As LIBOR fades away, alternative rates get a closer look

The London Interbank Offered Rate, or LIBOR, will die on Jan. 1, 2022 — sort…

The London Interbank Offered Rate, or LIBOR, will die on Jan. 1, 2022 — sort of.

The 36-year-old British invention served as the world’s benchmark for short-term interest rates, helping banks from Japan to the United States price contracts for all types of financial products.

But its legacy was marred by rigging scandals, in which major international banks fiddled with rates to sneak extra profits or hide default risks.

As a result, regulators around the world have made a multi-year effort to turn away from LIBOR. A major milestone is New Year’s Day 2022, when 1-week and 2-month LIBOR will no longer be published.

LIBOR will still live on through June 30, 2023, when other LIBOR tenors (overnight, 1-month, 3-month, 6-month, and 12-month) will also be phased out.

So what other rates are banks and financial firms using?

In the United States, a group of private participants including the Federal Reserve Board and the New York Fed (called the Alternative Reference Rates Committee) have encouraged the use of the Secured Overnight Financing Rate (SOFR).

SOFR is a broad measure of how much banks are paying each other to borrow cash overnight, when “secured” by U.S. Treasury securities as collateral.

Other alternatives exist that attempt to index unsecured rates: American Financial Exchange (AFX) offers AMERIBOR, Bloomberg has its Short-Term Bank Yield Index, and Intercontinental Exchange (ICE) is working on a Bank Yield Index.

AFX founder and CEO Richard Sandor told Yahoo Finance he expects the industry-wide transition to happen without any hiccups. But he noted that there’s still a lot of progress to be made.

“Do you think that the two months before the Volstead Act prohibition began, people stopped drinking two months before it became illegal?” Sandor said. “It’s not a surprise to me the behavior of human beings is that they approach a drop dead date and they do drop dead — on the date.”

‘No general motivation’

In the derivatives market, the transition looks to be going smoothly. The New York Fed in October estimated that about 80% or more of interdealer linear swaps risk are already linked to SOFR.

But loan markets appear slower to move, in part because lenders prefer benchmark rates that are more flexible around credit risks associated with the borrower.

For the large market of collateralized loan obligations (CLOs) and leveraged loans, this means pushback against the immediate transition away from LIBOR.

One example: investment company Eagle Point Credit, which specializes in CLOs. The company said that all of its CLOs are denominated in LIBOR, with a small number of loans issued tied to SOFR.

“Most loans in the market are still LIBOR-based, and there’s no general motivation for a company to switch to SOFR until such time as they want to refinance or reissue new debt,” Eagle Point Credit Company CEO Thomas Majewski told investors on Nov. 16.

Among regional and community banks, AMERIBOR has gained traction as an alternative because it is an unsecured rate that allows for a credit spread component.

Banks like ServisFirst, Brookline, and Frost have already started issuing AMERIBOR-linked loans.

In the end, Sandor says the post-LIBOR world will not be one ruled by a single rate but by a menu of choices.

“While some people think AMERIBOR is good, other people think that SOFR is good, they’re not at odds with each other,” Sandor said. “They’re saying, ‘I think I’ll take chicken instead of turkey.’”

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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https://finance.yahoo.com/news/as-libor-fades-away-alternative-rates-get-a-closer-look-110600413.html