End of an era: the death of LIBOR and what it means for investors

The London Interbank Offered Rate (LIBOR) has been a global reference point for financial products since the mid-1980s. It is one of the most widely-quoted interest rate benchmarks, with $260 trillion[1] worth of diverse financial contracts tied to it.

But its days are numbered. LIBOR is expected to be largely phased out by the end of 2021.[2]

What is LIBOR?

It is a benchmark, used for bonds, loans, mortgages, derivatives and other financial products, which indicates the interest rate that large banks would charge to lend to each other.

Each day, a panel of large global banks are asked to provide the interest rate at which they would secure lending from another bank. Their submissions are used to calculate Libor. If there aren’t enough transactions or there isn’t enough transaction-related data, the banks must use their “expert judgment”. LIBOR is calculated for five currencies and seven different maturities, ranging from overnight to 12 months.

Why is it being replaced?

There has been a significant decline in interbank lending in recent years. This means that Libor has become increasingly based on the expert judgment of panel banks rather than actual market activity. LIBOR has also been surrounded by controversy due to high-profile cases of manipulation. A combination of these factors has gradually undermined confidence in its reliability and robustness.

Its death knell was sounded in 2014, when the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, recommended the development of alternative so-called risk-free rates (RFRs) to replace LIBOR and other interbank offered rates (IBORs).[3]

In July 2017, Andrew Bailey, the Governor of the Bank of England who at the time was chief executive of the Financial Conduct Authority (FCA), said: “The absence of active underlying markets raises a serious question about the sustainability of the Libor benchmarks that are based upon these markets.”[4]

He added that the FCA would not compel banks to make LIBOR submissions after the end of 2021. This was widely interpreted as the date when LIBOR would cease to exist.

What will replace it?

The financial industry has worked together to develop new RFRs. In the UK, working groups have selected SONIA (Sterling Overnight Index Average) to replace sterling LIBOR. SONIA is seen as more robust than LIBOR because it is based on actual transactions in active, liquid markets. It reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions and other investors.[5] It is seen as predictable and tracks the Bank of England base rate closely.[6]

How will the end of LIBOR affect my investments?

The end of the use of LIBOR to underpin financial contracts could affect retail investors in two ways:

• Some investment funds use LIBOR in their benchmark (the standard against which the performance of a fund is measured). For example, a fund benchmark may be Libor + 2%. In this instance, investors would be notified by their fund manager that the benchmark was changing to another cash-based reference rate, or a short-dated bond or bills-based index. The new benchmark would be similar to the previous one and the change wouldn’t impact how a fund is managed, its performance or result in any additional charges.
• The second effect could be on the underlying financial investments within the fund. Some of Schroders’ funds have investments in financial assets that reference LIBOR. Financial products sold in the past couple of years were created in the knowledge that LIBOR was likely to cease to exist and so their documentation often includes appropriate “fallback” language. This outlines how the financial instrument would switch to using a different benchmark (such as SONIA) in the event of the phasing out of Libor. We at Schroders are in the process of assessing the fallback language in each of our investments so we understand what will happen when Libor ends. For the financial products that don’t have suitable wording written into their documentation, we will work with relevant parties to agree a suitable amendment to the underlying financial asset.

How prepared is Schroders for the change?

We at Schroders have been working for some time with the aim that the move from LIBOR-referencing benchmarks and financial products is smooth. We have taken part in industry working groups, engaged with the FCA and other regulators and kept abreast of the latest developments concerning the matter to ensure we adopt approaches in line with industry best practice.

We have had a global programme team in place for over two years, which has been working with investment teams and fund managers, as well as distribution, operations, technology and legal colleagues, on our transition from LIBOR to RFRs across the business.

When will the transition away from LIBOR be completed?

The phasing out of LIBOR has been an ongoing process. The industry has been reducing its exposure to LIBOR in recent years and investing in SONIA-based instruments. We at Schroders are aiming to have moved away from LIBOR-referencing investments for all of our funds by the end of 2021 at the latest[7], subject to viable alternative investments being available.

[1] https://www.fca.org.uk/news/speeches/libor-are-you-ready-life-without-libor-end-2021

[2] https://www.fca.org.uk/publication/documents/future-cessation-loss-representativeness-libor-benchmarks.pdf

[3] FSB https://www.fsb.org/2014/07/pr_140722/

[4] https://www.fca.org.uk/news/speeches/the-future-of-libor

[5] https://www.bankofengland.co.uk/markets/sonia-benchmark

[6] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/what-you-need-to-know-about-libor-transition