Updated December 15, 2021
The LIBOR Transition
LIBOR is a key benchmark interest rate underpinning many
they wished to borrow, giving banks some discretion in
financial contracts, but it is scheduled to be discontinued
what rates they reported. This problem grew following the
starting at the end of 2021. This In Focus discusses efforts
financial crisis because banks borrowed less as a result of
to transition away from the use of LIBOR in financial
the large increase in bank reserves.
products in order 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
Offered Rate. It is privately determined by polling more
handful of banks. Policymakers initiated several reforms in
than a dozen large global banks in London about the
response to the scandal. First, publication of the rate was
interest rate at which they can borrow for various lengths of
transferred from the British Bankers Association and made
time (“tenors”) in U.S. dollars and four other currencies.
more transparent. Second, production of the rate became
Thus, at any point in time, there are several “LIBOR” rates.
regulated by the British financial regulator. Third,
LIBOR dates back to the 1960s and has been published
calculation of the rate was modified to increase the weight
daily since 1986.
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 Happens Next? For all but the most popular
instruments are tied to dollar LIBORs, including certain
currencies and tenors, there is insufficient borrowing to
floating-rate loans, bonds, securitized products, and
determine LIBOR using only borrowing data, so data
financial derivatives. For example, an adjustable mortgage
quality and integrity remains questionable. Participation in
rate might be set at LIBOR plus a fixed markup. Each
the LIBOR sample is voluntary and confers limited benefit,
month, the rate on the mortgage would be reset based on the
and participants are leery of potential further legal
prevailing LIBOR. A type of derivative called an interest
exposure. As a result, British regulators have announced
rate swap might also reference LIBOR. One party to the
that LIBOR will be discontinued between December 31,
swap would receive a periodic payment based on a
2021, and June 30, 2023, depending on the type.
predetermined fixed interest rate, while the other party
would receive a payment tied to a rate that adjusts based on
The LIBOR Transition
the current LIBOR. As of 2020, LIBOR was referenced in
Given LIBOR’s shortcomings and its planned
an estimated $223 trillion of financial instruments.
disappearance after 2021, policymakers and market
participants are actively encouraging financial institutions
What Was the LIBOR Scandal? In 2012, the British-
to transition from LIBOR to alternative benchmarks. It is
based bank Barclays was fined by its British regulator and
unclear, however, whether sufficient progress has been
settled with the U.S. Justice Department, the Commodity
made to avoid disruption when LIBOR disappears.
Futures Trading Commission (CFTC), and a group of states
for manipulating LIBOR. Barclays was one of the banks
What Risks Does the LIBOR Transition Pose? Financial
that was polled to determine LIBOR. From 2005 to 2008,
firms using LIBOR face legal, operational, credit,
employees at Barclays submitted LIBOR data that did not
regulatory, and reputational risk. In addition, the LIBOR
accurately reflect Barclays’s borrowing costs. They did so
transition may pose systemic risk—the risk that a disorderly
for two reasons: (1) to profit from Barclays’s swaps trading
transition could cause widespread financial instability.
based on LIBOR and (2) to mask weakness in Barclays’s
financial condition during the financial crisis. Subsequently,
Financial contracts using LIBOR may include “fallback
several other banks reached settlements with regulators for
language” that explicitly addresses what would happen if
manipulating LIBOR and operating a derivatives cartel that
LIBOR is discontinued. These contracts are less
involved sharing information on, among other things,
problematic than “legacy contracts” that do not include
LIBOR submissions. Private parties have also sued
fallback language and mature after LIBOR’s disappearance.
submitting banks over LIBOR manipulation.
If unaddressed, legacy contracts could stop functioning or
lead to legal action between parties to the contracts. Parties
An inherent weakness of LIBOR that made it potentially
to a legacy contract can mitigate these risks by amending
susceptible to manipulation is that on any given day there
contracts to incorporate robust fallback language. However,
may be little or no actual borrowing by banks at the various
in many cases, all parties must agree to an amendment.
tenors that are reported. In that case, polled banks submitted
their best estimate of what their borrowing costs would be if
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The LIBOR Transition
The transition has faced hurdles—financial firms continued
(SEC) announced that companies should determine whether
to reference LIBOR in new financial instruments in 2021
LIBOR poses material risks that they should disclose and
even though its eventual disappearance has been well
made LIBOR-transition readiness a priority in SEC exams
known for years. Nevertheless, it is estimated that the value
in 2020. In June 2020, the Consumer Financial Protection
of outstanding assets referencing LIBOR has increased by
Bureau proposed a rule to allow lenders to replace LIBOR
$24 trillion since 2016. In many cases, recent instruments
in certain mortgage and consumer loans before it became
include fallback language—although its robustness will not
unavailable, subject to disclosure and other requirements.
be tested until LIBOR disappears. The value of assets
The CFTC has used no-action letters to ensure that
lacking robust fallback language is unknown.
amendments to legacy contracts do not trigger regulatory
requirements. Similarly, the Internal Revenue Service has
Table 1. Value of Assets Referencing Dollar LIBOR
clarified that certain amendments to legacy contracts do not
(as of end of 2020, tril ions of $)
have tax consequences.
Currently
Maturing After
Policymakers have also debated whether a legislative
Asset Class
Outstanding
June 2023
solution is required. In April 2021, New York enacted a law
overriding legacy contracts governed by New York law that
Derivatives
$214
$68
lack adequate fallback language. Some policymakers have
(notional value)
called for similar legislation at the federal level, and on
Loans
$6
$3
December 8, 2021, the House passed H.R. 4616, which
would create an override process led by the Federal Reserve
Bonds
$1
$0.3
that provides federal preemption and a limited safe harbor.
Securitizations
$2
$2
Policymakers could also reduce official use of LIBOR.
Total
$223
$74
Under Title 20, Section 1087-1, of the U.S. Code, certain
Source: CRS calculations based on ARRC data.
payments to student loan lenders are based on LIBOR. H.R.
4616, as passed, would provide a fallback for these loans.
Who Is Leading the LIBOR Transition? The Federal
The Small Business Administration, Department of
Reserve convened the Alternative Reference Rates
Housing and Urban Development, and Treasury also have
Committee (ARRC), a private group of market participants,
loan programs that use or allow the use of LIBOR through
to develop and oversee the LIBOR transition. ARRC has set
regulation.
out a timetable and a series of voluntary best practices. It
SOFR: A Potential LIBOR Replacement
has promoted the Secured Overnight Funding Rate (SOFR)
as an alternative to LIBOR. ARRC has also addressed
What Is SOFR? The Secured Overnight Financing Rate is
regulatory, tax, legal, and accounting obstacles to replacing
the interest rate on an overnight repo collateralized by
LIBOR. Internationally, the Financial Stability Board has
Treasury securities. It is compiled by the New York Federal
coordinated LIBOR reform, and the International Swaps
Reserve Bank and has been published since April 2018. It is
ARRC’s preferred alternative to LIBOR.
and Derivatives Association (ISDA) has addressed
Since its
transition issues affecting derivatives markets.
inception, the use of SOFR as a reference rate has grown
quickly but remains modest compared with LIBOR.
ARRC has provided model fallback language for debt
instruments that financial actors can voluntarily incorporate
What Is a Repo? Economically, a repo (repurchase
into their legacy contracts. For derivatives, ISDA has issued
agreement) is a fully collateralized short-term loan between
a protocol that automatically includes standard fallback
two financial institutions. Legally, a repo is structured as a
language in new contracts using ISDA definitions and
two-part sale. Initially, the borrower sells the lender a
provides market participants with a streamlined mechanism
security, such as a Treasury bond. At a later, pre-ordained
to amend legacy contracts to incorporate the language.
date, the borrower repurchases the security at a higher
Major clearinghouses require derivatives they clear to
price. The difference in price between sale and repurchase
include the ISDA protocol. As a result, the legacy contract
constitutes the borrowing rate. The repo market is one of
problem is easier to address for derivatives.
the largest short-term funding markets.
What Are Policymakers Doing? U.S. policymakers have
What Are the Differences Between SOFR and LIBOR?
supported ARRC’s recommendations, which are not
Some are concerned that differences between SOFR and
binding on financial market participants. Financial
LIBOR explain why LIBOR has maintained its dominant
regulators have taken various steps to reduce the transition
position, although inertia may also play a role. Reasons that
risks at the institutions that they regulate. Bank regulators
LIBOR may be preferred as a benchmark include its
have released a joint statement that summarizes how banks
availability at different tenors and long history, which helps
should manage LIBOR transition risk and explains how this
predict how it will perform. In contrast, reasons why SOFR
risk will be monitored by examiners, and they have required
may be preferred include its greater trading volume and the
banks to stop entering into new contracts using LIBOR by
fact that it is based solely on actual trading. These factors
the end of 2021. Entities regulated by the Federal Housing
make it more robust and less prone to potential
Finance Agency—Fannie Mae, Freddie Mac, and the
manipulation. Finally, LIBOR includes credit risk and
Federal Home Loan Banks—have plans to discontinue their
SOFR does not. For some financial products, referencing a
use of LIBOR. The Securities and Exchange Commission
rate with credit risk is desirable; for others, it is not.
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The LIBOR Transition

IF11315
Marc Labonte, Specialist in Macroeconomic Policy


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