ON 12. APRIL 2023
BY SVEN KLINGLER
It all started on a cloudy day in July 2017. The head of the Financial Conduct Authority (FCA), Andrew Bailey, was frustrated. His agency was overseeing the daily publication of the London Interbank Offered Rate (Libor), an interest rate that should reflect banks’ short-term funding costs. This oversight was a huge responsibility—the interest payments for derivatives, loans, and floating-rate debt with notional amounts exceeding $300 trillion were tied to Libor, making it arguably the financial world’s most important number.
About 50 years ago, publishing Libor seemed like a great innovation. Banks were giving long-term loans to their customers and financed themselves by borrowing short-term debt. By charging Libor plus a credit spread in the loans, banks were able to cover their own interest expenses—Libor was capturing their funding costs—and charge compensation for the default risk of the borrower. Libor just had one flaw. Instead of capturing the rates at which banks actually borrowed from each other, it captured the rates at which banks said they could borrow from each other. This flaw allowed banks to manipulate Libor and led to the Libor manipulation scandal that unraveled in 2012.
But fear of manipulation was not why Bailey was frustrated. In the aftermath of the scandal, Libor had been reformed and, wherever possible, banks had to report borrowing costs that were based on actual transactions. If there were no transactions, banks needed to apply a waterfall protocol and either interpolate rates from other transactions or use their “expert judgement”. Bailey’s issue was that there were so few actual transactions that everybody was unhappy. First, the public was unhappy because Libor never fully recovered from the manipulation scandal, not even after its reform. Second, most banks contributing to the Libor panel were unhappy because, after the manipulation scandal, they were afraid of using their “expert judgement”. They even wanted to stop contributing Libor quotes. Finally, leading academics were also unhappy about the lack of underlying transactions and Darrell Duffie called Libor “a sick man”.
On that cloudy day in 2017, Bailey acted on his frustration. Giving a speech at Bloomberg London, he explained how overseeing Libor had become a burden. Banks wanted to stop contributing quotes to the Libor panel, but he promised his agency would “compel banks to contribute to Libor where necessary”. Choosing his words carefully, he further promised to “sustain Libor until end-2021”. The interpretation of his speech was clear: The publication of Libor will likely stop after 2021. Market participants nicknamed Bailey’s speech “the Libor funeral” and the end of the financial world’s most important number posed a 300 trillion-dollar issue for financial markets. Which rates should replace Libor? What happens to contracts that are written on Libor and mature after 2021? And how would banks pass their own financing costs on to their borrowers without using Libor?
Answering the first question was difficult. For each of the major currencies, regulators had to settle on an alternative reference rate. In the United States, the Alternative Reference Rates Committee (ARRC) recommended to use the Secured Overnight Financing Rate (SOFR) as alternative benchmark rate. This rate is based on overnight borrowing collateralized with US Treasuries. In the United Kingdom and the Euro area, regulators settled on the Sterling Overnight Index average (SONIA) and the European Short-Term Rate (ESTR), respectively. Both rates are uncollateralized overnight rates. As pointed out by Klingler and Syrstad (2021) these alternative reference rates are not only problematic because they do not reflect banks’ own funding costs. They are also problematic because they are affected by regulatory frictions and the amount of outstanding government debt.
The answer to the second question posed another challenge. After a long debate about legacy contracts that reference Libor after 2021, regulators chose a solution called “fallback spread” that applies to most contracts. To illustrate how the fallback works, consider a derivatives counterparty receiving the 3-month Libor rate in US dollars. These payments will be replaced by the three-month average SOFR rate plus the historic median spread between Libor and SOFR, measured on March 5, 2021. Interestingly, the derivatives counterparty in our example is still receiving the three-month Libor rate because Bailey’s FCA changed its original plan to discontinue Libor after 2021; in late 2020, they announced to continue US dollar Libor until June 2023. While the publication of Libor in most other currencies has ended, US dollar Libor has not reached its expiration date yet.
The last question is giving rise to a heated debate. As discussed above, Libor was originally a great innovation because banks wanted to charge their borrowers a rate that reflects their own financing costs. SOFR, as an overnight rate, collateralized with Treasury securities, does not reflect these costs and everybody seems unhappy about the situation again. First, the public is slow at understanding that Libor is being replaced by alternative rates. Second, banks are unhappy because the alternative rates do not reflect their funding costs. Finally, leading academics ask “Is SOFR better than Libor” and warn of loan supply issues if they are tied to SOFR.
Is the only positive outcome from that cloudy afternoon in July 2017 that the 300 trillion-dollar issue is not Andrew Bailey’s problem anymore? No. One advantage is that the alternative reference rates are virtually manipulation-proof because they are based on large amounts of actual transactions. This is an advantage for derivatives markets, which now rely on more robust benchmarks. Moreover, while the transition away from Libor might become an issue for loan markets in the future, Klingler and Syrstad (2023) investigate how credit spreads in loans and floating rate debt change when Libor is replaced by SOFR. Surprisingly, we found that borrowers replacing Libor with SOFR benefited from a “SOFR discount”, paying less for their debt than issuers who stuck to Libor.