Advertisement

Ten ways the imminent cancellation of LIBOR could impact wealthy families

The shift from the London benchmark to alternative reference rates could most affect the sophisticated financial instruments in many HNW portfolios

Article content

LIBOR, the abbreviation for London Interbank Offered Rate, has been the most widely used benchmark for determining interest rates on financial instruments around the world over the past half a century. But regulators will soon kill it off – and high-net-worth investors (HNWIs) are most in line to feel the fallout.

Advertisement

Story continues below

Article content

LIBOR is the average lending rate that global banks charge each other on interbank loans in five currencies across seven maturities that range from overnight to a year. These rates guide flexible rates on trillions of dollars worth of bonds, mortgages, collateralized loan obligations, interest-rate swaps, and many other financial instruments.

A simple example is a floating-rate bond that pays annual interest at LIBOR plus 2 per cent. Another example is an interest-rate swap contract, where the fixed rate on one bond and the floating rate on another bond are exchanged between investors.

More On This Topic

  1. The classic merger arbitrage situation occurs when a company receives a takeover offer and its shares trade at a discount, or spread, to the offer price while waiting for approvals from shareholders and regulators.

    Consider merger arbitrage for high risk-adjusted returns for portfolios

  2. Six things to consider when leveraging business credit for increasing wealth

LIBOR rates are compiled by collecting quotes from participating banks. However, it was discovered that the banks were manipulating the quotes. This was proven in 2012 with the help of a whistleblower – who was awarded US$200 million (in the United States, informants are entitled to 10 per cent to 30 per cent of the fines levied).

The scandal ultimately led British regulator Financial Conduct Authority (FCA), in March this year to ban the publication of most LIBOR rates after 2021. The exceptions are the heavily used U.S. LIBORs (terms other than 1 week and 2 months), which cease publication after June 30, 2023.

In the United States, the Federal Reserve Bank of New York publishes a proposed replacement rate called the Secured Overnight Financing Rate (SOFR). It is derived from the U.S. repurchase (repo) market, where U.S. Treasuries are sold and repurchased the next day.

Advertisement

Story continues below

Article content

In effect, the repos are collateralized loans with an overnight term. This makes SOFR a virtually risk-free interest rate. Moreover, trading in the market is about 1,500 times that of interbank loans and is based on observable transactions, making SOFR a better gauge of market rates and harder to manipulate.

In Britain, SONIA (Sterling Overnight Average Rate) is the replacement rate. It is €STR (Euro Short Term Rate) in the Euro zone, SARON (Swiss Average Overnight Rate) in Switzerland, and TONA (Tokyo Overnight Average Rate) in Japan.

The FCA further announced in November that synthetic LIBORs (an adjusted form of the LIBOR rate) will be published. They can be temporarily used for the sterling- and yen-denominated instruments issued before 2022 (legacy contracts) that cannot be switched in time to new reference rates.

The shift from LIBOR to alternative reference rates comes with costs and risks. HNWIs could be particularly affected since their wealth tends to be held more in sophisticated financial instruments, where returns are more often tied to a reference rate.

“Updating legacy contracts can prove a complicated process, raising the risk of a chaotic transition that has been likened to Y2K,” noted William Shaw, Bloomberg’s LIBOR expert. “Asset managers face a … risk of fines, litigation and reputational damage if they poorly manage the transition,” he adds.

Concerns raised include:

1. Millions of legacy contracts are being searched to update fallback clauses for replacing LIBOR. Working on this Herculean task are teams of lawyers and automated processes with artificial intelligence. But given the vastness and complexities involved, errors in amendments are still a risk.

Advertisement

Story continues below

Article content

2. LIBOR exposure can be deeply embedded in many portfolio positions and could be overlooked in some cases. “To stand a chance of controlling your destiny, you need to know what your exposures are,” said Bank of England executive director Andrew Hauser in a recent speech.

3. LIBOR is based on unsecured loans while alternatives like SOFR are based on secured loans. Thus, returns linked to many alternative reference rates are not that sensitive to credit risk and they will not rise as much during unsettled times – like LIBOR did during the Great Financial Crisis of 2008.

4. SOFR and other alternatives trade only on an overnight maturity. If such a maturity is used to set a variable interest rate on longer maturities, borrowers and investors will be less able to predict the payments, and the assigned rates won’t reflect expectations of rate changes.

5. Regulators have simulated a term structure for SOFR out to a year, by boosting SOFR with term premiums extrapolated from historical data, and by using SOFR futures. This may be more useful, but it is an approximation – so estimation error could be a factor.

6. Many countries have developed their own replacement rates, with methodological differences. For example, unlike SOFR, Japan’s TONA is an unsecured rate. This lower level of uniformity across nations could give rise to new discrepancies in reference rates globally.

7. The change from LIBOR to another rate could trigger a taxable event, says U.S. law firm Duane Morris LLP. “If modifying the interest rate index is considered a significant modification to a loan agreement or note, it could be a major headache,” they caution.

Advertisement

Story continues below

Article content

8. The move away from LIBOR could affect the returns on some investment funds. For example, First Trust Advisors L.P. says the “effects of the transition can be difficult to ascertain … and they could result in losses to [its Senior Floating Rate Income Funds].”

9. Whereas the switch away from LIBOR is going well for assets like bonds, areas like loans are more challenging. This market has a much wider range of participants – and is largely private, thus more opaque. Smaller participants may not even be aware that LIBOR is on the way out.

10. Some financial instruments, such as derivatives, have become quite complex and are exceedingly difficult to switch over to new rates. While linear derivatives like interest-rate swaps are amendable, non-linear derivatives like swaptions (options on swaps), are less so.

Larry MacDonald is a retired economist who blogs at Investing Journey.

Get the latest stories from Canadian Family Offices in our weekly newsletter. Sign up here.

Latest National Stories

Advertisement

Story continues below

News Near #city#