Managing the LIBOR Transition
Underwritten by ION Treasury
LIBOR will cease to be calculated for most settings at the end of 2021. This means organizations with exposure to LIBOR, in both financial and commercial contracts, will have to move to a new reference rate.
This guide outlines the main differences between the new risk-free reference rates identified to replace LIBOR. It identifies the key questions for treasurers to ask when negotiating a replacement rate with a counterparty, including the variables regarding the calculation of interest. It also suggests how best to ensure treasurers can calculate interest and value instruments following the transition to new rates.
Replacement Risk-Free Rates Reviewed: ESTR, TONA, SARON, SONIA, and SOFRDownload the Guide
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1. LIBOR Defined
Initially developed as an informal market rate, the London Interbank Offered Rate (LIBOR) developed over time to become the most important global market benchmark. Its calculation was formalized in 1986, when it began to be administered by the British Bankers Association (BBA).
2. LIBOR Replacement
In the aftermath of the Global Financial Crisis, national regulators, convened by the Financial Stability Board (FSB), were worried about the scale of the transactions referencing LIBOR and its suitability as a market reference rate.
3. Why is LIBOR replacement a problem?
As the most significant market benchmark, LIBOR has been embedded in a whole range of financial contracts, from overnight derivative transactions to long-term loans, and is referenced in many standard commercial contracts as well. In 2018, the Financial Stability Board estimated that LIBOR underpinned about $300 trillion in various contracts. Of these, the majority of contracts were linked to USD LIBOR. As a consequence, the end of LIBOR has major implications across the global financial system.
4. What is LIBOR being replaced with?
In theory, all risk-free reference rates will be calculated in the same way. All will conform to the IOSCO Principles for Financial Benchmarks published in 2013. Notably, the principles state that a benchmark should be developed from data “formed by the competitive forces of supply and demand,” although the use of some non-transactional data is permitted in some circumstances (e.g., when there is a temporary reduction in actual market transactions).
5. Managing Risk-free Rates
Irrespective of the new rate selected to replace LIBOR for specific transactions, the method of calculating interest will change. Treasurers, especially when borrowing, will want as much certainty as possible over the value of any interest payments they will need to arrange.
6. LIBOR Transition Plan
With the majority of LIBOR settings being discontinued at the end of 2021, treasury practitioners should have a plan to transition to new rates, especially if they have exposures in non-USD LIBORs. This section provides four key steps to include.