For example, in the US, the Federal Reserve Board and the Federal Reserve Bank of New York have convened with a diverse group of private entities with a significant presence in markets affected by USD Libor, as well as banking and financial regulators, to form the Alternative Reference Rates Committee.
The alternative proposed by this group is the Secured Overnight Finance Rate (Sofr). Sofr is a measure of the cost of borrowing cash overnight, collateralised by US Treasury securities.
In the UK, the Bank of England and the FCA are working with market participants through the Working Group on Sterling Risk-Free Reference Rates to develop alternatives.
The Sterling Overnight Index Average (Sonia) has been proposed as the primary interest rate benchmark in sterling markets.
Administered by the Bank of England, Sonia is based on actual transactions and represents the average interest rate that banks pay to borrow sterling overnight from other financial institutions.
However, payments under contracts referencing new rates will differ from those linked to Libor due to a variance in the way they are calculated. Therefore, market participants will have to adapt a range of systems such as valuation tools and risk models.
Conduct and reputational risks
Significantly for market participants there could be important conduct, reputational and legal risks associated with the transition away from Libor. For example, although Libor will no longer be available, products referencing it will continue to exist.
These contracts typically include fall-back provisions, also called “replacement of screen rate” clauses, which define contract terms in the event that Libor is unavailable.
A short period of unavailability would allow for manageable losses and gains, but if that period continues over an extended period of time without a replacement alternative, there could be a meaningful economic impact, favouring one side to the detriment of the other.
In order to avoid any operational and financial implications, the parties involved need to re-write the terms, which will not necessarily be easy when one party might have the right to potential gains that they may be reluctant to surrender.
The implications span corporate finance divisions, banks, insurance companies, asset managers, brokers, dealers, central counterparties, exchanges and investors.
There will also be repercussions for everyday consumers, via commonly used products such as adjustable rate mortgages, credit cards, student loans, auto loans, and any other personal loans that use Libor as a benchmark or reference rate.
Financial institutions will require an appropriate communication policy to avoid confusion among customers if for example, the new reference rate leads to meaningful changes in their variable monthly mortgage payment compared to Libor.
