The decadelong transition away from Libor is almost complete

December 22, 2022 3:37 PM

WASHINGTON — Breaking up is hard to do. Breaking up with an interest rate that is baked into millions of contracts worth trillions of dollars is even harder, but 2022 was the year the financial system proved that it can be done.

Libor, or the London interbank offered rate, evolved out of the rampant inflationary cycle of the 1980s as a way for complex financial contracts to hedge against rising or falling interest rates. The benchmark was based on unsecured overnight loans that banks would make to other banks to meet liquidity needs and came to represent banks' fundamental cost of funds all over the world.

But in 2012 it was discovered that because fewer and fewer banks were making or receiving those kinds of overnight loans, the Libor rate became easier to manipulate and many banks and bankers were ultimatelyfined billions of dollars for colluding to fix the Libor rate to their advantage. But while there was widespread agreement that Libor could no longer serve as a reliable interest rate benchmark, it was by no means assured that something else would be able to easily step in and take its place.

What follows is a review of the decade between when the Libor scandal first broke and the sunsetting of the last Libor rates next year.

The Federal Reserve Bank of New York organized the Alternative Reference Rates Committee, which was tasked with identifying an alternative to Libor and implementing that replacement across the financial system.

Bloomberg News

The ARRC of history bends away from Libor

The Federal Reserve Bank of New York convened the Alternative Reference Rate Committee, or ARRC, in 2014 for the purpose of first identifying what interest rate-sensitive markets might serve as suitable replacements for Libor and then determining how to extrapolate a Libor-like interest rate benchmark out of that market.

In an interim report issued in 2016, the ARRC whittled the potential markets down to the Overnight Bank Funding Rate and the treasury repo market. Both markets are deep and resistant to manipulation — a must-have for any Libor replacement — but extrapolating a benchmark interest rate out of either remained a daunting task. What is more, then-Federal Reserve Gov. Jerome Powell said at the time that the market would ultimately decide whether whatever the committee came up with would serve their purposes.

"I think everyone agrees and understands that the plan to move a lot of the trading to a new rate is a much better equilibrium for the whole system," Powell said. "No one can just order that done. We need the expertise of these firms, they are committed to achieving this goal, so we're well aligned in this."

But even in those early days, bankers were concerned that the committee was paying too much attention to how or whether a Libor replacement would serve the derivatives market and too little attention to how a Libor replacement would work when tied to loans.

SOFR gets the nod; banks get to work

In 2017, the ARRC settled on the Secured Overnight Financing Rate, or SOFR, as its preferred alternative to Libor. SOFR, which is based on overnight Treasury repo transactions, differs from Libor in one important way — while Libor relies on unsecured transactions, Treasury repos are secured with Treasuries, making the market and resulting interest rates behave differently.

That same year, the UK's Financial Conduct Authority — the agency charged with overseeing Libor — announced that it would be phasing out the benchmark and could only commit to publishing Libor rates through the end of 2021, after which time banks would no longer be required to submit quotes to set the rate.

The Federal Reserve and the Federal Reserve Bank of New York, which convened the Alternative Reference Rates Committee that recommended SOFR as the new benchmark, urged financial institutions they supervise to get on board as soon as possible and leave the scandal-ridden Libor in the past.

"Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes and the end of Libor," New York Fed President John Williams said in a 2019 speech. "Everyone in the financial services industry needs to be aware that the date when the existence of Libor can no longer be guaranteed is fast approaching."

Challengers emerge

While the ARRC got busy turning SOFR into a Libor substitute, some banks became concerned that the preferred Libor alternative does not accurately represent banks' cost of funds and started seeking out alternatives.

"Until we get four or five months under our belts in the new regime … I'm going to hold my powder a little dry on whether this is a done deal or not," said Richard Jones, a partner at the law firm Dechert earlier this year, referring to SOFR.

Banks' rapid adoption of SOFR also fed the adoption of two alternatives in the United States: the Ameribor rate favored by some midsize lenders and Bloomberg's BSBY rate, which gained traction among other regional and larger banks.

Regions Financial, for example, began offering not one but all three rates in 2022 because "different clients have varying needs for managing their finances," said Libor transition lead Colleen Rabenstine.

Still, SOFR has quickly emerged as the rate that will replace the majority of former Libor-referencing contracts. The Federal Reserve said in December 2021 that banks' non-Libor lending primarily used SOFR in the fourth quarter of 2021.

Congress steps in

One important challenge in replacing Libor with SOFR is the problem of so-called "tough legacy" contracts. Under contract law, the terms of a contract can be changed only with the consent of all parties to the contract. But in some cases there are Libor-facing contracts with hundreds or even thousands of parties that date back many years and have no reference rate fallback language.

While a small segment of the overall Libor-referencing market, a failure to establish a backstop for tough legacy contracts had many in the banking industry concerned about endless and costly litigation to clear up those disputes.

In March, Congress folded a provision that would automatically insert fallback language into tough legacy contracts, averting that undesirable outcome. The remaining steps in the transition may fall more on borrowers than on banks. Banks have set up a range of services to assist customers, but some corporate borrowers may be a bit further behind in ensuring their internal systems can switch Libor contracts and payments to new rates.

With the last vestiges of Libor set to sunset in 2023, the banking system and regulators can say goodbye to a challenging but historic era in global finance.