However, a scandal around actions by bankers to rig the LIBOR rate – sending in incorrect figures used to calculate its rate every day – it not only prompted firms to fire miscreant bosses, but regulators looked at alternatives to prevent such actions happening again. LIBOR is fading away, and is due to be replaced in 2021. 

To understand what is in store is Dr Richard Sandor chairman and chief executive of the American Financial Exchange. He is well positioned to write about this topic, and he wants to explain why wealth managers in North America and elsewhere must understand what’s going on. The editors are pleased to share these ideas; readers are invited to respond and can email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com  The usual editorial disclaimers on the views of outside contributors apply. 

It has been called the most important number in finance – the $800 trillion in derivatives, mortgages, credit card accounts, asset-backed securities and other financial instruments tied to the LIBOR interest rate benchmark. The Wall Street Journal and other financial news outlets are writing about the transition away from LIBOR, expected to take place in 2021. Financial advisors need to be knowledgeable about the implications for client portfolios and the range of assets that are pegged to LIBOR.  Following is a primer on the transition.  

Most financial professionals know what LIBOR is but few financial experts know how it came to be the benchmark affecting trillions in loan obligations. It’s a curious story. In 1969, a consortium of banks led by Manufacturers Hanover organized an $80 million syndicated loan for the Shah of Iran. It was a variable rate loan, and the lenders had to decide how to reset the rate as interest rates changed. They decided they would call each other and each would say what he thought the rate should be. That is how LIBOR was born. 

The system was formalized during the mid-1980s by the British Bankers Association, but it remained more or less unchanged until 2012, when a rate-fixing scandal cast a pall on LIBOR.

Now it is likely that LIBOR will be phased out, or at least downgraded, in importance.  It will become one of several benchmark interest rates in 2021, when the UK’s Financial Conduct Authority stops requiring banks to submit the daily rates used to calculate the benchmark. Banks, asset managers, corporations and other players in the global financing market have three years to transition from LIBOR to one or more of the multiple alternative benchmark rates now found on several exchanges.  

Practitioners need to become familiar with the alternative new benchmarks and determine which best conform to their needs. Of particular concern are the roughly $4 trillion in LIBOR-linked loans whose contractual language enables lenders to renegotiate their terms if the base rate changes. 

It’s important to recognize that these changes don’t happen overnight. We are six years into the transition process and, in my experience, broad-based adoption of new tools and technology can take a decade or more. For instance, I started working on interest financial futures in 1969. We launched the first futures six years later, and it took a decade, and the Volcker tightening of the late 1970s, for them to take off. 

There’s still time for bankers and asset managers to prepare but there is also much work to be done on loan transition documentation. It is critical that financial players pay very close attention and start reviewing their documents if they haven’t done so already.

Redrafting
Specifically, capital market participants need to begin re-drafting their commercial and industrial loan documents to replace LIBOR with one or more alternative benchmark reference rates. Similarly, derivatives dealers and the International Swap Dealers Association need to alter their master service agreements and short-form trade confirmations to replace LIBOR with one or more alternative benchmark reference rates. 

This transition should be viewed as an opportunity. Already a number of alternative benchmark rates have emerged, giving financial markets participants the time to find the benchmarks that are best for them depending on the kind of loans they are making.  The new benchmarks include:

--  the Federal Reserve’s SOFR , a secured rate derived from borrowing and lending activity in Treasuries; 
--  the British government’s SONIA ; 
--  the Japanese TONAR; 
--  the Swiss SARON; and 
--  US Ameribor, a benchmark rate that reflects the actual market-determined cost of borrowing for US financial institutional based on overnight unsecured loans they have transacted on the American Financial Exchange , an electronic exchange based in Chicago.  

All these new benchmarks address what, even before the scandal, constituted a serious, structural flaw in LIBOR. It has always been based on what participating banks thought the interest rate should be, instead of the actual rates at which they borrowed and lent money.

LIBOR is like a political poll, measuring attitudes toward interest rate changes. A better, truer benchmark would track the actual election, which means the rates that lenders ask, and borrowers pay, in real time as they execute transactions. 

For instance, to calculate its Ameribor rate, the AFX tracks and incorporates trading data from the actual overnight unsecured loans of its 179 current exchange members trading an average daily volume of nearly $2 billion. It’s not people guessing what interest rates should be or hoping where they’ll go. It’s based on actual rates set in actual transactions, similar to the way prices on stocks are set.

The evolving landscape will offer asset managers far more choice and the ability to tailor hedging strategies to their needs. If you’ are a mega bank that borrows at the secured Treasury rate, you can hedge risk with SOFR, a secured rate benchmark. If you are a regional or community bank, setting unsecured rates on credit cards, home equity loans, auto financing or small business lending, you can employ the unsecured Ameribor benchmark. Are you lending or borrowing in the UK? SONIA may meet your needs. In Japan, there is Tonar. In Switzerland, it’s Saron.

The world after LIBOR will provide many more options to lending institutions than before. It is not that any of these benchmarks are better than the alternatives, just that they work better in some situations than other benchmarks. And that’s one of the really positive things about the transition away from LIBOR - that it will create multiple alternatives, each with their own distinct features and applications. It will make the lending market more like the stock market, with multiple benchmarks including the Dow Jones, the S&P 500, the Russell 2000 and EAFE. 

One lesson that economics teaches is that it is best to have choice. And choice, in this instance, will have tangible benefits. Because banks can select among multiple benchmarks, they may be able to borrow funds at lower rates or lend at higher rates. All market participants will benefit from increased transparency, as benchmarks reflect financing activity in real time. The lending markets after LIBOR will be less monolithic, but that will lead to more market efficiency, not less. 

About the author

Dr Sandor is Chairman and CEO of the American Financial Exchange ameribor.net, an electronic exchange for direct interbank/financial institution lending and borrowing. He is also the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School.