The LIBOR interest rate benchmark is set to be phased out as the main index in the market by the end of 2021. An estimated $350 trillion of loans and contracts are linked to LIBOR, including mortgages and student loans. Many of the financial arrangements that rely on LIBOR, such as variable rate commercial loans, mature after LIBOR is set to cease publication. This leaves many asking why is LIBOR being phased out and what will replace it.
The London Interbank Offered Rates (“LIBOR”) are set each business day and historically have been some of the most common benchmarks. The Intercontinental Exchange (ICE) calculates the LIBOR rates by aggregating interest rate submissions from certain banks. Those banks report to ICE the rates at which they expect they could obtain loans from other particular banks on specific terms. Each LIBOR rate is intended to indicate the average of the banks’ submissions.
ICE began overseeing LIBOR in 2014, after a scandal surrounding LIBOR (previously administered by the British Bankers’ Association) was uncovered. According to the United States Department of Justice, some of the world’s largest banks manipulated LIBOR rates by reporting false or misleading information regarding their expected interest rates in order to, among other things, profit from trades.
Although the LIBOR scandal may now be in the past, regulators are concerned that LIBOR is no longer a reliable index. LIBOR seeks to measure the market for unsecured wholesale term lending to banks, a market regulators believe is no longer sufficiently active to provide objective reporting by participating banks. Instead, many of the interest rates that are aggregated to produce LIBOR rates are merely hypothetical and do not reflect actual transactions. ICE maintains that LIBOR has been reformed to avoid subjective rates when possible and is still a viable benchmark.
If LIBOR is to be phased out, alternative benchmarks must be found and those benchmarks must establish a reliable track record. In the United States, the Federal Reserve Bank of New York and the Office of Financial Research has proposed publishing a broad Treasuries repo financing rate, which is reported to be the consensus favorite to replace LIBOR. However, the reality is that LIBOR may survive beyond 2021. Banks may continue to report rates to ICE and, in fact, regulators have suggested banks may be compelled to report to ensure continuity.
Although the death knell appears to have rung for LIBOR, the future is far from certain. Borrowers and Lenders need to be mindful of this uncertainty and the looming changes when entering into transaction that use LIBOR as a benchmark.
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