AFX: Life after LIBOR: Wonderful World of New Interest Rate Benchmarks

By Dr. Richard L. Sandor

Life after LIBOR.  Fear Not.  Remember that when financial tools are no longer effective is when market participants make their most important choices and biggest decisions.  Now is one of those times. 

The transition from LIBOR introduces unprecedented choice into fixed income markets. From a public policy perspective, the capital markets will benefit from multiple benchmarks, secured and unsecured. In the larger scheme of things, more benchmarks will also offset potential systemic risk.  All capital market participants and the public will benefit from choices.

Already a number of alternative benchmark rates have emerged, including:

• -the Federal Reserve’s SOFR (or Secured Overnight Financing Rate), a secured rate derived from borrowing and lending activity in Treasuries,
• -the British government’s SONIA (Sterling Overnight Interest Average rate),
• -the Japanese TONAR,
• -the Swiss SARON; and
• -U.S. AMERIBOR, a benchmark rate that reflects the actual market-determined cost of borrowing for U.S. financial institutions.

The world after LIBOR will provide many more options to lending institutions than before. It’s not that any of these benchmarks are better than the alternatives, just that they work better in some situations than other benchmarks. And that’s one of the really positive things about the transition away from LIBOR—that it will create multiple alternatives, each with their own distinct features and applications. It will make the lending market more like equities, with its multiple benchmarks from the S&P 500, Dow Jones Industrial Average, NASDQ, to the Russell 2000, EAFE and beyond.

With contracts tied to LIBOR that are valued at hundreds of trillions of dollars, practitioners need to become familiar with which of the alternative new benchmarks out there best conform to their needs. Of particular concern are the trillions in LIBOR-linked loans whose contractual language enables lenders to renegotiate their terms if the base rate changes or disappears.

We are currently six years into the transition process. That means there’s still time for bankers and other financial institutions involved in financial markets to prepare. There is also much work to be done on loan transition documentation. It is critical that financial players start to pay very close attention and start reviewing their documents.

Bankers need to begin re-drafting their commercial and industrial loan documents to replace LIBOR with one or more alternative benchmark reference rates. Currently, many banks have already started to completely move away from LIBOR and are using alternatives like AMERIBOR.

Similarly, derivatives dealers and the International Swap Dealers Association (ISDA) need to alter their master service agreements and short form trade confirmations to replace LIBOR with one or more alternative benchmark reference rates.

One lesson that economics teaches is that it’s better to have a choice. And choice, in this instance, will have tangible benefits.  Because banks can select among multiple benchmarks, they may be able to borrow funds at lower rates or lend at higher rates.  All market participants will benefit from increased transparency, as benchmarks reflect financing activity in real time. The lending markets after LIBOR will be less monolithic, but that will lead to more market efficiency, not less.  

Dr. Richard Sandor is the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School. He is also Chairman and CEO of the American Financial Exchange (AFX), theafex.com, an electronic exchange for direct interbank/financial institution lending and borrowing.