The arduous, decade-long process to end the financial system’s reliance on a tarnished interest-rate benchmark, which once underpinned trillions of dollars in contracts across the globe, is almost over. From next week, the rate, known as the London Interbank Offered Rate, or LIBOR for short, will cease to be published.
LIBOR is a collective term for dozens of rates, denominated in different currencies, intended to reflect how much it costs banks to borrow from one another. That rate is important because it reflects the baseline cost that banks pass on to customers. The ups and downs in LIBOR have been reflected in many mortgages, student loans, corporate bonds and a wide variety of financial derivatives, starting more than 50 years ago.
In 2012, the British bank Barclays became the first of many to be fined by regulators for manipulating LIBOR, which was compiled by taking an average of the rates quoted by a relatively small panel of banks each day. The submissions were supposed to reflect market conditions, but because they were not expressly linked to actual trading, the submitters were accused of gaming the system by quoting higher or lower rates to benefit specific trades. In the end, roughly $10 billion in fines were meted out across the financial industry over accusations of LIBOR rigging, which led to efforts to move away from the tainted benchmark.
This week, that mammoth effort is crossing the finish line.
“LIBOR was a ubiquitous rate across all global financial products; it was the single most important benchmark in the world, and to move the market away from that has been a truly herculean effort,” said Mark Cabana, the head of U.S. rates strategy at Bank of America. “There are still issues, but it’s remarkable that LIBOR will go out with more of a whimper than a bang. That was unthinkable years ago.”
In the United States, LIBOR is being replaced by the Secured Overnight Financing Rate, or SOFR. Unlike LIBOR, SOFR represents the cost of borrowing for a broader variety of market participants and is based on actual transactions in overnight lending markets.
The process to replace LIBOR began in earnest in 2014, with the creation of the Alternative Reference Rates Committee, a group of industry representatives and regulators who in 2017 decided to replace LIBOR with SOFR. Since then, a mammoth exercise has taken place to inform banks, fund managers and others about the transition, prodding them to shift contracts over to the new rate. Starting in 2022, new deals were not supposed to be linked to LIBOR.
But plenty of contracts written before then, and even some after, still cite the LIBOR benchmark, and there has been a last-minute dash to meet this week’s deadline.
Roughly half the $1.4 trillion loan market, for example, has switched to paying interest pegged to SOFR, according to JPMorgan Chase. Most of the rest of the market has adopted language in loan documents that will take loans still tied to LIBOR and switch them to SOFR next week.
“It’s been a gargantuan amount of work,” said Meredith Coffey, who has been part of the transition effort since 2017 as co-head of policy at the Loan Syndications and Trading Association. “When we started talking to people in cash markets telling them that LIBOR would cease, they thought we were crazy.”
A small portion of the loan market — roughly 8 percent, or around $100 billion — has no fallback language, according to data from the research firm Covenant Review. Most of those loans are by riskier borrowers that have struggled to refinance their debt to reference SOFR.
Analysts said most of these companies could take advantage of a decision made this year by British regulators, who oversee LIBOR, to publish a rate that mimics LIBOR through September 2024. This zombielike rate is designed to avoid any market disruptions after the deadline.
Still, a small number of companies may be forced to use what is called the prime rate, which reflects the cost for consumers to borrow from commercial banks — a much higher rate than what banks charge one another. With some borrowers already buckling under the drastic increase in interest rates by the Federal Reserve over the past year, the hit from moving to the prime rate could have severe consequences, the ratings agency Fitch has warned.
“This has been a colossal change,” said Tal Reback, a director at the investment firm KKR and member of the industry committee managing the transition away from LIBOR. “It’s been a re-engineering of global financial markets that came alongside a global pandemic, extreme inflation and rising interest rates. There are going to be growing pains, but for all intents and purposes it’s time to say: ‘Rest in peace, LIBOR.’”