John McCrank and Karen Brettell

NEW YORK, (Reuters) – The London Interbank Offered rate, also known as Libor, is no longer being used to fund new loans and derivatives. In the largest market shakeup since 1999, the benchmark and reference rates, with $265 trillion globally linked to them, are being scrapped.

What is LIBOR and WHY IS IT REPLACED

Libor is the rate that banks quote on short-term funding costs. This was once known as the “world’s most important number”. Although it dates to 1969 https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr667.pdf, it was formalized in 1986 and has been used as a reference rate for a vast array of financial products, including student loans, credit cards, corporate loans and mortgages.

Libor was discredited after the 2008 financial crisis https://www.reuters.com/article/us-libor-rbs-scandal/timeline-how-the-libor-scandal-unfolded-idUSBRE9150TB20130206 when authorities found traders had manipulated it, prompting calls to reform and eventually replace the tarnished rate. A number of global banks were punished.

WHAT IS THE REPLACING LIBOR?

Libor is a 35-permutation currency that can be used to transact new business. It has five currencies: The U.S.dollar, British pound and the Euro. Some Libor tenors – the length of time remaining before a contract expires – linked to the U.S. dollar, however, will continue until the end of June 2023 https://www.reuters.com/article/us-usa-fed-libor/key-dollar-libor-rates-get-18-month-stay-of-execution-idUSKBN28A1ZL to allow most “legacy” or outstanding contracts to mature.

Alternative rates are replacing Libor, and central banks prefer to recommend those that are based upon actual transactions. This makes them more difficult to manipulate. [L1N2TC0XL]

WHAT RISKS AVOIDING?

After Jan. 1, the vast majority of Libor Tenors won’t be released. However, analysts stated that there will be a small number of U.S. Dollar tenors through June 2023. These could pose legal challenges for those companies with outstanding debt.

New York’s state law allows “tough legacy” contracts to be used. These are those which expire after June 2023 without fallback language. Congress is working on a similar bill https://www.congress.gov/bill/117th-congress/house-bill/4616?r=7&s=1.

The UK regulators have also stated that six sterling and Japanese Libor rates would continue to be in “synthetic form” – the Bank of England’s Sterling Overnight Index Average (or SONIA) combined with a fixed spread for one year. This will give market participants more time for switching to other rates for their existing contracts.

LIBOR LIQUIDITY

A large portion of U.S. Dollar derivatives markets have already moved to SOFR. For short-term contracts that are used to speculate on or hedge against changes in interest rates, there is still a large amount of exposure based upon Libor. (For a graphic on CME SOFR futures volumes: https://datawrapper.dwcdn.net/XXwf9/1)

This is likely to reduce liquidity in these contracts, which could make it difficult for investors and hedge their existing Libor-based exposures. Furthermore, investors may need to consider alternative methods when betting on rate movements in the future.

LOAN PRICE QUESTIONS

For borrowers as well as loan issuers who want exposure to credit benchmarks that are flexible to changing credit market conditions, the move to SOFR is a pricing challenge.

SOFR is calculated using the U.S. Repurchase Agreement Market, which does not have credit risk but may drop during periods of stress. Libor measures the cost of borrowing from banks and increases during times of stress.

The spread is a price differential that lenders use to rate loans. If credit stresses unexpectedly occur, this spread can underprice risk.