will need to transition to an alternate reference rate in all related agreements and, in some cases, develop entirely novel products based on new models. Which leads us to our next point:
What types of products will need to be replaced or amended?
From 30-page mortgage agreements to 340-page commercial loan contracts, every type of financial product that utilizes LIBOR will be impacted. Below are a few types of financial offerings that will be affected:
- Derivatives: including interest rate swaps, cross-currency swaps, commodity swaps, credit default swaps, interest rate futures, and interest rate options.
- Bonds: for example, corporates, floating rate notes, covered bonds, agency notes, leases, and trade finance.
- Loans: including syndicated, securitized, business loans, real estate mortgages, private loans and even certain types of student loans. In short, any type of loan that utilizes a variable interest rate based, in whole or in part, on LIBOR will be impacted.
- Short-term instruments: such as repos, reverse repos, and commercial paper.
- Securitized Products: Mortgage-backed securities (MBS), Asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS).
- Retail: Loans, mortgages, pensions, credit cards, overdrafts and late payments.
What are the replacement rates?
The following are the Alternative Reference Rates (ARR’s) which will replace the LIBOR/IBOR rate, along with the geographic markets in which the new rates will be utilized:
|U.S.||Federal Reserve Bank of New York||Securities Overnight Financing Rate (SOFR)|
|U.K.||Bank of England||Reformed Sterling Overnight Index Average (SONIA)|
|Switzerland||SIX Swiss Exchange||Swiss Average Rate Overnight (SARON)|
|Europe||European Central Bank||Euro Short-Term Rate (ESTER)|
|Japan||Bank of Japan||Tokyo Overnight Average Rate (TONAR)|
When do I need to start preparing?
Many companies have thousands, even hundreds of thousands, of LIBOR-based financial agreements circulating within their organizations. There are some global investment banks whose volume of related contracts reaches into the millions.
There are quite a few steps involved in a successful transition. One of the most important and urgent is assessing where LIBOR is used across all business operations and identifying each individual contract, agreement and related document. Without a doubt, finding, collecting, and compiling every contract that utilizes the LIBOR rate will be an extensive and involved process.
Whether it’s a small- to mid-size bank or a large financial institution with hundreds of thousands of contracts, sifting through, reading, and pinpointing every document that references LIBOR will be cumbersome, costly and time-consuming if conducted entirely manually. The right technology, particularly those that are powered by AI and leverage Content Intelligence and RPA technologies, can prove to be invaluable for sorting through volumes of documents, accurately identifying relevant contracts utilizing advanced OCR and NLP technology, and automatically extracting relevant data. Leveraging the right tools can go a long way in simplifying the complex document-related processes involved in the LIBOR transition.
Identifying all related contracts is simply the first step, albeit a critical one. After all relevant agreements have been compiled, the next step is to transition each individual contract to the new alternate reference rate. For many financial institutions, there will likely be a significant degree of re-negotiation involved in this process, particularly for contracts governing high-value financial products or agreements serving commercial clients.
The transition process is one that will likely involve many business units – from legal and compliance for managing risk to product management for creating new offerings to marketing and PR for developing effective communication strategies for customers, investors and stakeholders.
The discontinuation of LIBOR as a reference rate may be over a year away, but for banks that want to minimize financial and legal risk and ensure customer loyalty, successfully navigating the transition will require a clearly defined roadmap, long-term vision, and the right technology tools.