4 questions to Xing Huan about a decade of LIBOR phaseout

What was LIBOR initially?

London Interbank Offered Rate (LIBOR) is a set of rates first published under the auspices of the British Bankers’ Association (BBA) in 1986. These rates represent the cost of short-term wholesale funds for major banks in the London interbank market. LIBOR was calculated and published each business day by Thomson Reuters, to which major banks submitted their cost of borrowing unsecured fund in ten currencies across fifteen maturities [1].

As a reference rate, LIBOR was one of the most important global reference rates that provides the basis for valuing financial instruments and establishing the terms of agreement for short-term floating rate contracts, such as interest rate swaps. As a benchmark rate, LIBOR was used as the performance measure for funding costs and investment returns, and it also served as an indicator of the soundness of business and financial markets.

What happened in 2012?

On 27 June 2012, Barclays was fined for manipulating the daily setting of LIBOR and the Euro Interbank Offered Rate (EURIBOR) by both UK and US regulators. Confidence in the integrity and reliability of the rate-setting process plummeted. The decade-long journey of LIBOR phaseout began after the Financial Stability Board (FSB) recommended the development of alternative reference rates in July 2014. In 2017, the UK Financial Conduct Authority (FCA) confirmed LIBOR phaseout. After several postponements, the ‘death day’ for USD LIBOR was fixed on 30 June 2023.

Several key LIBOR alternatives have been adopted across different jurisdictions. The Euro Short-Term Rate (ESTR), Sterling Overnight Index Average (SONIA), and the Secured Overnight Financing Rate (SOFR) are employed as alternatives to LIBOR in the Eurozone, UK, and USA, respectively.

Embarking on this landmark event, we have investigated a wide array of related issues, encompassing the historical, ethical, and technological dimensions of the scandal [2], the reputational and contagion effect of this event [3], the use of social media by involved banks for crisis management in the midst of the scandal [4], the significant overhaul of the UK regulatory architecture in the aftermath [5], the consequences of banks’ use of financial derivatives [6], and a broader exploration of the influence of national culture on bank malfeasance [7].

Why did it take so long for LIBOR phaseout?

Emerging in the 1980s, the LIBOR system was groundbreaking. However, no one anticipated the extent of its potential exploitation or the lengthy duration it would take to uncover such misconduct and replace it. The unusual volatility of LIBOR during the 2008 financial crisis raised questions about its credibility. Individual banks intentionally underreported their borrowing costs in their rate submissions to project financial strength at the peak of the crisis.

Replacing LIBOR is not merely a matter of substituting one rate for another.

The primary reason for the multiple delays in LIBOR phaseout is the difference in how LIBOR and the alternative rates are calculated. For example, in the US, SOFR was not selected to be the direct equivalent of LIBOR but to serve as a representative benchmark backed by high transaction volume in the overnight repo market. SOFR is an overnight rate, whereas LIBOR is typically quoted at forward points such as 1 month, 3 months, or 6 months. Therefore, a 3-month SOFR rate needs to be derived by compounding the overnight rate in arrears.

Second, LIBOR played a pivotal role in valuing most financial assets, particularly derivatives, which are inherently complex by nature. The phaseout of LIBOR extends beyond financial complexities to legal complexities, as it has led to numerous contract modifications. Many banks have a substantial number of legacy contracts tied to LIBOR, necessitating negotiations with counterparties to amend or replace existing contracts.

Third, LIBOR had been deeply embedded in financial institutions’ risk management practices, including valuation modes, pricing tools, and hedging frameworks. Switching to new reference rates requires banks to reassess and modify their risk management frameworks, which can be time-consuming and carry inherent risks.

Fourth, at the early stages, the new alternative reference rates were relatively unfamiliar to the markets, and therefore, they lacked market liquidity. This presented additional challenges for financial institutions in accurately pricing products linked to these new rates and managing risks, given the absence of a well-developed market.

Finally, regulators in different countries developed compliance rules for LIBOR discontinuation with varying degrees of divergence. In countries such as the UK, the transition coincided with the major overhaul of the former regulatory body, the Financial Services Authority, which made the process even more complex.

The financial institutions most affected by this transition are the largest multinational banks operating across multiple jurisdictions. Their LIBOR transition efforts require significant international coordination to navigate different regulatory frameworks and schedules. For the reasons mentioned above, many large banks have created new roles, such as LIBOR transition specialists, leads, or managers, to facilitate the coordination and management of this complex and time-consuming process.

What are we to expect with the new benchmark rates?

Discussion on the impact of LIBOR transition on banks has been centred on the valuation and risk effects. The valuation effect of the LIBOR discontinuation refers to the impact it has on the pricing and valuation of financial instruments and contracts that were previously tied to LIBOR. This transition can lead to changes in the valuation of these instruments due to the shift to alternative reference rates, potentially affecting their market prices and risk profiles.

A recent study carried out by the Bank for International Settlement finds that “the transition from LIBOR to ‘nearly risk-free’ rates (RFRs) has led to structural changes that have reshaped the trading and hedging behaviour of participants in the fixed income markets” [8]. The reform also yielded profound effects due to the fundamental differences between the old and new reference rates. On one hand, the reform mitigated fixing risk by basing the new reference rates on overnight tenor. On the other hand, the reform induced new basis risks arising from the coexistence of different types of reference rate.

The LIBOR phaseout has resulted in significant changes to the market behaviour, as seen in shifts in the mix of financial instruments and the geographical distributions of OTC interest rate derivatives. Between 2019 and 2022, forward rate agreements (FRA) became mostly irrelevant due to the decreased fixing risk. As a result, FRA trading declined, contributing to a decrease in overall turnover. Meanwhile, turnover increased for basis swaps, which were used to hedge the array of new basis risks. Moreover, the UK and US shares in global turnover declined while the Eurozone’s share increased.

New reference rates such as SOFR are transaction-based and, therefore, are not forward-looking like LIBOR. Investors holding LIBOR-linked investments could experience increased price volatility if the transition does not proceed as smoothly as expected. It is crucial for market participants to carefully assess and adapt their valuation methodologies, models, and assumptions to account for the impact of the LIBOR transition. Valuation adjustments may be necessary to reflect changes in interest rates, spreads, liquidity, and contractual terms associated with the shift from LIBOR to alterative rates.

We are currently developing a research project that examines the valuation effects of LIBOR phaseout on financial institutions in more detail, focusing on aspects such as information asymmetry, analyst forecast dispersion, and market return volatility. The aim is to understand whether the LIBOR discontinuation has heightened uncertainties among investors.

References

[1] International Monetary Fund (2012). What is LIBOR? [Online] Accessible at https://www.imf.org/external/pubs/ft/fandd/2012/12/pdf/basics.pdf

[2] Huan, X., Previts, G. J., & Parbonetti, A. (2023). Understanding the LIBOR scandal: The historical, the ethical, and the technological. Journal of Banking Regulation, 24(4), 403-419.

[3] Fabrizi, M., Huan, X., & Parbonetti, A. (2021). When LIBOR becomes LIEBOR: Reputational penalties and bank contagion. Financial Review, 56(1), 157-178.

[4] Huan, X., Parbonetti, A., Redigolo, G., & Zhang, Z. (2024). Social Media Disclosure and Reputational Damage. Review of Quantitative Finance and Accounting.

[5] Conlon, T., & Huan, X. (2019). Scaling the twin peaks: Systemic risk and dual regulation. Economics Letters, 178, 98-101.

[6] Huan, X., & Parbonetti, A. (2019). Financial derivatives and bank risk: evidence from eighteen developed markets. Accounting and Business Research, 49(7), 847-874.

[7] Conlon, T., Huan, X., & Muckley, C. B. (2024). Does national culture influence malfeasance in banks around the world?. Journal of International Financial Markets, Institutions and Money, 90, 101888.

[8] Huang, W., & Todorov, K. (2022). The post-LIBOR world: A global view from the BIS derivatives statistics. BIS Quarterly Review, December 2022.