Times of transition are when market participants make their most important choices and biggest decisions. Now is one of those times.
We are witnessing a structural change in the world of interest rate benchmarks. Everybody in finance knows what Libor is but few financial experts know how it came to be the benchmark affecting trillions in loan obligations. It’s a most widely accepted and 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, and it was in this way that Libor was born.
The system was formalized during the mid-1980s by the British Bankers Association, but it has remained more or less unchanged right up to 2012, when a rate-fixing scandal cast a pall on Libor, which affects some hundreds of trillions in derivatives, mortgages, credit card accounts, asset-backed securities and other financial instruments.
Libor is likely to become one of several benchmark interest rates in 2021, when the U.K.’s Financial Conduct Authority stops requiring banks to submit the daily rates used to calculate the benchmark. This means that banks, asset managers, corporations and other players in the global financing market have three years in which to make the transition from Libor to one or more of the multiple alternative benchmark rates now found, or soon to be found on multiple exchanges around the world.
With contracts tied to Libor that are valued at hundreds of trillions of dollars, capital markets participants need to become familiar with which of the alternative new benchmarks out there best conform to their needs. Of particular concern are the trillions in Libor-linked loans whose contractual language enables lenders to renegotiate their terms if the base rate changes or disappears.
We are currently six years into the transition process, and it’s important to recognize that these changes don’t happen overnight. In my experience, broad-based adoption of new tools and technology can take a decade or more. For instance, I started working on interest rate futures in 1969. We launched the first futures six years later, and it took a decade and the Volcker tightening in late 1979 for them to take off.
That means there’s still time for those involved in financial markets to prepare. There is much work to be done on loan transition documentation. It is critical that financial players start to pay very close attention and start reviewing their documents.
Bankers need to begin re-drafting their commercial and industrial loan documents to allow for one or more alternative benchmark reference rates. Similarly, derivatives dealers and the International Swap Dealers Association (ISDA) need to alter their master service agreements and short form trade confirmations to allow for 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 (or Secured Overnight Financing Rate), a secured rate derived from borrowing and lending activity in Treasuries,
- the British government’s SONIA (Sterling Overnight Interest Average rate),
- the Japanese TONAR,
- the Swiss SARON; and
- U.S. Ameribor, a benchmark rate that reflects the actual market-determined cost of borrowing for U.S. financial institutions.
The original architecture of Libor was based on what participating banks thought the interest rate should be, rather than the actual rates that they borrowed and lent money at. It was a poll, rather than the actual election. The structural change we are now experiencing will provide many more options to lending institutions than before. It’s not that any of these benchmarks are better than the alternatives, just that they work better in some situations than other benchmarks.
One lesson that economics teaches is that it’s always better to have a 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. This should lead to more efficient markets.
