The London Inter-Bank Offered Rate (Libor) is simply put, the global benchmark interest rate for borrowing costs between banks. However, despite being so simple in definition, Libor has had a truly scandalous existence, with the consequences of the financial crisis of 2008 having exposed Libor for being extremely un-robust. In a highly publicised scheme in 2012, bankers at several major financial institutions were found to have colluded in order to manipulate Libor. Not only did this bring into question the validity of Libor as a credible benchmark, but it set off a chain of financial research and investigation, which will ultimately conclude with Libor being put out of use by the middle of 2023. Nonetheless, with Libor currently still sitting at the heart of debt capital market deals, how are banks preparing for the transition, and which debt products are going to have their deal flow disrupted the most in the coming months?
What is LIBOR?
Libor stands for the London Inter-Bank Offered Rate, and is a rate that has historically underpinned a giant range and volume of loan and derivative products. The roots of Libor stem from the period in the 1980’s when banks developed increasingly more complex financial instruments and products, leading to a spike in trading activity. In order to value this large array of financial products, a standardised benchmark was required, with Libor first being introduced in January 1986. The construction of Libor is relatively simple, with a large range of banks being asked to provide a quote on how much interest they would charge to borrow money in the short-term, from other banks. From this data, outliers are excluded and the average is calculated by the International Exchange (ICE). Naturally this sounds simple enough, and for much of its history, Libor has succeeded in facilitating deal flows for new and robust debt instruments. However, this simplicity has truly been its downfall, and has exposed the shortcomings of both the benchmark and the financial markets themselves.
Why is there a transition away from LIBOR?
The first issue with Libor reared its ugly head in the wake of the 2008 Financial Crisis. For much of the inter-bank rates’ early years, almost all institutions had the perception of inter-bank lending as low risk. Hence, for many institutions, Libor was the primary risk-free rate that they would operate with. When the Global Financial Crisis then begun, and credit risk became a sharp focus in financial markets, it dawned on the industry that Libor was in fact an ‘artificial’ rate subject to abuse from the partaking banks. In fact, the machine for determining Libor had completely broken down within days of the crisis. With no day-to-day trading taking place between banks, there were no reference points for calculating what a bank would pay for a loan. In such a situation, game theory took over, and lenders became fixated on the inputs of rival banks. If a bank was an outlier and placed their rate too high, they would be put in acute liquidity risk on their balance sheet. As a result, the only option was to stay in the middle of the pack, rather than provide a true assessment of their ability to borrow unsecured cash. Put simply, Libor relied on banks telling the truth, but encouraged them to lie.
The issue of abuse was doubly compounded in 2012 with a major Libor scandal revealing that numerous top banking institutions tampered with the rates they provided in order to profit off of derivative deals. Through colluding together, the institutions were able to change the average rate across the board, impacting all $350tn in derivatives underpinned by Libor. From the scandal, 13 traders have been charged by the UK Serious Fraud Office with fines being handed down in excess of £757 million.
All in all, the recent history of Libor doesn’t paint a pretty picture, with the Bank of England itching to move away from the ‘artificial’ rate. That now brings us to the present day, where the Sterling Overnight Index Average (SONIA) is set to take over as the preferred risk free rate for the sterling. Proposed in 2017, SONIA uses daily transactional data rather than quotes from participants, preventing any element of trust being required between banks and the ICE. As of the end of 2021, the Financial Conduct Authority (FCA) has promised that Libor will no longer be necessary, and that SONIA will be the new benchmark.
Deal Mayhem in the wake of LIBOR transition
With Libor still underpinning $350 trillion worth of derivative deals, it has become increasingly evident that the benchmark won’t simply disappear overnight. In fact, data from October 2021 has suggested that there has been an uptake in deals underpinned by the Libor benchmark. Following the pandemic, companies have binged on the cheapest loans they could find, creating a big source of debt that financial institutions can package up. These packages primarily come in the form of Collateralised Loan Obligations (CLOs) which have become increasingly popular amongst investors due to expectations of rising interest rates. CLOs take bundles of leveraged loans and use them to buy back payments on new debt, allowing investors to mitigate risks in their fixed income portfolios. With the attractiveness of CLOs being so high, we have seen an unprecedented deal flow, with total issuance in 2021 having reached $140bn, already above the $130bn set in the whole of 2018. In fact, the news of the end of Libor has stimulated deal flow, with CLO managers wanting to maximise transactions before the new regime kicks in. Moreover, as CLOs bundle existing debt, the majority of this will still be pegged to Libor come January. This means that there will be a mismatch as CLO managers have to use new pricing models such as SONIA or SOFR on existing derivatives that use Libor. All in all, the future of Libor will remain ingrained in the financial markets despite its slow phasing out come the end of 2021.