The puzzle over LIBOR’s successor

There is no uniform view on what should come next as the reference rate for loans, but decisions will need to be taken soon.

One of the challenges lenders face when looking at how they respond to the retiring of LIBOR is what alternative benchmark they are going to use. Before taking on the huge task of updating documentation for existing loans, and making any new ones, fund managers must choose another way to ensure their loans can track and react to interest rate volatility through the lifetime of the loan.

LIBOR has been the global reference rate for so long that fund managers have never previously needed to put much thought into reference rates – they simply based their contracts on LIBOR as did much of the rest of the lending industry. But with its imminent retirement, firms have been forced to examine other options and look to see where industry consensus settles.

As the retirement of LIBOR was prompted by the UK’s regulator, the Financial Conduct Authority, it’s the UK that has the earliest deadline for firms to stop using LIBOR in their contracts, beginning from January 2022. The result is that UK lenders appear to have already determined which benchmark they will use instead in the form of SONIA, a reference rate administered by the Bank of England. SONIA is based on actual transactions and reflects average interest rates that banks pay to borrow sterling overnight from other financial institutions and institutional investors.

But while LIBOR was very much a global reference rate used by banks and alternative lenders across jurisdictions, it seems unlikely SONIA will enjoy the same kind of global utility. In the US, firms and regulators are instead looking at dollar-based reference rates for their loan contracts. The US’s Alternative Reference Rates Committee has put forward the Secured Overnight Financing Rate as a replacement for LIBOR and many, if not all, of the large banks have confirmed their intent to switch from LIBOR to SOFR products.

However, the US market has yet to reach a consensus on a replacement benchmark with three others vying to become the reference rate for US lending. There is Ameribor, an unsecured benchmark created by the American Financial Exchange; Bloomberg Short Term Bank Yield Index, which launched in January this year and is based on actual transactions and executable quotes; and the current LIBOR administrator, ICE Benchmark Administration, has launched its own Bank Yield Index.

Some market participants are unhappy with aspects of SOFR, crucially that it doesn’t reflect bank credit risk while the three alternatives do, with all three having higher prevailing rates than SOFR. However, with US regulators pushing to end the use of US dollar LIBOR by 2023, the industry does not have long to decide on an alternative rate.

The other major market impacted by the retirement of LIBOR is the EU, which has again opted for a different path. The European Central Bank has created the Euro Short-Term Rate benchmark, based on wholesale euro unsecured borrowing costs of banks in the euro area, which is thought to be the favoured benchmark in the region. However, the Euribor rate, determined by a different methodology to euro LIBOR, is expected to continue to be published and could be used by some lenders in the region.

With different regions adopting different deadlines to transition away from LIBOR, it could be many months or even years before it becomes clear which will become the industry standard. Only one thing is clear: the half-century long era of a single global reference rate is coming to an end.

The LIBOR transition will be covered in greater detail in the cover story of Private Debt Investor’s upcoming September 2021 issue.

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