LIBOR Transition to Alternative Reference Rate (ARR)
Here below I will provide a quick introduction on LIBOR transition as a lot of people reached out to me over LinkedIn asking for the same.
What is LIBOR Transition and how does it impact financial institutions?
LIBOR interest rate such as LIBOR USD, GBP, JPY, etc... has been the backbone for interest rates markets (derivative or cash products) for almost 5 decades. These rates come in 7 different tenors (Overnight to 1 year) known as term structure of interest rates. However, in early 2000 a consortium of financial institutions manipulated the LIBOR interest rate to profit out of their clients in an unfair way which forced regulators to reform the LIBOR interest rate.
What were the weaknesses in the LIBOR interest rate?
This rate does not need to be supported by financial transactions which means the participating banks in London can put any rate they desire for the day and that rate would become a global benchmark reference rate. This led to abusive practice by the bank where they could provide any rate to benefit them under "Expert Judgment" and market participants would accept such reference rate without further disputes.
What is the way forward?
Regulators across the globe have taken an aggressive stand and made the following reforms-
- LIBOR rates are to be discontinued by Dec 2021 with the exception to LIBOR USD for some of the maturity tenors. LIBOR USD to be discontinued completely by June 2023
- Each LIBOR rate is to be replaced by an alternative reference rate (ARR)
- Each regulator has taken the responsibility of publishing such rates and hence the administrations of such rates has been taken away from British Bankers Association
- Alternative Reference rates are nearly risk free and offered in overnight tenor only
- These rates are backed by official transactions that take place during the operating hours for the day
- LIBOR USD - SOFR
- LIBOR GBP - SONIA
- LIBOR EURO - ESTR
- LIBOR CHF - SARON
- LIBOR JPY - TONAR
