The London Interbank Offered Rate (LIBOR) is thedominantinterest rate benchmark and plays a central role in the daily dynamics of the financial markets. Financial institutions rely on LIBOR to represent their own funding cost and transfer it to the clients. It is used as a reference rate in more than $400 trillion of financial instruments, from retail, like credit cards, auto loans and student loans, to more sophisticated instruments, like derivatives, which play an essential role in helping financial institutions manage their risks.
To fully understand LIBOR and its importance, one needs to go back to the origins and development of the London money market and the history of theEurodollar. Nearly half a century ago, global corporations and international banks started placing short-term excess liquidity with each other, in the form of US dollar deposits in London.This market was a bit of a club, only accessible to prime institutions of high creditworthiness, and operating on an unsecured basis. Given the large volumes, high liquidity and ample range of maturities, the LIBOR market gradually became a global reference for funding costs of the largest corporates. As interest rate volatility skyrocketed in the 1980s, it prompted the development of a derivative markets, soon to become the largest asset class in the world in nominal terms. The interest rate swaps were primarily based on LIBOR as their reference.
The Beginning of the End forLIBOR
It all came to an end when confidence in mutual creditworthiness was lost in the run-up to the Global Financial Crisis. Institutions continued to place excess funding witheach other butrequired a pledge of security(a bit like pawnbrokers do) and for much shorter maturities, primarily overnight. The money market as we used to know it essentially disappeared, but the continued reliance and large volumes ofinterestratederivatives created powerful incentives for manipulation. It is ironicthat manythinkof manipulation as the reason for the dismissal of LIBOR,whenthetruereason is quite the opposite. It was the lack of liquidity in the money market that made manipulation possible.The newsecuredmoney market is now based onrepurchase agreements(repos), where bonds are used as security.
The financial services industry started to plan the transition from LIBOR to other reference rates that overcome LIBOR\'s weak points. A key focus is to ensure the new benchmarks are credible and robust. The proposed replacement ratefor the US dollar market isbased uponthe repo marketsthat replaced LIBOR a decade ago. Despite its thirty-year long fame and worldwide dependency, the Financial Conduct Authority (FCA), the UK\'s financial regulatory body, encourages the world to stop using this rate from now on, after some doubts about its governance and its current relevance to represent the up-to-date funding costsemerged.
There are still many things to determine and time is our tyrant: LIBOR could disappear as soon as December 2021 ifregulatorsso decide(there are consultations to extend the life of sometenors of theUS dollarLIBOR). Working groups in financial markets havetakenthe first steps, but many elements must be decided and defined.Expertshave been studying the key structural differencesbetweenLIBORand possible new benchmarks. To account forthem, spreads and adjustments are added to the replacement rate, such as credit and term premiums.
Questions remain about how to implement changes, how all players will adapt to them, and how they will impact sovereign, corporate, and retail borrowing and lending markets. Transitioning to alternative rates will affect how the prices of existing and new contracts are determined,and financial institutions will have to update their operating models.Some institutions are getting ready to proactively transition months before a hard end of LIBOR.
Three Sources of UncertaintySurrounding NewReferenceRates
Uncertainties around the transition can be grouped into three driving factors.The firstishow the new rates will be calculated. As mentioned above, the new reference rates are different than LIBOR.How to adjust them and how new financial products will be priced is yet to be defined.
The second factor is the level and speed of financial markets’ acceptance of the new reference rates, reflected in the number of contracts (or level of \'liquidity\') that adopt the new alternatives. For example, a rapid increase in the number of new loans linked to new rates means a quick acceptance by banks and clients.Moderate growth can mean the participants are not convinced the proposed replacement rate is the best option.
The third and last factor is the behavior of the borrowers. Retailer clients, governments, and smaller banks could adopt a receptive attitude towards the reform, or a wave of litigations could come. For example, clients could sue the banks after the rate of their current mortgage has changed.
Given the complexwebof interactions and the vast number of contracts, LIBOR\'s replacement represents a considerable challengeinmanydimensions, and itconstitutesan immense challenge for the global financial market.Lack of preparation across the world could lead to considerable disruption in the financial markets.
Scenarios for a World after LIBOR
To prepare forthe transition to a new reference rate,the IDB has built a set of possible scenariosbased on the three driving factorsdescribed above. These are aimed at aiding decision-making and can helpaddressquestionson the timing of the transition,how regulators could speed upthe process, and how the IDB should respond if the market does not converge into a single replacement rate for LIBOR. As these questions play out,the institutional planfortransitioningout of LIBORcanbe tested under the scenarios,and adjustments can bemade.Aswemove into uncharted territory,scenario planningcan bea powerful tool topreparefor the unknown.
The move away from LIBORrepresentsa paradigm shift for the financial industry, and it is happening now.