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Life after Libor: What next for loan markets?

11 November, 2019Ouida Taaffe

The London Interbank Offered Rate, or Libor, is set to end. But will the market be ready for a new era of regulation?

Bank of EnglandFrom 1 January 2022, the Financial Conduct Authority (FCA) will stop requiring banks to make daily Libor submissions.

That sounds innocuous, but it is part of the shift from Libor to other benchmark rates that regulators expect the markets to make – and the shift will not be easy.

John Williams, President of the New York Federal Reserve, has warned firms not to stick “their metaphorical heads in the sand”.  

“Implementation will be complex. Financial contracts need to be scrutinised. Operations need to be evaluated. And technology needs to be updated,” he said on 23 September.

“The work involves numerous jurisdictions and multiple asset classes, and will require changes from how business is conducted to how systems are built.”

The Loan Market Association (LMA) Conference in London on the next day discussed whether the market can find solutions in time.

“Libor has taken over my life,” said Clare Dawson, the Chief Executive of the LMA. “The LMA is spending an awful lot of resources and time…on finding solutions that work for the syndicated loan market.”

What will debt cost?

One of the biggest stumbling blocks is that, while Libor is forward-looking and can support a term rate – that is, borrowers know in advance what the interest charges will be – its replacements are backward-looking.

Both the Secured Overnight Financing Rate (SOFR) in the US, and the Sterling Overnight Index Average (SONIA) in London are based on overnight lending rates.

They were chosen because they are based on actual deals in liquid markets.

“The main thing is knowing what the debt is going to cost. Otherwise it is very difficult to plan and to measure cash flows,” said Sarah Boyce, Associate Director, Policy and Technical, at the Association of Corporate Treasurers.

“Everyone knows that Libor is flawed, but it is a number that has worked well for corporate borrowers.”

Arguably, large corporates should be able to cope with the shift. They have professional treasury teams and work closely with their relationship banks.

The risks of Sonia and SOFR

In the wider market, however, things could be much more difficult.

“Explaining a backward-looking compounding rate to a small borrower is a major challenge,” said Brian Fraser, Senior Manager, Markets and Lending Delivery, at Lloyds Commercial Banking.

“Even banks might need applied mathematicians to tell the borrower what is due, and you could be telling them on zero notice.”

Issues include:

  • whether to compound the rate over holidays
  • whether to use the overnight rate from before or after a holiday
  • and a mismatch between the derivatives market, which will be used to help work out the rate, and the loan market.

But the problems go beyond trying to explain the new system to individual borrowers.

“What if you will be calculating the interest on the morning when it is due? There is a potential for making assets unsaleable,” said Fraser.

It was also pointed out that different rate solutions for different currencies could make life hard in a multicurrency world.

“We could see people using single currency bilateral loans as anything else may be too complex,” said Boyce.

Benefits of transition

Can any positives be drawn from the discussions around transitioning away from Libor?

“There is now better dialogue between cash and derivatives markets from going through this process,” said Dawson.

The overall expectation was also that a way forward will be found.

“That is what a bank is there to do, to manage risk,” said Neil McCloud, Head of Group Treasury Market Trading at Erste Group Bank.

However much managing is required, the regulators look unlikely to back down.

“If your firm is one of those hoping the problem will go away…take this message back: The clock is ticking, Libor’s days are numbered,” said Williams at the Fed.

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