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Potential End of LIBOR and Operational Impacts

The 2012 “Liborgate” scandal highlighted the limits to this benchmark construction and led to many questioning its reliability. In order to tackle these issues, the European Union approved the “Benchmark Regulation", which came into force in January 2018. How will this affect financial institutions?

What brought about this change?

Since 1986, LIBOR, such as EURIBOR, has been the key benchmark for calculating interest rates in loan contracts and many other financial instruments. In 2012, the “Liborgate” scandal linked to LIBOR manipulation highlighted the limits of this benchmark construction and led to the questioning of its reliability. As a result of failing methodology in benchmark fixing (lack of Chinese wall between traders and benchmark administrators) and lack of regulatory framework, banks linked to the LIBOR manipulation were heavily fined.

In order to tackle the issues of manipulating benchmarks, the European Union (via European Parliament and Council) approved the “Benchmark Regulation” in 2016. This regulation came into force in January 2018 for new benchmarks that will be used by banks. Moreover, CIBs will have to adopt all necessary organizational transformations before January 1st 2022 in order to comply with regulatory requirements for already existing benchmarks. Regulatory measures require that banks and financial institutions perform an internal restructuring to avoid any conflict of interests, by clearly splitting the staff contributing to the benchmarks definition from those in charge of the client relationship. CIBs are also required to set up regular reporting on benchmarks used to construct their financial products.

New Alternative References Rates to LIBOR

Despite all efforts to regulate benchmark rates, LIBOR's reputation has been questioned, and its sustained and permanent use has therefore been threatened. Lack of reliability from stakeholders is leading to the creation of new alternative reference rates to LIBOR. Questioning the benchmark liability for short term interbank borrowings has gradually led financial institutions to start phasing it out. Convinced that LIBOR has not met its main objectives and that it could not last under its current parameters, some regulators have already stated that they want financial institutions to use alternatives rates to LIBOR. For instance, the FCA (Financial Conduct Authority) asked for “reliable alternatives by 2021”. In case of index disappearance, banks need to find a substitution rate and handle the transition for existing contracts referencing LIBOR.

LIBOR alternative challenge

Despite Alternative Reference Rates being studied by administrators and main financial markets regulators, Risk Free Rates (RFRs) seem to represent substitution benchmarks to LIBOR. However, the main challenge in leading transition from LIBOR to one or several of these rates will be to ensure a sustainable operational transition. This transition appears to be difficult given that:

  • LIBOR is a prospective rate based on seven types of maturities whereas RFRs are retrospective rates based on historical performances
  • RFRs are specific to each currency (published at different timings during the day) whereas LIBOR is quoted on the same basis for each currency and published at 11am every morning.

Another issue is ensuring the mitigation of potential disruptions to financial markets, highlighted by the fact that LIBOR is included in many contracts. A rough withdrawal from using LIBOR in contracts would lead to severe disruptions on the market.

Attention points

Even if the main challenge continues to be the necessity to find an alternative benchmark and lead an effective substitution from LIBOR to the selected rate, possible LIBOR disappearance implies a significant change management plan set up that would include existing contracts based on LIBOR amendments. In this context, a legislative amendment seems to be the best solution. The objective would be to modify the interpretation of LIBOR as a reference to a new benchmark. Nevertheless, this legislative solution raises new issues as it does not include fallback components to apply adapted interest rates for existing contracts. It would be necessary to include a new benchmark in the documentation for new contracts.

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