Feb 11, 2020
The end of LIBOR
Reading time: Six minutes
The end of LIBOR is in sight, and all industry sectors are preparing to transition to new benchmark rates.
Since its creation in the mid-1980s, the London Interbank Offered Rate (LIBOR) has been the benchmark interest rate to which investors and banks fix their credit agreements. LIBOR became the standard rate because it was based on five currencies — the US Dollar, the British Pound, the Euro, the Japanese Yen and the Swiss Franc — and because it served seven different maturities — overnight and one week, as well as one, two, three, six and 12 months.
The combination of these five currencies and seven different maturities results in a total of 35 different LIBOR rates being determined and reported for each business day. LIBOR, however, was not without its flaws.
LIBOR is based solely on estimates from the surveyed global banks. The downside of this became apparent in 2012, when certain banks were found to have falsely inflated or deflated their rates in order to fraudulently profit from trades or create a misleading perception as to their creditworthiness.
As such, the LIBOR rate is coming to an end. New benchmarks are being introduced in different locations and transition committees have been formed to oversee the changes, as outlined in the table below:
This end of LIBOR has led to concerns over potential disruptions to banks and financial services companies.
The Secured Overnight Financing Rate (SOFR) is set to become the new yard stick for USD-based financial markets as LIBOR is decommissioned.
Over the past year, US regulators have taken great strides in implementing LIBOR’s replacement …
and, after months of work, the Federal Reserve Bank of New York began publishing SOFR in April 2018. Currently, both LIBOR and SOFR coexist, with the latter taking over as the dominant benchmark for USD-based derivatives and credit products, and USD LIBOR being phased out by the end of 2021. The adjustment to a new benchmark rate involves considerable difficulty due to the volume of LIBOR-based contracts outstanding in 2018.
Furthermore, SOFR is not a simple substitution for LIBOR. The main purpose of the latter is to be used at the beginning of a given interest period. Most contracts that reference LIBOR use a three or six-month LIBOR, and mortgages often use a one-year LIBOR. SOFR, on the other hand, is an overnight and risk-free rate, so an additional margin needs to be determined to make the transition.
As a result, SOFR is more volatile and cannot be used as a spot rate at the beginning of the interest period. Typically, SOFR should be compounded or transformed for interest; however, this depends on the final decision taken by the transition committees. The Federal Reserve, for instance, recently proposed the daily publication of three compounded averages of SOFR, at 30, 90 and 180 calendar days. The idea is to begin publishing these averages during the first half of 2020. And the Federal Reserve also proposes publishing a daily SOFR index that would allow the calculation of compounded average rates over custom time periods.
The outcome of these proposals will certainly have a major impact on the complexity of transition challenges. ..
And SOFR is just one of the LIBOR replacement rates.
At Sopra Banking Software, we’re committed to supporting our clients’ transition from LIBOR with flexible software solutions, tools and services. Our Sopra Financing Platform (SFP) is a ready, out-of-the-box solution to accommodate the new rates, whether published daily or applied to contracts via daily compounding. SFP’s features — including powerful rate formulas, unlimited indexes and renegotiation events — will ease the transition. Tools to streamline required data conversion are already available. We’re ready with services to help you analyze your current portfolio and determine the best path forward. For new projects, the replacement of LIBOR will be included in the definition phase and form part of the project itself.
The shift from LIBOR to new rates is the biggest change to hit lending in 40 years, and there will be operational ramifications and financial challenges. Furthermore, the sheer volume of lending portfolios that will need to be adjusted is staggering.
Our clients can rest easy, though. Our LIBOR Transformation Project Committee is overseeing Sopra Banking Software’s readiness to help our clients meet the challenges ahead. We’re participating in industry workgroups such as ARRC’s Operations/Infrastructure working group, meeting with customer advisory groups, and ensuring that our software, tools and services are here to support the upcoming changes.
Fabien Oliveira, Chief Product Officer at Sopra Banking Software
Ronan du Halgouet, Commercial Lending Product Manager at Sopra Banking Software