Invalidity of LIBOR as Interest Rate Preference

By: Ryan Mandela, Savira Ramadhanty, and Izaldi Fikri Muhammad

 

A     Background

There are varieties of interest rate reference being used in banking services and/or facilities, one of which that is commonly used for global scale is the London Interbank Offered Rate (LIBOR)[1] and since the 1960s, LIBOR has also been the world’s main interest rate reference for financial transaction.[2] There are several currencies that underlie the use of LIBOR, which are US Dollar (USD), Euro (EUR), British Pound (GBP), Japanese Yen (JPY) and Swiss Franc (CHF) with the applicable seven tenors below:[3]

  1. Overnight;
  2. One week;
  3. One month;
  4. Two months;
  5. Three months;
  6. Six months; and
  7. Twelve months.

 

LIBOR usually uses floating rate which the amount of interest rate is adjusted within a certain period of time. Overtime, the industry experts have started to look for LIBOR’s alternatives due to the reliability aspects of interest rate’s change in LIBOR.[4] With that reasoning in mind, LIBOR is being phased out over the next few years. Therefore, it is important to understand the discontinuity date of LIBOR, replacement of LIBOR and key differences between LIBOR and its replacement.

 

B      The Cease of LIBOR

On December 31st 2021, the one week and two months USD LIBOR rate and all the seven tenors for EUR, GBP, JPY and CHF LIBOR will cease publication.[5] Additionally, by June 30th 2023, the overnight, one month, three months, six months and twelve months USD LIBOR rate will cease publication.[6]

With LIBOR being slowly driven out of the picture, a new replacement for it is needed, and currently the Risk-free Rate (RFR) is the leading contender to replace LIBOR.[7] RFR is a rate of return on risk-free instruments,[8] RFR provides a strong and credible overnight reference rate which is perfectly suited to a variety of market objectives and needs.[9]

 

C      Replacement of LIBOR

The replacement of LIBOR interest rate reference is based on each of LIBOR’s applicable currency:[10]

CURRENCY

LIBOR

RFR

USD

USD LIBOR

Replaced by Secured Overnight Financing Rate (SOFR)

EUR

EUR LIBOR

Replaced by Euro Short-Term Rate (€STR)

GBP

GBP LIBOR

Replaced by Sterling Overnight Index Average (SONIA)

JPY

JPY LIBOR

Replaced by Tokyo Overnight Average Rate (TONAR)

CHF

CHF LIBOR

Replaced by Swiss Average Rate Overnight (SARON)

Table 1: Replacement of LIBOR for each applicable currency

 

  • Key Differences Between LIBOR and RFR

The following are the key differences between LIBOR and RFR which are worth to note:[11]

DESCRIPTION

LIBOR

RFR

Calculation Reference

Forward looking by referencing to customer facility interest obligation for the few next periods

Backward looking by referencing to customer obligation based on real time day-to-day data and the previous days’ data

Interest Rate Reference

Based on the interest rate movement in the future

Based on the actual interest rate movement according to the market

Tenor Period

From overnight to twelve months

Overnight tenor only

Interest to be Paid

The amount of interest obligation is noticeable in advance

The amount of interest obligation is noticeable in arrears

Table 2: Differences between LIBOR and RFR

 

E      Conclusion

It is clear to say that LIBOR is on its way out and will no longer be used after the time stated on sub-chapter B above, and its replacement, RFR, is being put into place. LIBOR and RFR have their advantages and disadvantages, which we can see from the comparison we have given above, which we hope gives the necessary basic understanding of this topic to the readers.

If you are currently using any banking services and/or facilities that still refer to LIBOR then the discontinuity of LIBOR would definitely impact such banking services and/or facilities. With LIBOR being driven out of the picture, we can only now place our hope that its replacement, RFR, will be the better alternative.

 

[1] https://macroeconomicdashboard.feb.ugm.ac.id/interbank-offered-rate-ibor/

[2]https://www.smh.com.au/business/banking-and-finance/the-financial-world-s-most-important-number-refuses-to-die-20210127-p56x58.html

[3] https://kamus.tokopedia.com/l/libor/

[4] https://www.capitalone.com/commercial/solutions/libor-sofr/

[5] https://www.permatabank.com/id/article/perubahan-suku-bunga-acuan-ibor

[6] https://www.permatabank.com/id/article/perubahan-suku-bunga-acuan-ibor

[7] https://www.permatabank.com/id/article/perubahan-suku-bunga-acuan-ibor

[8] https://money.kompas.com/read/2019/08/07/133000226/mengenal-instrumen-risk-free-rate-di-indonesia?page=all

[9] https://www.bis.org/publ/qtrpdf/r_qt1903e.htm

[10] https://www.permatabank.com/id/article/perubahan-suku-bunga-acuan-ibor

[11] https://www.permatabank.com/id/article/perubahan-suku-bunga-acuan-ibor