- Interest rate benchmark, LIBOR is used to price financial contracts and is likely to be replaced by SONIA after 2021
- All financial contracts are supposed to make transition to a new framework by the end of 2021
The central banks are calling time on LIBOR (London InterBank Offered Rate). The deadline for dropping the LIBOR benchmark interest rate would not be extended due to the economic impact of the novel coronavirus. The lenders and borrowers are expected to undergo transition by the end of 2021, according to top central bankers in Britain and the United States.
The benchmark rate, LIBOR, is traditionally used to value all kinds of financial contracts, specifically in the debt and money market across the industry. Andrew Bailey, the Governor of Bank of England (BoE), said that it is important to make a transition and remove the country’s financial system’s dependence on LIBOR.
The economic impact of the unprecedented crisis reinforces the importance of devising new mechanisms for pricing financial contracts. Andrew Bailey gathered support from the top official of the Federal Reserve Bank of New York, John Williams on adhering to the existing deadline. It is important for businesses or individuals to be prepared for the transition while moving away from LIBOR. In the pandemic-struck environment, continuing with LIBOR would only worsen the state of the economies.
If you were to go and ask for a loan or mortgage to borrow from a financial institution such as a bank, the rate that which they charge you is calculated based on LIBOR. A group of banks decide an average rate every day which is known as the LIBOR rate. Since this rate is decided by the banks, this could be manipulated. There have been several instances in the past when huge fines were imposed on big financial institutions for manipulating the LIBOR. Moreover, during the financial crisis of 2008, several banks were fined for manipulating with LIBOR and some officials from Barclays and UBS were even jailed.
The LIBOR is not the real interest rate, it is just a benchmark, which is set privately by the banks. Based on LIBOR, the interest rate is used to price the financial contracts in the economy which affects several individuals and businesses. If the banks determine the benchmark rate in an untruthful way, they can influence a whole host of other prices, and can manipulate various transactions they make in the derivatives or debt markets.
For the banks, the ability to manipulate the LIBOR, is a key mechanism to make extra profits. They have got this ability because they set the benchmark rate privately. The system seems to be rigged. Notably, setting up LIBOR is beyond the jurisdiction of central banks.
The authorities were directed by the UK’s Financial Stability Board last week to prepare for the transition away from the LIBOR with reference to existing financial contracts having maturity beyond 2021. Due to the coronavirus pandemic, Britain’s Financial Conduct Authority (FCA) extended the use of LIBOR for pricing of new products until the end of March 2021.
SONIA-The new alternative
LIBOR is a major interest rate benchmark, which underpins financial contracts worth trillions of pounds, including derivatives and debt market securities. The shift to new pricing mechanism of financial contracts could affect several businesses and individuals. In addition to being vulnerable, the markets in which LIBOR operates, is less liquid.
Therefore, the Working Group (the Working Group on Sterling Risk-Free Reference Rates) chose SONIA (Sterling Overnight Indexed Average) as the preferred sterling risk-free rate alternative to LIBOR. Based on overnight unsecured wholesale funds, SONIA measures the rate paid by banks. SONIA is a better measure of the general level of interest rates than LIBOR as it does not include a term bank credit risk component. SONIA is robust to any inherent changes in its underlying markets and has the capability to evolve over time. In addition, SONIA tracks the bank rate (rate at which the central bank lends money to commercial banks), hence, tends to be more predictable.
Loan products based on LIBOR would not be offered beyond the third quarter of 2020. SONIA is an overnight rate, measured on each day over the interest period to arrive at a final rate of interest unlike LIBOR, which is pre-determined for a set tenure. SONIA does not include any term bank credit risk or liquidity premium and therefore offers almost a risk-free rate. The transition to SONIA for existing contracts could impact the way interest is calculated.
What should be the plan of action for individuals?
It is imperative of people having financial contracts governed by LIBOR to discuss about the required transition and the actions needed thereof with their respective bank or financial institution. First and foremost, individuals need to identify their respective LIBOR exposures in the form of mortgages, loans, derivatives, or floating rate notes. It is important to assess how things would shape up in the absence of LIBOR.
Even though most of us are financially literate, however, we need to educate ourselves with the SONIA. It is important to understand that SONIA would be replacing LIBOR, but it is pertinent to note that SONIA cannot be directly substituted into the existing LIBOR contracts. Individuals or businesses must seek advice from financial service professionals to make a swift transition to the new framework within relevant deadlines.
The economic impact of the coronavirus on firms’ LIBOR transition plans over the coming months has been under discussion by the Working Group, Bank of England and the FCA. The target date of migration to new framework remains unchanged.
The transition from LIBOR (London InterBank Offered Rate) to SONIA (Sterling Overnight Indexed Average) would strengthen the global financial system and remains an essential task. However, this transition might require some businesses to make changes in the way they operate. Timing is another aspect which needs to be taken into consideration due to the prevalent conditions in the economy. UK’s economy must cover a lot of ground in terms of making a switch as the loan market is heavily reliant on LIBOR. The respective authorities will continue to monitor and assess the impact on the changeover timelines in the meantime.