The end of LIBOR

Feb 11, 2020 - 6 min read
Ronan du Halgouet, Commercial Lending Product Manager at Sopra Banking Software

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.