By Charley Babb
Chances are you haven’t ever heard of the United Kingdom Financial Conduct Authority. However, their recent announcement of plans to end the use of the LIBOR index (the London Interbank Offered Rate which is the average of interest rates estimated that each leading bank in London would charge to lend to other banks) by 2021 has many in a twitter about how this will affect the nearly $350 trillion in outstanding securities. When I heard the news, I asked, “Why are they dumping the LIBOR Index? And, for what reason?
The short answer is due to previous manipulation of the Index. The problem is that several banks were found to have colluded and profited from setting LIBOR at rates that benefitted their own trading positions, rather than reporting their actual lending costs. Even after the previous scandals, enacted reform measures have fallen short of their desired effect. In addition, LIBOR doesn’t really reflect the cost of borrowing between banks as originally intended. The bottom line is that there is an overarching need and desire to have transparency and trust in the capital markets.
There has been plenty of overreaction in the media regarding this change. Think Y2K. Remember when the world was allegedly going to come to an end at the end of the last millennium? What actually happened? Basically not much. There is absolutely no need to panic. The finance industry body orchestrating the transition is the ARRC (Alternative Reference Rates Committee), set up by the US government. The ARRC plans to refine its proposed transition plan and publish a final report before the end of the year – a full three years ahead of the burial of LIBOR. Current indications are that they are leaning towards a market-based Treasury repurchase agreement index (the “Broad Treasuries Repo Financing Rate”), which is essentially a reference of the cost of overnight loans that use the US Government debt as collateral. It would be based on actual transactions and published by the Federal Reserve Bank of New York.
But what about those $350 trillion in securities that utilize LIBOR as an index for their current contracts? To be sure, there is some complication with revising contracts that will extend beyond 2020. That being said, trillions of dollars’ worth of contracts will expire/mature prior to the deadline; others may have to be amended. New contracts should have a clearly defined process for amending the LIBOR index once it has been replaced.
Chances are that many of you reading this article either have loans that have a LIBOR based index or you may own derivatives that are based upon the LIBOR index. DO NOT PANIC! If you have a loan or contract that extends beyond 2020, start by having a simple conversation with your lender or another party to discuss an orderly transition plan. You have three years to work it out. If you are about to enter into a loan or contract that will mature after 2020, make sure you negotiate in a language that provides for a flexible and orderly transition to an alternative index once one is determined by ARRC. Don’t get caught up in the hype; we should all let LIBOR rest in peace.
The author, Charley Babb is a Principal and Senior Director at Metropolitan Capital Advisors. Charley can be easily reached at [email protected] or 303-598-7652.