Innovation and Choice in the Post-Libor Landscape

By Richard L. Sandor

Some banks are reluctant to give up the London Interbank Offered Rate benchmark, which is no longer guaranteed to be available after 2021. I believe the hesitation in making this transition is understandable but mistaken. The sooner we get rid of scandal-ridden Libor, the better. The post-Libor landscape offers a world of better options for lenders, including multiple benchmarks, transparency, efficiencies, lower costs and greater innovation.

Libor, which is based on a poll of international banks, isn’t viable. It is a very small cash market used to price hundreds of trillions of dollars. It is akin to electing the president of the United States based on a national telephone opinion poll instead of a national election. We can and we will do better.

Having multiple benchmarks will enhance market efficiency and drive down transaction costs. In the U.S., we are seeing growing adoption of the Federal Reserve’s Secured Overnight Financing Rate, or SOFR, which is derived from borrowing and lending activity using Treasurys as collateral. Others such as Ameribor, short for American Interbank Offered Rate, which is based on overnight unsecured lending on the American Financial Exchange that I co-founded and lead. Both benchmarks are transparent and offer capital markets participants a choice of secured, in SOFR’s case, and unsecured, in Ameribor’s case, options. Internationally, there are the British government’s Sterling Overnight Interest Average, or Sonia, rate, the Japanese Tonar and the Swiss Saron.

The transition will also lead to greater innovation. AFX connects borrowers and lenders across the U.S., creating, for the first time, a national market for unsecured lending. AFX now has its data on the blockchain. This is a first-of-its-kind initiative to provide greater transparency to market participants, regulators and academics. Unlike other markets that only provide time, quantity and price transaction information, AFX now has records with additional data fields related to each transaction. This additional data includes: the entire order book at the time of each transaction; geographical region of the counterparties to each transaction; and detailed counterparty information such as credit rating, type of institution and detailed financial metrics for each counterparty.

Since AFX has members in all 50 states, this data provides a wealth of information for analyzing and anticipating capital flows among different areas of the country. It can benefit members by helping them better understand trends and patterns in the marketplace. It can also be of value to researchers and regulators who can use the data for research and policy.

The world after Libor will provide many more options to lending institutions than before. One size need not fit all. A choice of multiple benchmarks will make the lending market more like other markets, all of which have a plethora of benchmarks like the commodity markets (with three different kinds of wheat), oil (Brent, WTI, Dubai) and equity (S&P 500, Dow Jones Industrial Average, Nasdaq, the Russell 2000, EAFE and many more) markets.

Bankers and capital markets participants need not fear a Libor sunset in 2021. There’s still time for financial institutions to prepare. But there is also a lot of work to be done. It is critical that financial players pay very close attention to and start reviewing their loan documents in advance of the transition.

Bankers need to begin redrafting their commercial and industrial loan documents to replace Libor with one or more alternative benchmark reference rates. Similarly, derivatives dealers and the International Swap Dealers Association need to alter their master service agreements and short form trade confirmations to replace Libor with one or more alternative benchmark reference rates aligned with IOSCO benchmarks.

Economics teaches us that it’s best to have choices. Choice will allow banks and their customers to have access to a truly representative American rate. All market participants will benefit from increased transparency as benchmarks reflect financing activity in real time. The lending markets will be more diverse, and market efficiency will increase. I urge those who are doubtful about leaving Libor to consider it an opportunity.

Richard Sandor is the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School and chairman and CEO of the American Financial Exchange, an electronic exchange for direct interbank lending and borrowing.