More than a decade since manipulation of Libor triggered regulatory investigations and, ultimately, billions in fines, the rate remains the financial world's favored benchmark. But it appears 2021 might be the year banks and borrowers alike finally start to adopt alternatives.
For years, regulators have been telling finance companies that Libor would be phased out by year-end 2021. Banks have been slow to adopt and some corporate borrowers are largely oblivious to the looming seismic shift, consultants said. Recent figures from the Federal Reserve Bank of New York put the U.S. dollar Libor market at $200 trillion. By contrast, the New York Fed's preferred replacement, and the most commonly used alternative, the Secured Overnight Financing Rate, or Sofr, had roughly $4 trillion in outstanding notional contracts as of October.
"I would say the majority of the transactions that we're assisting clients with remain predominantly Libor, but there is a transition process," said Bob Newman, a managing director for Chatham Financial, an advisory firm with a focus on debt and derivatives.
On Nov. 30, regulators offered something of a reprieve for the many outstanding contracts still tied to Libor. The rate's administrator announced that it would continue publishing certain U.S. dollar Libor benchmarks through June 2023. However, regulators in both the U.S. and the U.K. made clear in a pair of coordinated statements that the continued publication of those rates should not delay banks' transition to alternative rates. In fact, the Federal Reserve's statement on the news urged banks to make the transition as soon as practicable and that no new contracts should include Libor after the original end date of Dec. 31, 2021.
Consultants said the primary purpose of the extension in publication schedule was to allow more difficult legacy contracts tied to Libor the time to mature. That would allow financial institutions the ability to focus on new volume rather than having to amend existing contracts.
"In my mind, the main purpose of the extension was from a contract and tough legacy point of view," said Nitish Idnani, a principal with Deloitte & Touche LLP. "I don't think the extension was meant to be applied to other aspects of the Libor transition program."
If anything, the confirmation in the Nov. 30 regulatory statement that banks would not be allowed to use Libor past Dec. 31, 2021, escalates the pressure on lenders, and their borrowers, to transition away from Libor.
"I think they start getting an urgency in the first six months of 2021," said Richard Sandor, chairman of American Financial Exchange and creator of Ameribor, a proposed Libor alternative. "If they are lending money beginning in January for a term of one year or more, they're going to run into trouble. The regulators will not be pleased with people entering into loans with Libor that extend beyond 2021."
Sandor's alternative rate caters to community banks, calculating its rate using transactions conducted on its marketplace. Ameribor's total volume has reached $1.2 trillion, and Chatham Financial recently executed the first interest rate swap as a hedge using the community bank-focused replacement.
While Libor remains commonly used, Idnani and Newman both said market participants have made strides in transitioning away from the benchmark rate. Fallback language, or clauses in the contract that dictate what happens when Libor ceases to exist, has become widely adopted and more robustly structured, with lenders closely following the guidance coming out of the Fed's Alternative Reference Rates Committee. Further, lenders and their third-party vendors have started to transition infrastructure needed to move away from Libor.
Yet Libor persists, in part because of clunky back-end systems. But more fundamentally, Libor has become so familiar to lenders and borrowers alike that there is a market preference for the rate. Also, Libor has a robust term structure with well-developed rates for various term lengths, allowing lenders to easily match maturities when executing hedges.
"People know what to expect [with Libor], and we just don't have a term structure yet for Sofr," Idnani said.
At the same time, Idnani said lenders and borrowers alike have started to recognize the urgency of adopting alternative benchmark rates or, at the very least, developing the infrastructure to smooth the transition. That should set up 2021 to be the year that the industry's move away from Libor finally gathers serious steam.
"It's not just a sell-side topic anymore. Insurance companies, asset managers, they're all very focused on it," Idnani said. "Over the last year or so, we've seen significant interest across financial services on what it means for them, which is encouraging."