Moving Away from Libor: A Quick Guide for the Puzzled
Maybe you heard the old saying about fish and water: fish do not notice water, because it is always there, and they only miss it when it is gone. Much the same can be said for the Libor reference rate, and the efforts many of us are making to move away from it.
If you have a variable rate mortgage or have signed a corporate or consumer loan, you may be familiar with Libor, a market benchmark used for many, perhaps most, financial contracts that require a variable rate. Libor is, fundamentally, a flawed compromise that has outlived its usefulness, and will be phased out by mid-2023.
A variable rate essentially depends on market conditions. If market participants – banks, investment funds, pension funds – perceive that the global economy is on a sound footing, and everyone is repaying debt on time, then the cost of debt is lower: so, interest rates are low. And, if there’s turmoil in markets from economic uncertainty, interest rates go up. But how high? Libor was created in London, in the 1970s, as a universal proxy for the cost of debt.
Imagine a man in an office in London; every morning, this man would call a number of commercial banks in London and would ask them about the rates at which they lent money to each other, at various terms (3 months, 6 months, 1 year…). He then would calculate the average of those rates and notify the Bank of England, which would publish the rate at midday, London time. This may sound like a joke but, trust me, that is literally the way Libor was calculated and published.
The system served its purpose for quite a while, but it was also open to abuse and manipulation. This became evident a decade ago when several people went to jail for manipulating Libor. In recent years, financial authorities across the globe have been looking at ways to move away from Libor, and multiple solutions have been proposed.
In many developed economies, the Secured Overnight Financing Rate (SOFR, based on repo transactions conducted by the U.S. Treasury, rather than estimates) is slowly replacing Libor. Albeit not perfect, it is a good alternative. Like many other financial and multilateral development institutions, IDB Invest will also replace Libor with SOFR but, boy, is it a complicated task.
Currently, the plan is for IDB Invest to stop signing new Libor loans by January 2022, and by June 2023 all existing Libor contracts will have been moved to SOFR-referenced rates. This is easier said than done. We are talking about thousands of contracts of multiple types across counterparties, that must be renegotiated and modified.
Our work is roughly divided into four workstreams: one of those refers to the existing Libor book, largely focused on the legal part of changing the documents; the second one focused on how SOFR will be implemented for new loans, and whether Term SOFR rates (forward rates, like the 3-month, 6-month, etc. Libor equivalents) will be available in time, so that daily compounding of rates would not be required; the third is technology, getting our systems ready for the change; and the fourth one is financial and risk management, heavily focused on managing IDB Invest’s balance sheet and income statement in a way consistent with our risk appetite and other policies and principles.
We are not alone in facing these issues. Many other actors in the financial markets face the same challenges. The good news is that, in terms of technology, we are almost there. It took plenty of hard work, testing, meetings, and coordination, and it is still on-going, however, we have already obtained key system functionality for SOFR-linked loans.
One remaining important consideration is our clients. In Latin America and the Caribbean, we have various types of counterparties, from small start-ups to commercial banks or financial cooperatives to large international firms. Some will be ready for the change, and can even teach us a trick or two, while others are only now beginning to ask questions. To some extent, everyone will remain puzzled as the market continues developing. The best we all can do is to watch the market closely and try to be as ready as possible. As it may become necessary to readjust the course along the journey, being operationally ready for more than one alternative helps.
We are now in the process of collecting feedback from our clients to better understand their preferences and preparedness for the change. It is going to be a bit complicated for a while, but I am sure we will all be better off with SOFR in the long run.
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