Explanation: The Libor era is coming to an end

The City of London Financial District is seen in London, Great Britain on October 22, 2021. REUTERS / Hannah McKay

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NEW YORK, December 28 (Reuters) – The Libor, or the London Interbank Offered Rate, will no longer be used for new derivatives and loans as of January 1. early 2021, is scrapped in the biggest market upheaval since the euro was introduced in 1999.

WHAT IS LIBOR AND WHY IS IT REPLACED?

The Libor, once dubbed the world’s largest number, is a rate based on quotes from banks on how much it would cost to borrow short-term funds from each other. Although it dates from 1969, it was formalized in 1986 and has been used as the benchmark rate for a wide range of financial products, including student loans, credit cards, business loans, and mortgages.

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Libor was discredited after the 2008 financial crisis when authorities discovered traders had manipulated it, prompting calls to reform and ultimately replace the tarnished rate. Several global banks have been fined.

WHAT IS LIBOR REPLACEMENT?

Regulators said no new business could be done after Dec.31 using Libor, which has 35 permutations in five currencies, the US dollar, British pound, euro, Swiss franc and Japanese yen. Some Libor tenors – the term remaining before a contract expires – linked to the US dollar will however continue until the end of June 2023 to allow most “old” or current contracts to expire.

Libor is being replaced by alternative rates, with a preference for those recommended by central banks which are based on actual transactions, making them more difficult to rig. L1N2TC0XL

WHAT ARE THE RISKS FOR THE FUTURE?

The vast majority of Libor tenors won’t be released after January 1. But a few U.S. dollar tenors will continue until June 2023, which could create legal problems for companies whose debt is still tied to the rate, analysts say.

To help minimize disruption, New York State passed a law allowing “hardened” contracts – those that expire after June 2023 and do not have a fallback language specifying an alternate rate and therefore cannot be changed. – use the secure overnight funding rate, or SOFR, recommended by the US Federal Reserve. Congress is working on a similar bill.

In the UK, regulators have also said that six Libor rates for the pound sterling and the yen will hold in a “synthetic” form – the Bank of England’s Sterling Overnight Index Average, or SONIA, combined with a fixed spread. – for one year, giving market participants more time to change. at alternative prices for existing contracts.

LIBOR LIQUIDITY

Much of the US dollar derivatives market has already moved to SOFR. Relatively large Libor-based exposures remain in the Eurodollar space, however, for short-term contracts used to speculate or hedge against interest rate fluctuations. (For a chart on CME SOFR futures volumes: https://datawrapper.dwcdn.net/XXwf9/1/)

The liquidity of these contracts is expected to decrease, which will likely make it more difficult for investors to hedge existing Libor-based exposures. Investors will also need to adapt to the use of alternative instruments when making bets on future rate movements.

LOAN PRICING CHALLENGES

The move from Libor to SOFR also poses pricing challenges for borrowers and loan issuers, who prefer exposure to credit benchmarks that will adapt to changing credit market conditions.

SOFR is based on the US repo market, which does not present a credit risk and can decline in times of stress. Libor, on the other hand, measures bank borrowing costs and rises in times of stress.

Lenders adapt by valuing loans with a spread to SOFR. However, there are risks that this spread underestimates the risks in the event of unexpected periods of credit stress.

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Reporting by John McCrank and Karen Brettell; Editing by Dan Grebler

Our Standards: Thomson Reuters Trust Principles.

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