The London Interbank Offered Rate, or Libor, will cease to be available at the end of 2021. Launched in 1986 by the British Bankers’ Association, Libor is the average of interbank borrowing rates quoted by large banks. Issues of Libor manipulation and false rate reporting surfaced during the 2008-09 financial crisis. Lending banks had assumed unhindered access to interbank funding at Libor, irrespective of their own credit quality, but much was amiss in the system. The manipulation scandal led G20 economies to ask for a review of the system and the introduction of credible new benchmark rates with no structural instability. Thus it was that the crisis set in motion the demise of Libor and the move towards alternatives.

Significant progress has been made. The new rates will have inputs from bank as well as non-bank players, and will no longer be the average of interbank borrowing rates quoted by large banks. The principle is that new reference rates should be based on deep and liquid markets that are difficult to manipulate. The underlying volume of funds that determine these would be substantially higher than what went into determining Libor. New rates will incorporate shorter tenors with large volumes, non-bank wholesale counterparties and secured transactions, thus marking a shift from unsecured benchmark rates to near risk-free benchmarks. Markets are now getting accustomed to the secured overnight financing rate (SOFR), euro short term rate (ESTER), sterling overnight index average (SONIA), Tokyo overnight average rate (TONA), and Swiss average rate overnight (SARON) that will likely replace equivalent Libor benchmarks. Singapore, Brazil, Australia, Canada, Hong Kong, and Mexico are also contemplating a transition for their respective currency benchmarks. To avoid volatility, SOFR will be averaged out for a 90-day period.

Capital markets should be prepared for the shift. International accounting standard-setting bodies are engaged in a project to update rules and revise financial reporting norms after a market-wide migration to alternative reference rates. Legacy financial and derivative contracts in the nature of loans, leases, debt, hedging deals and futures with embedded Libor would require amendments. A vast majority of existing contracts may not be adapted to a post-Libor scenario. The non-availability of Libor could trigger market-disruption clauses in financing agreements, requiring the selection of a substitute basis for interest rate determination. The exercise will be complex. Standard-setting bodies are inclined towards the principle that modifications be considered a continuation of the original contract. The US-based Financial Accounting Standards Board has recently put out proposals on the basis of reference-rate reforms and invited public comments.

Despite transition planning, some issues remain. A small error could have monetary transmission implications, which could give rise to migration, transition and financial stability problems. Emerging markets are more likely to feel the spillover effects. Coordination will be key, as many parties will be involved in the smooth implementation of new reference rates in numerous locations, unlike Libor, which was limited to London. In the line of direct impact will be internationally active banks, financial intermediaries, and businesses that have borrowed in foreign currency, apart from users and offerers of derivatives and futures. Another issue is of contractual robustness, post-Libor. The New York-based International Swaps and Derivatives Association and Basel-based Financial Stability Board are working on fallback arrangements, as derivatives comprise a substantial component of exposure to Libor. Some $400 trillion worth of financial contracts are estimated to be in place, as of mid-2018, with Libor as a reference rate. Efforts are on to frame globally accepted conversion mechanisms for existing Libor positions. The entire exercise needs to follow principles of equity.

A disorderly transition could create systemic risks. Traditionally, risk-free rates have been lower than Libor rates. For the new reference rates, ample liquidity will be required if large volumes of financial and derivative contracts are to be accommodated. A substantial number of emerging market businesses and individuals have some form of exposure to Libor, and they need to be prepared as well. The new reference rates will impact financial reporting in emerging markets too, since Libor figures in so many contracts. The transition away from Libor will entail asset-liability, operational, credit, litigation and systemic risks. What happens if risk-free rates in developed economies turn negative? Stakeholders need to understand all the regulatory, tax and disclosure implications carefully. Applicable dispute resolution authorities, arbitration councils and securities regulators, among others, may need to be sensitized to the new mechanisms that will replace Libor. In preparation, central banks have contemplated undertaking stress tests on their countries’ financial systems.

The demise of Libor is not an astrological prediction. It’s a certainty—with a date to it. To be forewarned is to be fore-armed. As the phase-out date approaches, anxieties have arisen. Financial sector regulators in emerging markets need to facilitate a smooth transition as the deadline nears. Awareness campaigns are required on the likely impact of the exercise. Accounting standard-setting bodies, securities regulators, stock exchanges and central banks across emerging economies need to get active on reviewing Libor positions and exposure. The asset-liability impact of a switch to risk-free rates from interbank offer rates would need to be properly assessed. Importantly, no party should get to make opportunistic gains once Libor vanishes.

Ajay Sagar is a former senior staff of Asian Development Bank Philippines

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