What the end of LIBOR means for investors
The London Interbank Offered Rate (LIBOR) was officially adopted in 1986, with roots dating back to the 60s. Underpinning some $300 trillion1 of financial instruments, it is one of the most widely quoted reference rates in the world. It is expected that LIBOR and other interbank offered rates (IBORs) will cease to exist after the end of 2021.
What is LIBOR?
LIBOR is based on submissions by a panel of global banks. Each bank is asked every day to provide the rate at which they could secure short term lending from another major bank and those submissions are used to calculate LIBOR in accordance with an agreed methodology.
LIBOR is used as a reference rate in a wide range of financial contracts, including derivatives, bonds and loans. It is set for seven maturities, ranging from overnight to 12 months, and five different currencies for each maturity. LIBOR rates exist for the US dollar, sterling, euro, yen and Swiss franc.
Where there are insufficient actual transactions or transaction-related data on which to base their LIBOR submissions the panel banks must use their “expert judgement” within certain agreed parameters to provide their submissions.
Why is it being replaced?
A significant decline in interbank lending and some high-profile instances of LIBOR manipulation resulted in the publication of the Financial Stability Board’s (FSB) recommendation in 20142 to develop alternative so-called “risk-free” rates (RFRs) for use instead of LIBOR and other IBORs. Fast-forward to July 2017, the CEO of the FCA Andrew Bailey, said in a speech that “…the underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active.3
In the same speech, Andrew Bailey also said, “In our view, it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them”.
He went on to say that the FCA would not compel banks to make LIBOR submissions after the end of 2021 which was widely understood as a sign that LIBOR would cease to exist post-2021.
New risk free rates
Following the FSB’s recommendation in 2014 industry working groups were established to develop the new RFRs (also known as “alternative reference rates”) that are expected to replace LIBOR and other IBORs after the end of 2021.
The new RFRs selected by those working groups for the five major currencies of LIBOR are summarised below.
New risk free rate
|Sterling LIBOR||Reformed SONIA (Sterling overnight index average)|
|US dollar LIBOR||SOFR (Secured overnight financing rate)|
|TONAR (Tokyo overnight average rate)|
|Swiss franc LIBOR||SARON (Swiss average overnight rate)|
|Euro LIBOR||€STR (Euro short term rate)|
The complexity of the transition to new RFRs will vary across each currency and be dependant on the asset or instrument type. For example, it is widely recognised that the transition is likely to be more difficult in the bond market than in the over-the-counter derivatives market due to the need under the terms of most bonds to obtain the consent of a high percentage of bondholders to such a change.
Additionally, there is currently much more liquidity in the SONIA derivatives market than the SOFR derivatives market. SONIA has been in use since 1997 while SOFR was only established in 20184. Progress in the transition also differs globally. For clients’ portfolios that hold more than one affected asset type (such as derivatives being used to hedge IBOR-linked cash products) the inter-relationship between those assets will need to be considered. In certain markets across the globe (such as Hong Kong, Singapore and Australia) modified versions of local IBORs may continue to exist post-2021, in some instances alongside new RFRs.
The FCA and the Bank of England jointly published a factsheet on 16 January 2020 which gives further information about the transition.5
What is Schroders’ approach to LIBOR cessation?
Schroders recognises the importance of the industry-led transition to RFRs and is aware that it will be of particular interest to our clients and other third parties. The impact of the transition will not be the same for all investment funds and portfolios that we manage and we will work with our clients to understand the specific implications for them. For example, some fixed income portfolios may hold multiple different IBOR-linked investments while an equities portfolio that doesn’t permit the use of derivatives may not include any IBOR-linked investments.
Schroders is monitoring and participating in industry discussions regarding the development of conventions for the amendment of terms from IBOR-linked products to RFR-linked products. Each market is developing these at a different pace. The conversion from an IBOR-linked product to a RFR-linked product will most likely result in a payment being made from one party to the other to account for the change in the characteristics of the underlying reference rate. While new industry conventions being developed are intended to minimise this value transfer they will not remove it entirely. This payment could be due to or required to be paid by a client’s portfolio. These costs related to the transition will need to be considered as part of each client’s transition plan.
Schroders is planning for the effective management of the impact on our clients’ investments with us of the transition away from LIBOR and have a dedicated team responsible for this task. We have recently completed an assessment to determine the impacts of the transition for our clients and our business. We are also participating in industry working groups (e.g. the Bank of England’s Working Group on Sterling Risk-Free Reference Rates), engaging with the FCA and other regulators and following developments in this evolving area so that we can adopt approaches that are consistent with industry best practice.
We are working towards the transition away from LIBOR for all our clients by the end of 2021 at the latest in line with market developments, subject to viable alternative investments being available which reference RFRs. We will be contacting our clients to discuss what this means for them early this year.
Any questions on the transition from LIBOR can be directed to Libor.firstname.lastname@example.org
2. Reforming Major Interest Rate Benchmarks, 22 July 2014↩
3. Andrew Bailey, 27 July 2017, The Future of LIBOR↩
4. See further “Interest Rate Benchmark Review: Full Year 2019 and the Fourth Quarter of 2019” published by the International Swaps and Derivatives Association in January 2020 ↩