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1 1 (September 20, 2019)

handle is hein.crs/govbbda0001 and id is 1 raw text is: September 20, 2019 The LIBOR Transition LIBOR is a key benchmark interest rate underpinning many financial contracts; this rate, however, might disappear as soon as 2021. This In Focus discusses efforts to transition away from the use of LIBOR in financial products in order to avoid disruption if LIBOR disappears. LIBOR What Is LIBOR? LIBOR refers to the London Interbank Offering Rate. It measures the interest rate at which banks can borrow unsecured for various lengths of time (tenors) in U.S. dollars and four other currencies, thus, at any point in time, there are several LIBOR rates. LIBOR dates back to the 1960s and has been published daily since 1986. It is privately determined by polling more than a dozen large global banks in London about their borrowing costs. How Is It Used? LIBOR is a benchmark or reference rate that helps financial market participants gauge prevailing interest rates. In the United States, many financial instruments are tied to dollar LIBORs, including certain floating-rate loans, bonds, securitized products, and financial derivatives. For example, an adjustable mortgage rate might be set at LIBOR plus a fixed markup. Each month, the rate on the mortgage would be reset based on the prevailing LIBOR. A type of derivative called an interest rate swap might also reference LIBOR. One party to the swap would receive a periodic payment based on a predetermined fixed interest rate, while the other party would receive a payment based on a rate that adjusts based on the current LIBOR. As of 2016, LIBOR was referenced in an estimated $199 trillion of these financial products. What Was the LIBOR Scandal? In 2012, the British- based bank Barclays was fined by its British regulator and settled with the U.S. Justice Department, Commodity Futures Trading Commission (CFTC), and a group of states for manipulating LIBOR. Barclays was one of the banks that was polled to determine LIBOR. From 2005 to 2008, employees at Barclays submitted LIBOR data that did not accurately reflect Barclays' borrowing costs. They did so for two reasons: (1) to profit from Barclays' swaps trading based on LIBOR and (2) to mask weakness in Barclays' financial condition during the financial crisis. Subsequently, several other banks reached settlements with regulators for manipulating LIBOR and operating a derivatives cartel that involved sharing information on, among other things, LIBOR submissions. Private parties have also sued submitting banks over LIBOR manipulation. An inherent weakness of LIBOR that made it potentially susceptible to manipulation is that on any given day there may be little or no actual borrowing by banks at the various tenors that are reported. In that case, polled banks submitted their best estimate of what their borrowing costs would be if they wished to borrow, giving banks some discretion in what rates they reported. This problem grew following the financial crisis because banks borrowed less as a result of the large increase in bank reserves. How Was It Reformed? The LIBOR scandal revealed that a rate determining the value of financial products worth trillions of dollars could be manipulated by employees at a handful of banks. Policymakers initiated several reforms in response to the scandal. First, publication of the rate was transferred from the British Bankers Association and made more transparent. Second, production of the rate became regulated by the British financial regulator. Third, calculation of the rate was modified to increase the weight on actual data and reduce the weight on best guesses in the absence of borrowing. Fourth, policymakers have encouraged a transition away from the use of LIBOR. What Problems Remain? Borrowing by banks remains insufficient to determine LIBOR using actual data alone for all but the most popular currencies and tenors. Participation in the LIBOR sample is voluntary and confers limited benefit, and participants are leery of potential further legal exposure. As a result, British regulators have guaranteed LIBOR will exist until 2021, but not beyond then. The LIBOR Transition Given LIBOR's shortcomings and its potential to disappear after 2021, policymakers and market participants are actively encouraging financial instruments transition from LIBOR to alternative benchmarks. It is unclear, however, whether sufficient progress has been made to avoid disruption were LIBOR to disappear in 2021. What Risks Does the LIBOR Transition Pose? If LIBOR ceased to exist, it could pose a threat to financial stability as long as it continues to be referenced in trillions of dollars in financial instruments (see Table 1). The problem can be divided into financial instruments referencing LIBOR that already exist and those that will be created in the future. Existing instruments that will be outstanding past 2021 (or whenever LIBOR potentially disappears) need to be renegotiated to state what will happen if LIBOR disappears. Replacing LIBOR with another reference rate is one possible option (multiple candidates exist), but requires complex adjustments because no other rate exactly matches LIBOR over time. If the adjustment is done incorrectly, one party to the contract will benefit at the other's expense, because the interest rate will be higher or lower than it would have been. For financial instruments entered into in the future, the LIBOR problem could be avoided by using a different https://crsreports.cong

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