Five years ago today, the regulator of the London Interbank Offered Rate (LIBOR) declared that the world’s most widely used interest rate for pricing financial contracts was likely to end.
The statement on 27 July 2017 by Andrew Bailey, then chief executive of the UK Financial Conduct Authority and now Governor of the Bank of England, had huge significance.
LIBOR had served as a globally accepted key benchmark interest rate for financial markets for more than 40 years. Published in five currencies and seven tenors, it comprised daily estimates of borrowing costs in the unsecured market provided by a panel of major banks.
The issue was that when liquidity in that borrowing market dried up – as it did after the Global Financial Crisis of 2007-08 - LIBOR was no longer anchored in a robust underlying market, making it unsuitable as a widely used reference rate. Its demise would impact trillions of dollars of financial contracts around the world, from derivatives to bank loans and from overdrafts to mortgages.
Major financial markets around the world, including Australia, set out to identify and adopt alternative reference rates to function alongside, and ultimately in lieu of, their respective LIBORs. This was not only done out of concern about LIBOR’s long-term viability: many LIBOR-referencing contracts didn’t really need a reference rate that reflected bank credit risk in the first place. The alternative was to adopt so-called ‘risk free’ overnight rates, or RFRs.
Given that RFRs are overnight rates and not forward looking term rates like LIBOR, the operational use of these new rates required considerable preparations. That wasn’t the only challenge: what to do with all those ‘legacy’ contracts still referencing LIBOR?
Industry groups developed widely used standard clauses that would enable these contracts to transition from LIBOR to an RFR, upon LIBOR’s cessation. These clauses typically include an adjustment to limit any unwarranted economic transfer that would otherwise result from replacing one reference rate with another. Relying on such a fall-back is one of several ways to transition, and pro-actively restructuring exposures is another way.
Most LIBOR rates, with the exception of the US Dollar setting, successfully transitioned by the end of last year. USD LIBOR’s lifespan was extended until 30 June 2023, to allow more time for transitioning the vast amounts of LIBOR contracts denominated in the world’s reserve currency – although USD LIBOR is no longer used in new contracts.
What does it mean for Australia?
Whilst LIBOR has a definitive end-date, not all interest rate benchmarks that reflect bank funding costs – “IBORs” – are expected to discontinue. IBORs that will remain for the foreseeable future include, for example, EURIBOR, as well as Australia’s local credit-benchmark BBSW.
BBSW measures the cost for highly rated banks in Australia to issue short-term bank paper for each monthly tenor between one month and six months. Australia has an active bank bill market, where the major banks issue bills as a regular source of funding, and a wide range of wholesale investors purchase bills as a liquid cash management product. AONIA is the name for what is commonly known as the official cash rate (OCR). It is administered by the Reserve Bank of Australia and calculated as the weighted average interest rate on unsecured overnight loans between banks.
BBSW remains robust and is expected to continue and our regulators are not advocating a wholesale transition from BBSW to an RFR. Instead, Australia is taking a multi-rate approach: market participants should choose the reference rate that best suits the particular product and situation. As most of the world adopts risk-free rates, the Australian market may see a shift towards referencing AONIA across certain products, such as, for example, cross-currency swaps and multi-currency lending facilities.
The LIBOR transition has been a remarkable example of a ‘market led’ transition driven by supervisory guidance. When all is said and done, global markets will have undergone a historic transformation, with LIBOR rates replaced with more robust alternatives.
Pieter Bierkens is Commonwealth Bank of Australia’s Interest Rate Benchmark Reform Lead and Chair of the IBOR Transformation Australian Working Group.
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