2021: An odyssey away from LIBOR
More than three decades later, after determining that LIBOR was vulnerable to interest rate manipulation, it was announced that the benchmark rate would be discontinued beginning Dec. 31, 2021.
The 1980s were a much different time than today, to say the least. Many of us remember, or are too young to remember, an age when the typical computer only had 64 kilobytes of memory or when cell phones weighed as much as 20 pounds, with no one anticipating we would ever call them “smart” any time soon.
The 1980s were also a period of change for global economics and banks. In 1986, the London Interbank Offering Rate (LIBOR) was officially introduced and published as an interest rate benchmark for widespread usage by both financial and non-financial firms in response to banks trading in new interest markets.
However, more than three decades later, after determining that LIBOR was vulnerable to interest rate manipulation, it was announced that the benchmark rate would be discontinued beginning Dec. 31, 2021. This discontinuation meant that many businesses, banks included, would have to make the arduous transition away from using LIBOR in the future as well as address existing products that already use it.
Under normal circumstances, 2020 was supposed to be a significant year in the transition away from LIBOR. However, the financial impact of the COVID-19 pandemic may have caused a shift in priorities for many banks. While regulators have provided a temporary reprieve in several areas of banking for this year, it still stands today that LIBOR will no longer be here after 2021.
FSB progress report
To underscore the crucial need to address this issue by that deadline, the Financial Security Board (FSB) published a 2020 progress report on the year of transition away from LIBOR. As the transition remains a global priority, the FSB also included a roadmap of milestones that banks should follow as a guidance in navigating this process in a timely manner.
The FSB report addresses how the COVID-19 pandemic has been a “defining feature of the past year with widespread implications.” Understandably, the pandemic has impacted many firms in their transition away from LIBOR, but according to a survey of FSB members, it has not created pressing substantive roadblocks to the transition.
In fact, the report states that the direct correlation between LIBOR and banks’ overall borrowing costs weakened during the pandemic with volatility leading banks to scarcely rely on LIBOR markets for funding.
Those that did use LIBOR rates faced challenges because of the pandemic. While central bank rates were decreasing throughout the world, LIBOR rates were increasing and were passed on to borrowers in a time when financial systems were supposed to play a role in providing much-needed liquidity.
Despite pandemic-induced market disruptions, the FSB states that progress has been made throughout the past year in the transition. Many national working groups have produced their own timely roadmaps as guides that have been widely adopted while also considering the economic impact of COVID-19.
Over the past year, the FSB continued to work with the International Swaps and Derivatives Association (ISDA) to address the transition away from LIBOR in derivative contracts. In October 2020, ISDA released amendments to its definitions and protocols with these contracts and included new fallback language that can be used by firms.
Last year, more have adopted the Secured Overnight Financing Rate (SOFR) as the preferred alternative in U.S. dollar markets. Significant progress has indeed been made and, while regulators have launched a number of initiatives, what remains is for both financial and non-financial firms to globally lead the effort to a timely market transition by no longer issuing products linked to LIBOR and by modifying their legacy contracts linked to LIBOR wherever possible.
Identifying existing LIBOR exposures
Currently, the FSB Global Transition Roadmap states that firms should at a minimum have identified all existing LIBOR exposures, including what will happen after 2021 and if those contracts have any fallback measures in place.
Further, those that provide customers with products that reference LIBOR must have a plan in place to inform them of the transition and the steps being taken by the bank to move to alternative rates. Banks should by now understand industry and regulatory best practices with the transition away from LIBOR, including necessary steps taken with the assistance of legal counsel.
By mid-2021, banks should have already determined which legacy contracts can be amended before the end of the year and consummate those changes where parties can agree. New contracts should contain robust alternative reference rates wherever possible by this time.
By the end of 2021, banks should be fully prepared for LIBOR’s discontinuation. At this point, all new business should involve alternative rates or at the very least be capable of switching in a short amount of time.
In cases where it was impossible to amend legacy contracts linked to LIBOR, the implications of the benchmark rate no longer being published should have already been discussed, with necessary steps being taken to prepare for this kind of outcome. The goal by Dec. 31, 2021, is for all market participants, financial and non-financial firms alike, to operate without relying on LIBOR. To meet this, the importance of a market-led transition will remain significant all year.
At the outset of LIBOR in 1986, it would be difficult to say many could have predicted that more than 30 years later, the rate would be discontinued and that the transition would be impacted by a global pandemic.
Just as 2020 was a significant year for the transition away from LIBOR, 2021 is equally, if not even more, critical. If banks have not taken the necessary steps to address their potential LIBOR exposure for new and existing products, they must immediately put plans in place.