July 28, 2017
The U.K. Financial Conduct Authority announced yesterday that LIBOR, the long-time global interest rate benchmark, will be eliminated by 2021. CBRE Research and Capital Markets professionals conclude that although the banking and securities industries have relied on LIBOR for the past 50 years to determine short-term interest rates, its elimination will have little impact on the cost of borrowing.
An objective and broad-based mechanism other than LIBOR for benchmarking short-term interest rates is long overdue. Lending markets are sufficiently liquid and transparent with respect to other short-term instruments, any of which could be the new benchmark used for setting base-rate derivatives, loans or other short-term instruments.
After some period of debate, the market likely will come up with an alternative short-term base rate that will be written into loan contracts and, more importantly, derivatives contracts that determine the swap spread. Consensus should prevail relatively quickly, as this is the base rate for more than $300 trillion of derivatives and the market will not tolerate any uncertainty. Until then, having several alternative benchmarks is possible. For example, the U.S. Alternative Reference Rates Committee has already proposed alternative benchmarks tied to the “risk- free” U.S. Treasury rate.
In the interim, borrowers may incur somewhat higher legal costs as lawyers try to “Y2K-proof” contracts in the unlikely event there is no reasonable alternative to LIBOR by 2021. From a practical standpoint, there is little risk to borrowers in that whatever alterative benchmark is derived, it will be almost identical to LIBOR in mathematically determining the floating rate that borrowers pay.
Regarding derivatives, the key element of the swaps spread isn’t the spot market value of LIBOR today (set by bankers in London every morning). It is the forward LIBOR expectations taking into consideration all known market conditions and more than a little speculation—just like U.S. Treasury securities, which is why the two curves (Treasurys and swaps) are so closely related.
The mechanisms for determining future market credit conditions will not change whether the base rate is LIBOR or another market benchmark tagged to a new risk-free rate like that of U.S. Treasury securities. As such, the elimination of LIBOR will not impact the cost of borrowing.