The London Interbank Offered Rate, best known as Libor, is now in its last legs and will cease to exist come December 2021. It will be replaced by alternative benchmark rates (ARR), and this is set to pose several challenges.
But first, an explanation on why Libor is in its last lap. I doubt if you are aware that the Libor is based on the 'Ask-James' model. A clutch of suit-clad bankers is asked, “At what rate are you likely to borrow money of a reasonable quantum before 11a.m.” The average of their quoted rates becomes the benchmark Libor! The Libor then becomes the risk-free rate and lendings happen with a spread tagged to recognise risk premium. While I believe in the ‘wisdom of the crowd' and 'magic of averages,' the fact that these men have a vested interest in fixing the rate since they make investments tied to it made the Libor ripe for rigging.
For instance, the moment these 'polling' banks began to accept Euro dollar deposits at interest rates linked to Libor, the crap was bound to hit the roof. Remember, banks also hold large derivative and loan contracts that are priced by using Libor rates. There was a clear incentive to report lower rates, and it began what would in later years become a full-blown scandal.
The global financial crisis gave the first clear indication that the rates did not reflect reality. In 2008, when actual transactions were way off the Libor, it gave the god-like rate feet of clay. By 2012, manipulations in Libor fixations were confirmed, and it was decided Libor would cease beyond 2021. We are now staring at end-2021. The 50 plus-year-old Libor is now set for a goodbye.
Greek inventor
Let's turn a bit to history. Greek banker Minos Zombanakis invented the Libor. In 1969, he syndicated a loan for the Shah of Iran and used a benchmark based on USD, UKP, and JPY. Today, Libor is for seven maturities, each for five major currencies, with the CHF and Euro added.
Libor's most significant value is that it is used for several financial instruments of differing characteristics, thereby reducing complexity. It also took care of credit risk premium, liquidity premium, and the term premium. Aside from the pricing of financial instruments, Libor is used for valuation and accounting.
We must not jump from the frying pan to the fire. An Alternative Reference Rate (ARR) must:
* Provide an accurate representation of interest rates.
* Offer reference rates beyond the money market.
* Serve as a benchmark for term lending.
Alternative benchmarks
Several jurisdictions have identified alternative benchmarks by linking them to actual transactions in liquid markets. However, these are for secured, rather than unsecured, transactions. Some countries where Libor forms one component of the local interest rate ‘basis’ have also fixed new criterion. Singapore and India are prime examples.
ARRs still have a long way to go as they present a reflection only of liquidity and that too from overnight markets. For natural transition, we need both 'term rates' and a 'liquid market.'
A view that is gathering ground is that instead of the ‘Ask-James’ model, benchmarks should be based on actual transactions. The best way is to compound overnight interest rates. But this has the flaw of being historical rather than futuristic. However, I don't think we should wait until someone comes out with a forward-looking version of risk-free rates.
Homemade benchmarks
A few issues are discernible. Many of the already-entered transactions will continue beyond December 31, 2021, when Libor will formally cease. New contracts are also being entered into, which would be live on the cut-off date. These throw up challenges. First, the parties will have to sit across the table and renegotiate. It will lead to winners and losers and large payments by one party to another. Then contracts may have to be re-designated if qualifying standards for hedge effectiveness assessment are not met. Finally, there will be tax and accounting issues.
While India has announced six homemade benchmarks, it is not as though there are no Libor exposures. ECBs, FCNR (B) deposits with floating rates of interest rate are prime examples.
Backend work to alter information technology systems that use Libor has to begin. The development of a deep liquid market is a pre-requisite to the use of alternative reference rates and this is now at its nascent stage. The accounting and finance professional will indeed have an interesting, even if it is disturbed, time.