LIBOR has been dubbed the most important number in finance but its demise is nigh. Formally, it is an acronym for London Inter Bank Offered Rate but in essence it means much more than that. It has forever been a guesstimate and in more recent years it has become mischievously known as a Lousy Interest-rate Benchmark On Reality.
A cosy cartel of banking trader types setting borrowing reference-rates on financial transactions in every corner of the world was bound to lead to abuse – and that it did. Regulators were stupendously slow at spotting the obvious risks. The league of insiders had the opportunity to skew the rates to suit themselves and they carried on for years.
The ideals had merit. The principled plan was to establish a rate-setting system that would act as an independent purveyor of key lending rates across several time periods and in several currencies (some 35 iterations overall) – resulting in acceptance by all financial market participants without exception. The 11 o’clock pronouncements each business day had an air of infallibility and unquestionable obeisance. The law courts burst the bubble, fined the banks heavily and prosecuted the traders.
After 45 years of relevance, the flawed remnants of LIBOR are being phased out – far too slowly for some commentators. From now on LIBOR cannot be used as a reference rate in any new financial transaction, derivatives’ contract, commercial loan, household mortgage, credit card overdraft, etc. However, it will continue to be used for millions of existing contracts that have not yet matured. This is worrying because many of the time periods underpinning LIBOR have no relevance to modern-day financing activities. These rates will continue to be guesses.
All new financial transactions will be based on overnight lending rates derived from actual contracts the previous day. But devising the framework around this simple construct has not been easy. The EU has replaced the rather exotically-named EONIA, (Euro Overnight Index Average) with €STR – the Euro Short-Term Rate, which will be administered by the European Money Markets Institute (EMMI); a not-for-profit Belgian company with members from the national banking associations within the EU. The reason for moving to €STR is quite simply a new methodology that is not subject to potential manipulation by some of the 28 panel banks. These are the same issues that dogged LIBOR.
On the other hand, the US has opted for SOFR – Secured Overnight Financing Rate; while the UK will rely on the ever-dependable SONIA – Sterling Overnight Index Average. The primary problem with moving to these new benchmark rates is that the transition will not be seamless – but regulators are confident that over time any teething difficulties will be overcome.
MMPI has its doubts. Overnight rates are not term rates. For example, they are not suitable for pricing 30-year mortgages. Overnight rates are also subject to wild liquidity shocks where financing shortages/gluts drive prices higher/lower until the market corrects. In cases where such liquidity issues are prolonged, how will the new system cope?