The London Interbank Offered Rate (Libor), the interest rate benchmark used to calculate interest rates on short-term loans by many large banks, will be phased out after 2021 according to its regulator. The London based Financial Conduct Authority (FCA) recently announced that due to growing concerns regarding the long term sustainability of the benchmark, which prior to the financial crisis of 2008 was little-known to those outside of the finance world, a move in another direction was necessary. Libor use in recent years has declined due in part to the dwindling volume of unsecured lending among banks, which is largely transaction driven, and because of new regulations that encourage banks to seek longer term funding options.

When is Libor used?

Libor is calculated daily based on submissions by panel banks on the estimated rate at which they would be willing to lend to their counterparts. Libor is used to set rates on instruments such as mortgage loans, bank loans, floating-rate debt and interest rate derivatives. It also helps determine the value of certain transactions, along with acting as a general barometer of interbank confidence. Aside from allegations of Libor manipulation in recent years, one of the foremost drivers of the phase-out decision is that the value of transactions determined by Libor has been steadily decreasing.

While oversight of Libor has increased in recent years including a requirement that submissions by panel banks be based to the greatest extent possible on the actual value of transactions to ensure that it accurately represents market conditions, the Chief Executive of the FCA Andrew Bailey stated in a speech to Bloomberg London earlier this summer that transactional data has been increasingly difficult to realize because “the underlying market that Libor seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active”. Interbank lending among U.S. commercial banks is at its lowest levels since the 1970s.

The phase-out of Libor

Data gathering efforts on actual transaction value are ongoing, however recent data from central banks suggest that eligible term borrowing transactions are becoming few and far between – as a result, the underlying market for Libor has begun to evaporate as panel banks cease submitting their rates. The rationale for the phase out put forward by Mr. Bailey is that if there is not an active market for eligible transactions, how can Libor continue to measure it effectively?

Libor alternatives and moving forward

The alternatives to Libor remain in the balance, but there are several other benchmark rates anchored in arguably more robust markets that could be used after Libor. Perhaps more problematic is what will happen to parties with contracts tied to Libor after 2021. The answer to that question is unclear, but some commentators have suggested that Libor’s administrator and panel banks could continue to generate Libor rates notwithstanding the transition away from it. Others have suggested that contract parties could enter into agreements prior to Libor’s retirement to clarify the rates to be used going forward after the retirement of the benchmark. While it is unclear which approach will be adopted, transition planning for Libor contracts should begin now.

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