LIBOR: The Final Countdown?
An Overview of the Numerous Challenges for the Industry Ahead of the Libor Transition
Formed in 1986 out of a market necessity for a standardized interest rate benchmark, the LIBOR rate has been one of the most important benchmarks in the world.
However, after multiple cases of manipulation and shrinking volumes of interbank unsecured term borrowing, regulators have announced that banks will no longer be compelled to publish the rates needed to calculate LIBOR after the end of 2021.
The transition out of LIBOR will lead many products that currently reference the benchmark to switch to alternate risk-free rates. This complex journey of switching from LIBOR to the fallback risk-free rates may cause significant market disruption, as a forward-looking LIBOR and backwards-looking risk-free rates create an economic value transfer problem in a post-LIBOR world. This challenge will be impossible to solve without continuing the publication of LIBOR throughout the transition.
An overview of the numerous challenges for the industry ahead of the LIBOR transition.
In many respects, the LIBOR transition can be seen as an escape from past mistakes into what the industry hopes might be a brighter future. As economists and financial markets experts, we propose a technical overview of the challenges ahead and emphasize the importance of history when transitioning towards a more reliable interbank rates benchmarking environment. Benchmarks are by their very nature imperfect substitutes to real markets and therefore hard (if not impossible) to fix.
Practitioners willing to rely on such benchmarks should carefully consider such imperfections and the extent to which a benchmark can become a liability before deciding to rely on it. Although solving LIBOR is a complex undertaking and solving complex situations requires compromises, some market participants are not in favour of a clean-cut farewell to the LIBOR index by the end of 2021 and worry about potential disruption to the market.