By the end of 2021, LIBOR – the London Inter-bank Offered Rate – the most important number in finance – will be retired, bringing a significant challenge to the financial services industry. For 30 long years, LIBOR has been the dominant benchmark rate for determining interest payments on almost all floating rate financial products. With over $350 trillion of global financial contracts linked to LIBOR, the impact will be far-reaching.
As a replacement for LIBOR, each central bank has chosen an overnight Risk-Free Rate (RFR). However, a simple rate substitution for existing contracts is not possible – RFRs are not equal to LIBOR. Risk-Free Rates are processed in a fundamentally different way compared to LIBOR. The new alternative rates are backward-looking, overnight and published with a delay. While LIBOR is fixed at the beginning of a given period, in advance, Risk-Free Rates have to be compounded each business day until a final rate is calculated at the end of the period. The retirement of LIBOR will have a significant impact on all floating rate contracts referencing this benchmark – loans, deposits, bonds, derivatives.
Given the complexity of the transition away from (L)IBORs and the potential size of the disruption to the financial industry, any strategic initiative on the subject should be carefully calibrated. Banks need to work closely with each other and with any other affected entity to limit any losses in the process of moving to RFRs. The operational challenge for all financial institutions will be enormous as a fundamentally new approach will be required.
Software vendors need to provide the ability to deal with the alternative to LIBOR reference rates to achieve migration of exposure before 2021. Providing solutions for referencing backward-looking overnight rates and considerations for future term RFRs are essential in navigating through the complex puzzle created by the retirement of LIBOR.
As regulators are already requesting banks to set out their readiness for these changes and present a plan on how they will manage the transition, banks, along with their software providers, need to begin transition efforts now. All entities affected by the discontinuation need to assess their exposures to and plan for a comprehensive transition away from, LIBOR.