New interest rate benchmarks will have impact on market participants.
For more than 33 years, the London Interbank Offered Rate (LIBOR) has been the most cited benchmark reflecting the rate at which banks are willing to pay to borrow unsecured funds from each other. One of many interbank offered rates (IBORs), LIBOR underpins more than US$260 trillion in loans and derivatives globally.
On July 17, 2017, the UK Financial Conduct Authority announced that after the end of 2021, it will no longer compel or oblige panel banks to submit the data on which LIBOR is calculated and set. This decision reflects the views of global regulators that the continued use of IBORs is no longer reflective of market conditions. The purpose of this discussion is to provide some background on the phase-out of LIBOR and the possible scenarios that will emerge.
What will replace LIBOR?
Global regulators and governmental agencies have been investigating alternatives to LIBOR, and in the last few years have signalled the markets to lessen their use of IBORs in favour of alternative risk-free-rates (RFRs). The RFRs that have been selected in each IBOR market, as outlined in the following table, are rates based on more robust overnight markets and more reflective of interbank lending activity.
Why do financial markets need alternatives to LIBOR?
While the precursor to LIBOR was first used as a benchmark rate in 1969, LIBOR was established in 1986, when traders at various banks began providing daily estimates of the interest rate at which they believed they could borrow funds on an unsecured basis. LIBOR eventually became the standard benchmark in derivatives markets. However, since the 2008 financial crisis, concerns regarding the subjectivity of underlying data arose along with recognition of the continually shrinking market of unsecured lending on which LIBOR is based.
How will changes take place?
Phasing out LIBOR requires coordination among private and public sector institutions. Organizations like the Alternative Reference Rates Committee (ARRC), which was convened by the U.S. Federal Reserve Board and Federal Reserve Bank of New York, have been leading the transition away from U.S. dollar LIBOR, and were instrumental in selecting the proposed replacement rate, the Secured Overnight Financing Rate (SOFR). The previous table also outlines the key jurisdictions, in which RFRs have been selected, the timing around the introduction of new RFRs and the dates for the expected discontinuation of the relevant IBORs.
Currently, no plans to discontinue the Canadian Dollar Offered Rate (CDOR) exist. However, the Bank of Canada and the Canadian Alternative Reference Rate Working Group have selected an alternative RFR for CDOR: the Canadian Overnight Repo Rate (CORRA), which will reflect similar underlying markets as other RFRs. Unlike in LIBOR markets where transitions will be required to an alternative RFR, CDOR and CORRA will be concurrently available.
What’s the road ahead for reference rates?
While the phase-out of LIBOR will take place over time, as LIBOR has been used as a benchmark reference rate for many financial instruments, such as corporate loans, mortgages, floating-rate notes, derivatives (including interest-rate swaps) and virtually all adjustable-rate financial products, it is recommended that market participants undertake reviews of their portfolios and assess their exposures to LIBOR.
Scotiabank is closely monitoring the changes to interest rate benchmarks and the adoption of RFRs in order to ensure the smoothest possible transition for its clients and counterparties.
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