After many decades of being widely used across both UK and global financial markets, new use of the London Interbank Offered Rate (LIBOR) has now ended.
From the beginning of 2022, LIBOR should not be used in any new derivative, bond, or lending contracts, with only a small number of temporary exceptions in USD to support risk management of legacy positions while they are transitioned to alternative rates.
The orderly phasing out of LIBOR is necessary due to concerns about its robustness, and the relatively opaque risks to which it exposes borrowers.
Since the global financial crisis, banks have moved funding away from the short-term wholesale interbank markets on which LIBOR is based.
As activity in these underlying markets decreased, the rate became more vulnerable to short-term illiquidity effects.
The LIBOR rates became reliant on expert judgement. This meant LIBOR was increasingly based on estimates of what the borrowing rates would have been had the panel banks that contributed to the rate wanted/needed to borrow in the markets LIBOR sought to measure, rather than being based on actual qualifying/underlying transactions.
In periods of stress, activity in these markets reduced to extremely low levels that led to sharp movements in the rates that would be passed directly onto borrowers.
With LIBOR forming such an important reference rate for so many financial contracts, it became necessary to cease publication and move markets onto more robust alternatives.
Synthetic LIBOR: Temporary support to finish transition
Publication of 24 of the 35 LIBOR settings ended permanently on 31 December 2021 as planned.
Six of the most widely used sterling and yen LIBOR settings continue to be temporarily published on a ‘synthetic’ basis, under a changed methodology to ensure an orderly wind-down.
These rates are only available to be used for legacy LIBOR-linked contracts and are not available for use in any new contracts.
The synthetic LIBOR rates are part of a set of measures to support those contracts that weren’t able to be actively converted away from LIBOR ahead of cessation at the end of last year.
For example, where a lender could not get in touch with the borrower to change a contract, or reach the necessary consent thresholds to change a contract where there were multiple parties to that contract.
These synthetic LIBOR settings are based on more robust risk-free rates (RFRs), with the addition of a fixed adjustment spread to reflect the difference in credit risk between LIBOR and RFRs.
The adjustments are based on wide international consultation to build consensus on a fair way to calculate a replacement for LIBOR.
A number of other large-scale conversion processes have been implemented as part of the work to move contracts away from LIBOR.
Central Counterparty Clearing Houses converted over £13 trillion of sterling derivative contracts during December 2021; the International Swaps and Derivatives Association (ISDA) 2021 Fallbacks Protocol has been supporting transition of covered contracts since the beginning of this year; and the active conversion of legacy contracts by affected parties continues.
SONIA: The preferred alternative
If you still have exposure to LIBOR or synthetic LIBOR, you should speak to your financial service provider about moving that contract onto a robust alternative such as the Sterling Overnight Index Average (SONIA) as soon as is feasible.
SONIA is the preferred interest rate benchmark to LIBOR in sterling markets, as recommended by the Working Group on Sterling Risk-Free Reference Rates (RFRWG).
It is administered and published by the Bank of England on every London business day, and based on actual transactions reflecting the average of interest rates that banks pay to borrow sterling overnight.
In the UK, the transition from sterling LIBOR to SONIA has been a great success after six years of intense work – moving financial markets, businesses, and consumers to more robust alternatives with minimal disruption.
UK markets were well prepared for the cessation of panel bank sterling LIBOR – not just due to strong cooperation between the Bank of England, Financial Conduct Authority (FCA), and HM Treasury, but also through practical and constructive cooperation with industry through the RFRWG.
The RFRWG is made up of a range of financial institutions, trade associations, and non-financial corporates.
Compounded in arrears SONIA is the most robust form of the rate and has been widely adopted for GBP lending since April 2021.
There is now over £100 billion of SONIA-linked lending, and the stock of SONIA-linked cleared derivatives is in excess of £25 trillion.
Compounded in arrears SONIA is being used across a wide range of different sectors and types of borrowing facilities.
However, there are a narrow set of use cases where a forward looking term rate may be appropriate; for example, where a rate is used for discounting future cash flows, such as in trade finance.
Term SONIA is different from overnight SONIA produced by the Bank of England. A number of term SONIA reference rates are available from private sector benchmark providers.
Guidance on the use cases for term SONIA have been set out by the RFRWG, and more recently in a finalised standard on use of Term SONIA reference rates published by the FICC Markets Standards Board.
The road ahead
Panel bank sterling LIBOR has now ceased, marking an important step forward in ensuring markets have continued access to financial products linked to robust reference rates.
More broadly, no new LIBOR business should now be being undertaken across all the LIBOR currencies, including USD.
If you have continued exposure to sterling LIBOR, then you should use the time provided by the temporary publication of synthetic LIBOR to look to transition away from the rate.
Transition to the most robust rate applicable for your use case. In many cases, this will be the relevant risk-free reference rate recommended by the applicable national working group.
With synthetic LIBOR not guaranteed beyond end-2022, this is something that should be addressed as soon as is practical.
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