ARR Leaves LIBOR behind

Introduction

The Name LIBOR (London Interbank Offered Rate) used to be synonymous in every other loan which is raised in global currencies i.e., USD, EUR, GBP, JPY and CHF. And the trust was also unshakable on LIBOR that no one could even think to question the validity of LIBOR as benchmark. Almost all over the world banks used to price different financial products by keeping LIBOR as the benchmark. But in the beginning of 2012 investigation in LIBOR revealed that manipulation in LIBOR rate was happening by some of the top global banks notable Deutsche Bank, Barclays, UBS, Rabobank, and the Royal Bank of Scotland for benefiting their positions and this manipulation was taking place as far as 2003. Then administration of LIBOR was transferred to Intercontinental Exchange, earlier The British Bankers’ Association was issuing the LIBOR rates. Regulators in United States, UK and European Union fined the banks for more than USD 9 Billion for rigging the LIBOR. Criminal charges were also levelled against individual traders and brokers for their role in the manipulation of LIBOR rates. The British Regulator that was compiling the LIBOR said the banks are no longer required to submit interbank lending rates for LIBOR post 2021. According to the Federal Reserve and regulators in the UK, LIBOR will be phased out completely by June 30, 2023

In 2017 the Federal Reserve constitute the Alternate Reference Rate Committee (ARRC) comprising several large banks to select the alternate reference rate for the United State to replace the LIBOR as many irregularities were found in the LIBOR Calculationwhich bankers and other stakeholders were reluctant to keep as the benchmark for the interest rate setting. The ARRC recommended Secured Overnight Financing Rate (SOFR) an overnight rate as the new benchmark for US Dollar denominated contracts. And in other markets other ARR prevails e.g., in European Union – Euro Short-Term Rate (ESTR), in UK – Reformed Sterling Overnight Index Average (SONIA), in Japan – Tokyo Overnight Average Rate (TONAR) and in Switzerland – Swiss Average Rate Overnight (SARON).

Understanding LIBOR

LIBORofficially now known as ICE LIBOR stands for Intercontinental Exchange London Interbank Offered Rateis the interest rate at which banks can borrow money (unsecured funds) from other banks in the London interbank market for a specified period of time in a specified currency. Here important point to note is that banks are submitting rates at which they ‘can borrow’ not the actual rates at which transactions are taking place.

The benchmark rate LIBOR was being published on daily basis once a day at around 11:55 a.m. London time and calculated for seven different maturities which are 1 Day, 1 Week, 1M, 2M, 3M, 6M, 12M and for five currencies: USD, GBP, EUR, JPY and CHF. Total of 35 different LIBOR rates calculated and reported on each business day by combination of 7 Maturities and 5 Currencies.

The London Interbank Offered Rate was used to price adjustable-rate mortgages, asset-backed securities, credit default swaps, municipal bonds, private student loans and other types of debt. As of 2019, $1.3 trillion of consumer loans and $1.2 trillion worth of residential mortgage loans had been priced using LIBOR.

When there is an application for a LIBOR then Financial firm would refer LIBOR for the specific period and will add an additional percentage. For example, a consumer loan based on 3 month LIBOR plus 2.5 percent has come for consideration. At that time 3-month LIBOR is 0.20 percent, then effective rate for the loan is 2.70 percent. Other factors such credit risk, term of the loan, income etc are also factored in.

Origin of LIBOR

During 1980s the uniform measure for interest rate became necessary for Financial Institutions as the market for Interest rate based products was evolving in that era. In 1984 the British Bankers’ Association (BBA) which represented the banking and financial services industry – set up BBA interest-settlement rates. Further developments led to the evolution of BBA LIBOR in 1986, initially with only three currencies the US Dollar, Japanese Yen and Great Britain Pound. Which then became the default standard interest rate for transacting in the interest rate and currency-based financial dealings between financial institutions at the local and international levels.

But major change happened in the aftermath of the scandal in LIBOR, Britain’s primary financial regulator, the Financial Conduct Authority (FCA), shifted supervision of LIBOR to a new entity, the ICE Benchmark Administration which is an independent UK subsidiary of the private U.S.based exchange operator Intercontinental Exchange or ICE.

Calculation of LIBOR

Every day 18 international banks submits their quotes of the rate on which they are ready to pay if they borrow funds from other banks on the interbank lending market in London. To help guard against extreme high or lows that might influence the final rate Intercontinental Exchange (ICE) Benchmark Administration uses “trimmed mean” method, where in trimmed mean is calculated by discarding the top 4 and bottom 4 of the submitted interest rates and then taking an average of the remaining middle 10 submissions. This calculation reduces the impact that any single contributing bank can have on the final officially published rate.

Importance of LIBOR

The LIBOR was important not because banks used to transact with each other at announced rate but LIBOR derived its importance from its widespread use as a benchmark for many other interest rates products in which business was being carried out. According to a U.K. Treasury report, USD300 trillion in financial contracts were tied to LIBOR. And that did not even include rates on uncounted tens of billions of dollars of adjustable rate home mortgages and other consumer loans all around the globe in which LIBOR, in one way or the another, was referenced. LIBOR was established as a standardized benchmark for pricing floating rate corporate loans. LIBOR was instrumental in development of various financial products such as forward rate agreement, interest rate swaps etc.

Various types of loans were linked or priced using LIBOR such as Corporate Debt, Adjustable-rate Mortgages, Asset-backed Securities, Municipal Bonds, Interest Rate and Other Derivatives Products, Private Student Loans, Personal loansand Other Types of consumer loans etc.

 

LIBOR Scandal

• Several major financial institutions e.g., Deutsche Bank, Barclays, Citigroup, JPMorgan Chase and the Royal Bank of Scotland colluded with each other to manipulate the LIBOR.
• Although the scandal came to light in 2012, It is estimated that the collusion in question had been ongoing since as early as 2003.
• During the LIBOR Scandal, traders as many of these banks deliberately submitted artificially low or high interest rates in order to force the LIBOR higher or lower, in an effort to support their own institutions’ derivative and trading activities.
• Regulators in both the United States and the United Kingdom levied some $9 billion in fines on banks involved in the scandal, as well as a slew of criminal charges.
• As a result of the rate fixing scandal, questions around LIBOR’s validity as a credible benchmark rate have arisen and it is now being phased out.
• According to the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023 and is being replaced by the Secured Overnight Financing Rate (SOFR).
• Britain’s Financial Conduct Authority (FCA) took the responsibility for LIBOR supervision away from the British Bankers Association (BBA) and turned it over to the Intercontinental Exchange’s Benchmark Administration (IBA).
• The IBA is an independent U.K. subsidiary of the private U.S.-based exchange operator, Intercontinental Exchange (ICE). LIBOR is now commonly known as ICE LIBOR.

LIBOR to ARR

• FCA has announced that it will support LIBOR only until 2021, at which point it hopes to transition to an alternative system.
• From 1 January 2022, 26 of the 35 LIBOR settings, which relate to specific currencies and time periods, are no longer available.

Alternate Reference Rates – ARR

• In 2014 Federal Reserve Board convened a Alternate Reference Rate Committee (ARRC) to come up with suggestion for a new rate.
• After 3 years of deliberations ARRC recommends Secured Overnight Financing Rate (SOFR) as the preferred alternative to LIBOR.
• In April 2018 – FED start publishing SOFR rates on its website.
• In July 2018 – Fannie Mae (Government owned housing Mortgage Institution) becomes the first entity to issue instrument linked to SOFR.
• In August 2018 – Barclays becomes the first bank to issue instruments based on SOFR.
• On November 30, 2020, the Federal Reserve announced that LIBOR will be phased out and eventually replaced by June 2023. In the same announcement, banks were instructed to stop writing contracts using LIBOR by the end of 2021 and all contracts using LIBOR should wrap up by June 30, 2023.

 Comparisons b/w LIBOR and ARR

	LIBOR	ARR
Overview	Unsecured uncollateralized rate at which banks lend / borrow from another	Overnight rates based on actual transactions
Calculation	Forward looking based on banks survey	Backward looking based on actual transactions
Stability	Less efficient, stable	More efficient, stable
Term structure	Fixed term	A single date overnight rate
Publication	11:45 AM London time. Published for various durations and in various currencies	Published at different times for each currency
Validity	Rates published are valid for 2 days	Single day validity

 

Secured Overnight Financing Rate (SOFR)

• The SOFR is a benchmark interest rate for dollar-denominated derivatives and loans.
• SOFR is based on transactions in the Treasury repurchase market
• The SOFR is based on data from observable transactions rather than on estimated borrowing rates, as is the case with LIBOR.
• SOFR is based on Treasury repurchase market (Repo), Treasuries loaned or borrowed overnight.
• Rate is calculated and published at around 8:00 am New York Time the next business day
• The Rate is published by the US Federal Reserve Bank of New York.

 Other ARRs

Country	EU	UK	JAPAN	Switzerland
Current Benchmark	Euro LIBOR	GBP LIBOR	JPY LIBOR	CHF LIBOR
ARR	Euro Short-Term Rate (ESTR)	Reformed Sterling Overnight Index Average (SONIA)	Tokyo Overnight Average Rate (TONAR)	Swiss Average Rate Overnight (SARON)
Regulator	European Central Bank	Bank of England	Bank of Japan	SIX Swiss Exchange
Description	Unsecured Fully transaction-based Reflects euro area banks’ borrowing costs in the wholesale unsecured overnight market.	Unsecured Fully transaction-based Encompasses a robust underlying market Overnight, nearly risk-free reference rate Includes a volume-weighted trimmed mean	Unsecured Fully transaction-based Encompasses a robust uncollateralized overnight call rate market. Published on  a daily basis using information provided by money market brokers	Secured Became a reference interbank overnight repo on August 25, 2009 Secured rate that reflects interest paid on interbank overnight repo

 

Way Ahead

Though LIBOR was in use for many decades, Financial sector was heavily dependent on the same but Alternate Reference Rate is more secured than the LIBOR and is based on the actual transactions. So, it has been taking LIBOR place more rapidly. Since in ever changing environment and to go with the pace of time, regular updation is required in order keep its sanctity and prevent fraudulent activities.