FEATURE
FROM LIBOR TO SONIA By Vasilios Kyriacou
J
une 2012 saw one of the largest financial scams ever, with an MIT professor commenting that ‘it dwarfs by order of magnitude any financial scam in the history of the markets’. This is referring to the LIBOR scandal, which saw a series of fraudulent actions of traders colluding with other divisions in the Bank to report false interest rates on inter-bank loans in an attempt to increase profit. The London Inter-Bank Offered Rate (LIBOR) is the average interest rate calculated through submissions of interest rates of major banks across the world. LIBOR is enormously influential due to its use in the valuations of financial products worth trillion of dollars and as such, manipulation LIBOR will have massive consequences as its used as a benchmark for: mortgages, student loans, financial derivatives and countless other financial instruments.
LIBOR is enormously influential due to its use in the valuations of financial products worth trillion of dollars and as such, manipulation LIBOR will have massive consequences as its used as a benchmark for: mortgages, student loans, financial derivatives and countless other financial instruments. The entire US derivative market is based on LIBOR and an attempt to manipulate LIBOR is an attempt to manipulate the US derivative market. However, this isn’t new as this is thought to have been common since 1991, but the 2012 scandal brought all the inefficiencies and short-comings of the model to light. Since then the Financial Conduct Authority (FCA) and Bank of England (BoE) has looked into alternative risk-free rates (RFR) and as such, starting from the 2nd of March 2020, the BoE will transition from the LIBOR to the Sterling Overnight Index Average (SONIA). The implications of the transition from LIBOR to SONIA will be huge, and marks a shift in the way in which the financial markets operate. Since the financial crash in 2008, more and more regulations have been added on such as the Markets in Financial Instruments Directive (MiFID) in 20
2008 and the revised version brought out in 2018. LIBOR was established in 1986 by the British Banking Association and is defined as ‘the rate at which a Contributor Panel bank could borrow funds and then the accepting inter-bank offer in reasonable market size, prior to 11:00[am] (London time)’. The Contributor Panel (Banks chosen by the BBA) makes a blind submission and a complier (Thomas Reuters) averages the second and third quartiles. LIBOR soon became the fundamental interest rate because of three main characteristics: (a) it was viewed as a measure of the borrowing cost in the inter-bank market, (b) before the 2008 financial crisis it was interpreted as risk free and (c) lastly, it’s a sign of the health for the credit market. As it stands now the current system for calculating LIBOR cannot continue, so question arises – do you reform or replace LIBOR? The UK has decided to replace LIBOR in favour for SONIA, however, this transition won’t be an easy one and will require a great deal of finesse to pull off, especially in wake of the UK’s separation from the EU. This begs the question, did the UK make the right choice? The Wheatly Review, authored by Martin Wheatly the CEO of the FCA, suggests that reform is most advantageous option. The review stipulated that transaction data should be used explicitly to support LIBOR and that market participants should continue to play a major role in the oversight and production. To prevent history repeating itself, the report urged for an increase in oversight and enforcement, with the administration and submission of LIBOR to become regulated under the Financial Services and Market Act 2000. There’s a strong emphasis on sanctions in order to ensure compliance among the banks. The review outlined that three areas that are failing the current LIBOR model and explained the path reform. Firstly, there was an ‘insufficient independence from governance structure’, relying too heavily on participating banks and their own industry organisation. The review postulated that LIBOR should be a market-led benchmark led by a private organisation rather than a public body. Subsequently, this would curb the other two shot-comings, the lack of transparency and inadequacies that comes with the government organisations. There is still a lot of hesitations surrounding the potential of reform as many claimed it would not make a significant difference. A great deal of resources has been put into reforming LIBOR after the 2012 yet there has been no noticeable change and is still riddled with problems.
