The LIBOR replacement: which reference interest rate comes after the LIBOR?

The LIBOR replacement: which reference interest rate comes after the LIBOR?

LIBOR replacement at the end of 2021

The LIBOR (London Interbank Offered Rate) will finally be replaced by the end of 2021. Then an end to the interest rates caused a scandal. I have now asked myself what will come afterward and have researched this a little.

Manipulation of LIBOR

But let’s start all over again. As is well known, it happened manipulation scandals at LIBOR. The LIBOR had been manipulated by traders from various big banks by means of mutual agreements. As a result, the British Financial Market Authority (FSA) will only support the calculation of LIBOR until the end of 2021. Internationally, no LIBOR successor reference interest rate has yet emerged.

Anchoring the LIBOR

Since the LIBOR is firmly anchored in many places and in many instruments, it is important to avoid chaos in the course of the LIBOR conversion. The Commission of the European Union, therefore, wants to set a new reference rate. While the EURIBOR will remain in place, even after 2021, the LIBOR must be replaced. This means that banks and companies have to convert many old contracts before the end of 2021 – because most of them do not contain an alternative for the permanent removal of a reference interest rate.

European Union action

The European Union, through its Commission, proposes to find a single solution for most of the treaties. If this push to adjust the benchmark regulation comes through, the EU Commission can simply determine which interest rate is to be used as a replacement for the Libor that is no longer applicable in the different currency areas.

This solution would relieve an enormous amount of revision work, since old contracts would not have to be revised, but simply defined what would be new instead of LIBOR. Since this solution has almost all advantages and is practically easy to implement, it is considered likely that the proposal will come through. In the best case, the final legal text could already be available at the end of 2020.

Which interest rates will replace LIBOR?

It can be assumed that these so-called fall-back interest rates will be based on new overnight interest rates that have already been developed and therefore already exist. The United States, for example, works with the Secured Overnight Financing Rate (SOFR), the United Kingdom with SONIA (Sterling Overnight Index Average) or Switzerland with SARON, the Swiss Average Overnight

Adjustment of the spread to the previous LIBOR

Since there are structural differences to LIBOR, these interest rates would have to be given a fixed spread premium in order to compensate for these differences. This new fall-back interest rate would then be SONIA + x, for example. The serve is still unclear. Working groups in the individual countries are working on the changeover. Ideally, new contracts in 2021 can already be based on the new interest rates, while the old ones would then simply be automatically converted to the new interest rate from 2022 without having to change anything in the contracts.

Validity

Another open problem is the validity of these fall-back interest rates and the automation of the changeover. This could only apply to contracts with financial institutions. Intercompany liabilities, for example, meaning payments from one company to another under the same roof or transactions outside the financial sector would not be affected. This problem is also still being clarified. This could for example also be regulated by mirroring the decisions on the LIBOR within financial parties.

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For reading the whole story on the LIBOR manipulation I strongly recommend the following book, which is very well written by two Bloomberg journalists: