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September 20, 2019
The LIBOR Transition
LIBOR is a key benchmark interest rate underpinning many
they wished to borrow, giving banks some discretion in
financial contracts; this rate, however, might disappear as
what rates they reported. This problem grew following the
soon as 2021. This In Focus discusses efforts to transition
financial crisis because banks borrowed less as a result of
away from the use of LIBOR in financial products in order
the large increase in bank reserves.
to avoid disruption if LIBOR disappears.
How Was It Reformed? The LIBOR scandal revealed that
LIBOR
a rate determining the value of financial products worth
What Is LIBOR? LIBOR refers to the London Interbank
trillions of dollars could be manipulated by employees at a
Offering Rate. It measures the interest rate at which banks
handful of banks. Policymakers initiated several reforms in
can borrow unsecured for various lengths of time (“tenors”)
response to the scandal. First, publication of the rate was
in U.S. dollars and four other currencies, thus, at any point
transferred from the British Bankers Association and made
in time, there are several “LIBOR” rates. LIBOR dates back
more transparent. Second, production of the rate became
to the 1960s and has been published daily since 1986. It is
regulated by the British financial regulator. Third,
privately determined by polling more than a dozen large
calculation of the rate was modified to increase the weight
global banks in London about their borrowing costs.
on actual data and reduce the weight on “best guesses” in
the absence of borrowing. Fourth, policymakers have
How Is It Used? LIBOR is a benchmark or reference rate
encouraged a transition away from the use of LIBOR.
that helps financial market participants gauge prevailing
interest rates. In the United States, many financial
What Problems Remain? Borrowing by banks remains
instruments are tied to dollar LIBORs, including certain
insufficient to determine LIBOR using actual data alone for
floating-rate loans, bonds, securitized products, and
all but the most popular currencies and tenors. Participation
financial derivatives. For example, an adjustable mortgage
in the LIBOR sample is voluntary and confers limited
rate might be set at LIBOR plus a fixed markup. Each
benefit, and participants are leery of potential further legal
month, the rate on the mortgage would be reset based on the
exposure. As a result, British regulators have guaranteed
prevailing LIBOR. A type of derivative called an interest
LIBOR will exist until 2021, but not beyond then.
rate swap might also reference LIBOR. One party to the
swap would receive a periodic payment based on a
The LIBOR Transition
predetermined fixed interest rate, while the other party
Given LIBOR’s shortcomings and its potential to disappear
would receive a payment based on a rate that adjusts based
after 2021, policymakers and market participants are
on the current LIBOR. As of 2016, LIBOR was referenced
actively encouraging financial instruments transition from
in an estimated $199 trillion of these financial products.
LIBOR to alternative benchmarks. It is unclear, however,
whether sufficient progress has been made to avoid
What Was the LIBOR Scandal? In 2012, the British-
disruption were LIBOR to disappear in 2021.
based bank Barclays was fined by its British regulator and
settled with the U.S. Justice Department, Commodity
What Risks Does the LIBOR Transition Pose? If LIBOR
Futures Trading Commission (CFTC), and a group of states
ceased to exist, it could pose a threat to financial stability as
for manipulating LIBOR. Barclays was one of the banks
long as it continues to be referenced in trillions of dollars in
that was polled to determine LIBOR. From 2005 to 2008,
financial instruments (see Table 1).
employees at Barclays submitted LIBOR data that did not
accurately reflect Barclays’ borrowing costs. They did so
The problem can be divided into financial instruments
for two reasons: (1) to profit from Barclays’ swaps trading
referencing LIBOR that already exist and those that will be
based on LIBOR and (2) to mask weakness in Barclays’
created in the future. Existing instruments that will be
financial condition during the financial crisis. Subsequently,
outstanding past 2021 (or whenever LIBOR potentially
several other banks reached settlements with regulators for
disappears) need to be renegotiated to state what will
manipulating LIBOR and operating a derivatives cartel that
happen if LIBOR disappears. Replacing LIBOR with
involved sharing information on, among other things,
another reference rate is one possible option (multiple
LIBOR submissions. Private parties have also sued
candidates exist), but requires complex adjustments because
submitting banks over LIBOR manipulation.
no other rate exactly matches LIBOR over time. If the
adjustment is done incorrectly, one party to the contract will
An inherent weakness of LIBOR that made it potentially
benefit at the other’s expense, because the interest rate will
susceptible to manipulation is that on any given day there
be higher or lower than it would have been.
may be little or no actual borrowing by banks at the various
tenors that are reported. In that case, polled banks submitted
For financial instruments entered into in the future, the
their best estimate of what their borrowing costs would be if
LIBOR problem could be avoided by using a different
https://crsreports.congress.gov
The LIBOR Transition
interest rate from the start or including contract language
efforts. So far, they have not made the transition
that spells out how the contract will be modified if LIBOR
recommendations compulsory. Partly, this may be due to
disappears. In principle, since all parties would benefit from
limits on their authority. Some financial firms, such as
not entering into a contract based on an interest rate that
banks, have institution-based regulators with the authority
disappears, all parties have an incentive to stop using
to potentially compel them to reduce their exposure to
LIBOR going forward. In practice, many financial
LIBOR, but others do not. Partly, this may be
instruments continue to be based on LIBOR (data gaps
philosophical—policymakers tend to give sophisticated
make it difficult to know how many).
financial market participants the benefit of the doubt that
they will negotiate contracts that are in their self-interest.
Table 1. Value of Instruments Referencing LIBOR
For products such as derivatives, both parties are
(estimated notional value outstanding as of end of 2016)
sophisticated actors, but for consumer loans, the institution
making the loan arguably has an informational advantage
Volume
% which matures after:
that raises consumer protection concerns. Arguably,
LIBOR-based instruments are generating systemic risk that
Instrument
(Trillions)
2021
2025
the parties to the contract are not fully bearing or are not
aware of. Thus, a policy solution could improve outcomes
Derivatives
$190
18%
8%
because the parties’ incentive to reach a solution is not as
Loans
$4.7
23%
7%
great as society’s overall incentive.
Bonds
$1.8
16%
7%
Policymakers could also move away from official use of
Securitizations
$1.8
51%
22%
LIBOR. For example, under 20 U.S.C. 1087-1, certain
payments to student loan lenders are based on LIBOR.
Total
$199
18%
8%
Another example is the Federal Housing Finance Agency
Source: CRS calculations based on SIFMA data.
has encouraged Freddie Mac and Fannie Mae to make
SOFR-based mortgages eligible for their purchase.
Unless a solution is found, parties to any financial
SOFR: A Potential LIBOR Replacement
instrument based on LIBOR will not be able to fulfill the
legally binding terms of the contract if LIBOR ceases to
What Is SOFR? SOFR is the interest rate on an overnight
exist. For individual parties to those contracts, a failure to
repo collateralized by Treasury securities. It is compiled by
fulfill the terms of the contract could lead to legal action.
the New York Fed and has been published since April
Because many of these financial instruments were created
2018. It is ARRC’s preferred alternative to LIBOR. Since
by large, systemically important (“too big to fail”) financial
its inception, the use of SOFR as a reference rate has grown
firms, unexpected losses or legal liability could cause them
quickly, but remains modest compared with LIBOR.
liquidity or solvency problems. A problem for a
systemically important firm could undermine the stability
What Is a Repo? Economically, a repo (repurchase
of the overall financial system. For the system as a whole, if
agreement) is a fully collateralized short-term loan between
trillions of dollars of financial instruments are in limbo
two financial institutions. Legally, a repo is structured as a
following LIBOR’s end, normal financial intermediation
two-part sale. Initially, the borrower sells the lender a
could be disrupted, which would have serious economic
security, such as a Treasury bond. At a later, pre-ordained
consequences. A solution is not required until a decision is
date, the borrower repurchases the security at a higher
made to retire LIBOR, but a later solution would leave less
price. The difference in price between sale and repurchase
time to rework existing contracts and more time for new
constitutes the borrowing rate.
LIBOR-based instruments to be created.
The repo market is one of the largest short-term funding
Who Is Leading the LIBOR Transition? Federal
markets. Repos are popular, in part, because the use of
regulators convened the Alternative Reference Rates
collateral and other features removes credit risk—if the
Committee (ARRC), a private group of market participants,
counterparty defaults, the lender keeps the collateral.
to develop and oversee a LIBOR transition plan. To that
end, ARRC has set out a series of voluntary best practices
What Are the Differences Between SOFR and LIBOR?
and milestones. Their preferred alternative to LIBOR is the
Some are concerned that differences between SOFR and
Secured Overnight Funding Rate (SOFR), discussed below.
LIBOR explain why LIBOR has maintained its dominant
ARRC has also addressed regulatory, tax, legal, and
position, although inertia may also play a role. Reasons that
accounting obstacles to replacing LIBOR. At the
LIBOR may be preferred as a benchmark include that it is
international level, the Financial Stability Board has
already available at different tenors and there’s a long
coordinated LIBOR reform and the International Swaps and
history to help predict how it will perform. In contrast,
Derivatives Association (ISDA) has addressed transition
reasons why SOFR may be preferred include that it has
issues, such as fallback language for new contracts and
about 100 times greater trading volume than LIBOR and it
amendments for existing contracts.
is based solely on actual trading. These factors make it
more robust and less prone to potential manipulation.
What Are the Policy Options? Policymakers and industry
Finally, LIBOR includes credit risk and SOFR does not; for
stakeholders could encourage or compel parties to address
some financial products, referencing a rate with credit risk
the LIBOR transition. To date, the financial regulators and
is desirable, but for others, it is not.
the U.S. Treasury have supported ARRC’s and international
https://crsreports.congress.gov
The LIBOR Transition
IF11315
Marc Labonte, Specialist in Macroeconomic Policy
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https://crsreports.congress.gov | IF11315 · VERSION 1 · NEW