There are only a few certainties in life: death, taxes and change. When questioned about what’s going to change in the next 10 years, Jeff Bezos rhetorically answers what’s not going to change in the next 10 years. The financial markets are currently grappling with some large changes in the future, notably the end of LIBOR, also known as the London Interbank Offered Rate.

First, a History Lesson

LIBOR is an average of the estimated interest rate that a high quality bank in London would be charged to borrow from other leading banks. In essence, it is a short-term unsecured interest rate charged between banks for wholesale funding. However, LIBOR is also the primary benchmark for short-term interest rates around the world. LIBOR rates are calculated for five currencies and seven borrowing periods ranging from overnight to one year and are published each business day. Daily LIBOR interest rate fixings have been published since January 1^st, 1986 and have since become deeply entrenched into the global financial markets. Many financial institutions, mortgage lenders and credit card agencies set their own interest rates relative to LIBOR. In fact, over $350 trillion dollars’ worth of financial derivative contracts, mortgages, bonds and retail and commercial loans have their interest rates tied to LIBOR. Most consumers probably have at least one financial instrument, such as a mortgage, home equity line of credit, or business loan that has an interest rate tied to LIBOR.

Why Change This Key Benchmark?  

The answer has to do with the relevance of LIBOR and the liability associated with submitting estimated LIBOR rates. Post financial crisis regulation has significantly reduced bank appetite to issue commercial paper and wholesale deposits. As such, there is now a very low volume of transactions for banks to base their LIBOR submissions and as a result, banks must rely upon their “expert judgement” translating other interest rates into a LIBOR rate. In fact, submissions based upon “expert judgement” as opposed to real transactions now make up 70% of the daily three-month LIBOR submissions according to Barclay’s Bank. The liability associated with generating such an important and highly utilized interest rate based upon expert judgement is enormous, especially in the wake of the LIBOR fixing scandals. During this scandal, it was discovered that some banks were falsely inflating or deflating their rates in order to profit from trades or to give the impression that they were more creditworthy than they actually were.

The Financial Conduct Authority (The FCA) is the regulatory agency currently responsible for overseeing LIBOR while ICE Benchmark Administration (IBA) is currently responsible for administering and publishing LIBOR. The FCA and IBA are aware of the concerns with LIBOR and a global effort has been underway to find new benchmark rates to replace LIBOR. On July 27^th, the CEO of the FCA created a stir in the market when he recommended an expiration date for LIBOR or more specifically recusal of their regulation over LIBOR at the end of 2021. By using a set date, the FCA is hoping to get all market participants involved in finding alternatives rather than simply ignoring this herculean task. However, the IBA will likely continue to publish daily LIBOR rates for several years post-2021 although the form of derivation could be different, the panel of contributing banks could be significantly less and the usefulness of the index rate could be much diminished.

 Steps to Transition

Focusing on U.S. Dollar LIBOR, within the United States, the Federal Reserve has tasked the Alternative Reference Rate Committee (ARRC) to be responsible for the transition from U.S. Dollar LIBOR to a new benchmark replacement rate. This replacement rate in the U.S. proposed by the ARRC is a newly created index called the Broad Treasury Financing Rate (BTFR). The BTFR rate contains a broad set of US treasury market based financing transactions, also known as repo transactions. Thus far, the BTFR rate appears to be the best replacement for U.S. Dollar LIBOR although daily volatility of the index will likely need to be smoothed using a geometric average, transaction volume will need to substantially grow, and an actively traded futures and derivatives market in this new index rate must develop. The Federal Reserve is supposed to begin publishing the BTFR index rates in the first half of 2018. This BTFR rate will have to run in parallel with LIBOR for several years in order to help determine a fair compensating credit spread between LIBOR and BTFR for those financial assets that will need to change their reference interest rate to the new index. Outside of the U.S. Dollar LIBOR solution proposed by the ARRC, we are likely to see multiple differing benchmark replacement rates for LIBOR in non U.S. dollar LIBOR markets.

It’s Complicated

Removing and replacing LIBOR is an enormously complicated task. While there are trillions of dollars’ worth of financial instruments that reference LIBOR, the largest complication rests is those financial assets and those financial contracts that have a maturity beyond the 2021 deadline. As it relates to futures and derivatives contracts, ISDA master agreements between counterparties will have to be amended or replaced.  Retail mortgages, home equity lines of credit, and any other consumer or business debt tied to LIBOR will have to be amended unless a back-up interest rate index is referenced in the original documentation.  Mortgage backed securities, loans and floating rate bonds all tied to LIBOR will have to be addressed contractually, and with regard to deal specific covenants, may require consents from the owners of these securities. In addition, as previously discussed, all of the parties involved will need to come to some consensus that the compensating spread between LIBOR and the BTFR is fair and reflective of the original interest rate and credit risk imbedded within LIBOR.

The current uncertainty surrounding the transition away from LIBOR and the mechanics of that transition are enormous and remain too large to quantify or speculate on any likely impact. We would however expect reduced liquidity in LIBOR once the replacement reference rates have been identified globally and gain significant momentum thereby making LIBOR nearly useless post the transition date despite the potential for LIBOR rates to continue to be published.

A Herculean Task with One Likely Winner

There are ultimately three takeaways that are clear during the replacement of LIBOR both in the U.S. and globally. One, it will prove to be a herculean task, especially within the five year window identified by the FCA. Two, we believe the largest complications will come from determining a fair compensating spread and dealing with the legacy securities and contracts that mature beyond 2021 that currently reference LIBOR. Three, the ultimate winner over the next five years or more from the LIBOR transition will be financial and contract lawyers.