By Richard L. Sandor
U.S. regulators ended the year joining their counterparts in the United Kingdom in telling banks to stop writing contracts using the London Interbank Offered Rate benchmark by 2021. At the same time, they approved a plan to allow an additional 18 months for existing interest-rate derivatives and business loans tied to the rate to mature before Libor fully winds down in June 2023. (Both countries previously stated Libor would be phased out after 2021.)
This should come as no surprise to market participants. Libor’s reach into our capital markets is deep. For many banks, which are still in the process finding a replacement for Libor, it was greeted as an early holiday gift. With hundreds of trillions of dollars of securities tied to the benchmark, Libor needs to be carefully assessed and excised from banks’ holdings. Blunt instruments, such as hard and fast deadlines, were unlikely to work.
However, this reprieve for Libor should not viewed as license to slow down efforts to replace it. It’s worthwhile to revisit Libor’s troubled history and why this initiative was started in the first place. Its prominence in the world’s capital markets is largely an accident of financial history.
In 1969, a consortium of banks led by Manufacturers Hanover organized an $80 million syndicated loan for the shah of Iran. It was a variable-rate loan, and the lenders had to decide how to reset the rate as interest rates changed. They decided they would call each other up and each would say what he thought the rate should be, and it was in this way that Libor was born.
The system was formalized during the mid-1980s by the British Bankers Association, but it has remained more or less unchanged right up to 2012, when a rate-fixing scandal cast a pall on Libor, which is referenced by some hundreds of trillions in derivatives, mortgages, credit card accounts, asset-backed securities and other financial instruments.
In 2014 the Federal Reserve commissioned the Alternative Reference Rate Committee to recommend a benchmark interest rate to replace Libor. Four years later, the Federal Reserve Bank of New York began publishing the ARRC’s recommended successor to Libor: the Secured Overnight Financing Rate, or SOFR.
I believe a choice of benchmarks is a critical component of the transition and a healthy development for U.S. capital markets. SOFR meets the lending needs in particular of larger banks, which hold Treasurys that secure SOFR. Other banks may prefer a rate that better reflects their cost of lending, such as Ameribor. A transaction-based rate used by members of the American Financial Exchange, Ameribor is calculated based on the weighted average of overnight unsecured interbank transactions on AFX. Through a partnership with Cboe, a federally regulated exchange, the AFX is subject to market surveillance and a rulebook that guides members’ conduct and is thus a robust, transparent rate not subject to manipulation. In addition, Ameribor has been reaffirmed to meet International Organization of Securities Commission standards for financial benchmarks.
Regulators in 2020 have made clear that banks are free to choose their own “appropriate” Libor alternatives as long as the alternatives are robust and lending contracts contain fallback language to accommodate the winddown of Libor. I applaud regulators’ recognition that lenders need the flexibility to choose benchmarks that reflect their actual costs, risk tolerance and client needs.
As we count down to the cessation of at least certain Libor tenors at year’s end, I believe we will see a family of diverse benchmarks emerge to replace Libor in history’s rearview mirror. Let all capital market participants resolve to build better benchmarks in the future and bid Libor a prompt farewell.
Richard L. Sandor is chairman and CEO of the American Financial Exchange, which publishes Ameribor.
