Here’s what will happen after the death of the magical number underpinning $350 trillion in trades

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day of the dead hat

  • Libor, linked to about $350 trillion worth of financial products, will be replaced by an alternate pricing benchmark for everything from mortgages to credit cards. 
  • Replacing Libor will be lengthy and problematic, and is one of the key themes to look out for in 2019 as financial services and asset managers start transferring to new systems. 
  • Thousands of existing contracts will need to be renegotiated causing a huge operational and financial burden that will consume legal teams for months. 

Libor, the rate that banks agree on when lending to each other, was problematic from the beginning. Unsurprisingly, it turned out to be widely rigged, and some of the biggest and most notorious banks had gotten tangled up in the Libor rigging scandal. Some criminal charges were brought against low-level traders, and huge fines were levied against some of the banks.

Another big thing that came out of the scandal was the realization that Libor, crucial to the credit-based economy and to hundreds of trillions of dollars in derivatives, had to go. It is due to die by the end of 2021.

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“This is a material change in one of the most important numbers in finance,” said Sandie O’Connor, chief regulatory affairs officer at JPMorgan Chase in New York.

Short for the London Interbank Offered Rate, Libor underpins everything from credit card loans to mortgages to the more arcane derivatives and syndicated loan contracts. Millions of financial products use the benchmark. 

Upending Libor has become key in 2019, meaning that this is the year to start worrying about the thousands of contracts that need to be renegotiated as the financial world shifts to new systems. 

“Operationally, the amount of work needed to make changes is tremendous,” said Kevin McPartland, head of market structure at Greenwich Associates. 

The new benchmarks 

Enter new alternate benchmarks SOFR (the secured overnight financing rate) will be introduced in the US and will be secured against US Treasuries. Europeans will be served by Sonia/Eonia (Sterling/Euro overnight index average) instead.

Where Libor relied on a system of individual banks submitting their figures for lending costs each day — making it ripe for manipulation — SOFR will be calculated using real transactional data. Banks paid $9 billion in fines following the rigging scandal, with new rates introduced to reduce human error, and even outright fraud. 

Referring to SOFR, JPMorgan’s O’Connor said: “We need to leverage financial infrastructure to get people trading on this benchmark, because just having a rate does not make a market.”

It’s complicated

There’s another catch for replacing a 35-year old system. Libor and SOFR represent different levels of risk, so swapping out one system for the other will be a lengthy, and potentially costly, process for some contracts. 

Similarly, SOFR needs significant trading volume in order to build up enough data to determine value for one month, three month, and six month rates.

From a documentation and interest rate perspective, things get more complicated still. In June, The Bank of England pointed out that in the previous 12 months the stock of Libor-linked sterling derivatives stretching beyond 2021 had grown.

Significant runway is needed

Market structure experts cite the need to amend existing contracts to include “fallback” clauses which which specify what happens when Libor disappears.

This is comparatively easy for loans, but for derivatives, swaps, and options, amending existing contracts could potentially lead to legal battles. 

That’s why 2019 is a crucial year.

“Loan documents, systems and practices will need to evolve to accommodate SOFR,” said Meredith Coffey, executive vice president of the Loan Syndications and Trading Association. “Significant runway is needed to restructure, given the magnitude of the issue and the thousands of deals that will need to be converted.”

London is behind

Some companies haven’t got their act together quite yet. A survey conducted by JCRA, an independent financial risk management consultancy, and Travers Smith, a London law firm, has found that a large majority of firms with exposure to Libor are yet to start making preparations for its discontinuation. 

Beyond that, prospectuses and technology will need to be changed and new futures contracts will need to be drawn up. CME has launched SOFR futures, ICE did the same last October, LCH (The London Stock Exchange’s clearing unit) cleared its first SOFR swap contract last July and CME followed a few months later.

SEE ALSO: Once big banks crack the code of how to win millennials, star fintech unicorns will be crushed

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