Why is this a big deal?

Some call it the most important number of the financial world and for the others, it’s the gold standard for what to charge, if you’re going to use their money. This practice started in the early 40’s and evidently is as rudimentary as the times. One set of phone calls between a 45-minute window determined what that standard was going to be.

The London Interbank Offer Rate (herein and after, LIBOR), as the name suggests, is the interest rate at which banks in London can borrow cash from one another, akin to the Repo Rates in India, except the commercial banks are borrowing from the Reserve Bank of India at the Repo rate and not other banks. The difference being that although the Monetary Policy Committee of the Reserve Bank of India decides the repo rate, the LIBOR stems from a rather different process altogether.

As I mentioned earlier, the rudimentary process clearly stems from a verbal telephonic confirmation to the British Banking Association of interbank offer rates between participating banks in London, which then leads to the BBA publishing the LIBOR rates for the world to use as a benchmark all the way from complex derivative contracts to residential mortgage contracts. Most often Interest rates in financial contracts in the US and the EU were denominated in the LIBOR viz. LIBOR plus a premium as per the type of contract and the risks therein, which is why it was touted as the world most famous ‘base’ rate.

You may gasp at this number, but LIBOR is linked to more contracts than you can fathom, for starters contracts worth $ 240 Trillion refer their interest rates to LIBOR. Compare that figure to the combined global Gross Domestic Product and you’ll know exactly what I’m talking about.

Why do away with LiBOR?

Long story short, banks that were essentially involved in stating interbank interest rates, the summary of which would form the LIBOR as declared by the British Banking Association had allegedly cartelised the process, accusations of price fixing hit British Banks and this was essentially the trigger that lead to an adoption of overnight financing rates, ones that are more robust, dynamic and actually reflect the market rates.

The British Banks conveyed information to the BBA that led the LIBOR to be what they wanted it to be, not what the inter-bank offer rate actually was, obviously to benefit their position in the non-interbank contracts worth trillions of dollars. Well, when Andrew Bailey of the Financial Conduct Authority of the United Kingdom made a startling claim which clearly indicated that market participants must not rely on the LIBOR after 2021, that marked the beginning of the end for the benchmark in July 2017. In fact, the President and CEO of the New York Federal Reserve famously jested in his speech in 2019, “some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes and the end of LIBOR.” 

One can really make an informed guess that even the anticipated end of LIBOR lead to banks, financial entities and other market participants gradually moving away and pacing towards the complete elimination of the LIBOR rates which is fundamental to organisational processes and functions. To no soul’s surprise, the United States’ financial authorities started working on a replacement for LIBOR under the auspices of the ARRC (Alternative Reference Rates Committee), which recently published a best practices guideline for smooth transitioning away from the LIBOR.

What’s LIBOR going to be replaced with?

Well, the answer is not in one word.

This is where overnight interest rate benchmarks come into play. In fact, the MIBOR- Mumbai Interbank Offer Rate is an excellent home-grown example of this. It’s safe to assume the Indian markets had a first mover advantage in transitioning from a MIBOR that was based on a similar rudimentary mechanism of 30 participating banks, to rates that actually reflected market trades & transactions.

The LIBOR would effectively be transitioned to SOFR (Secured Overnight Financing Rate) in the United States, SONIA (Sterling Overnight Index Average) in the United Kingdom and it’s like in the European Union, Japan and other major economies across the globe. These rates would reflect a more robust, dynamic and credible set of benchmarks that stem from financial contracts actually exercised as opposed to a rather arbitrary but consensus based rate.

Above everything else, these rates are ‘secured’ as compared to the unsecured LIBOR rate, for example the SOFR is a broad measure of the cost of borrowing cash overnight secured by U.S. Treasury securities. SOFR rates would effectively be lower than LIBOR rates (technically reducing the base rates of financial contracts) as SOFR is an overnight, secured rate which means it does not include any liquidity premium or any bank credit risk element, unlike a LIBOR rate, where interest is paid at the end of a specified term representing an unsecured rate. Massive changes are also expected to reflect in leasing agreements, especially operating ones where both the Lessee and Lessor need to agree on how the LIBOR transition would be achieved in their existing agreements, with an appropriate allocation for cost of transitioning/amendments if any.

As an eminent ‘MIT non-linear equations professor’ once said, “always account for variable change”. Clearly, there’s a ton of accounting to be done for ’21.