Understanding the LIBOR Transition and its Impact on Accounting
The London Interbank Offer Rate or more commonly known as LIBOR is due to cease by the end of 2021. As we go through another phase of change, it’s imperative that you get a comprehensive understanding of the upcoming LIBOR transition.
What is LIBOR?
LIBOR is an international standard that financial institutions use as a benchmark interest rate based on the borrowing costs between banks. This is often referenced in financial contracts like loans, and non-financial contracts such as leasing contracts.
LIBOR has been around for more than 4 decades, which has evidently been a helpful resource for financial markets all over the world by serving as a basis for different types of debts, a variety of mortgages, securities, bonds, adjustable-rate loans, and the likes. Forbes reported a value of $1.2 trillion in residential mortgage loans and $1.3 trillion in consumer loans grounded on LIBOR principles in 2019.
Why is LIBOR being replaced?
However, due to surrounding scandals and challenges, the standard has been questioned by regulatory bodies. There are existing qualms about its validity as a benchmark, clouded by financial crises and vulnerability, hence leading to the phasing out of LIBOR as 2021 ends.
Going way back from 2017, there had already been calls to halt banks in submitting rates to compute for LIBOR as it is seen as susceptible to manipulation. There are grand-scale controversies involving the rigging of the [LIBOR] rates through the collusion of major banks, who then faced regulatory scrutiny. But in 2019, Britain’s Serious Fraud Office (SFO) ended its investigation [which started in 2012] about the LIBOR manipulation, saying that no further charges are to be filed.
In addition, the UK’s Financial Conduct Authority (FCA) found out that LIBOR is non-compliant to the globally accepted principles for the benchmark rates. Fast forward to 2017, the FCA announced that it will no longer require banks to provide quotes for most LIBOR rates after 2021.
What’s next for the transition?
As we move along the year, there are preparations for the impending cessation of LIBOR such as the corporate uptake of new reference rates, though it is limited, and its replacement with more robust and up-to-date pricing schemes.
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The Working Group on Sterling Risk-Free Reference Rates (RFR) is responsible for overseeing the developments and finding an alternative to replace LIBOR. And in 2017, they endorsed the transition to the Sterling Overnight Index Average (SONIA).
LIBOR to SONIA transition
SONIA is less vulnerable compared to LIBOR as it is based on actual overnight rates where interest is paid on Sterling short-term wholesale funds— meaning credit, liquidity, and other risks are minimal.
The Sterling RFR Working Group prefers SONIA because:
- It has a more dynamic framework to stand and adapt to the changes of its underlying markets,
- Its foresight about Bank Rates is almost accurate, and
- It is already used in liquid Sterling Overnight Indexed Swap (OIS), thus making the transition easier.
As published by the Sterling RFR’s Working Group, the LIBOR transition timeline and development for 2021 is (included but not limited to what is shown) as follows:
- Quarter 1
- Cease initiation of new GBP LIBOR-linked loans, bonds, securities, and derivatives that expire after 2021.
- Complete identification of all legacy GBP-LIBOR contracts expiring after 2021 that can be converted, and progress active conversion to completion by the end of the 3rd quarter of 2021.
- Make a move to shift from GBP LIBOR to SONIA in non-linear derivative markets.
- Quarter 2 to Quarter 3
- Cease initiation of new GBP LIBOR non-linear derivatives that expire after the end of 2021,
- Cease initiation of new GBP LIBOR-linked exchange-traded futures and options that expire after the end of 2021,
- Cease initiation of cross-currency derivatives with a LIBOR-linked sterling leg, expiring after 2021, and
- Complete active conversion where viable.
- Quarter 4
- Make sure to be fully prepared for the end of GBP LIBOR.
If you need more references for the LIBOR to SONIA transition, you can visit the Bank of England’s page for more resources.
Is your firm ready for the transition?
Aside from Brexit and the pandemic, this transition spells a huge difference to the financial economy of the UK as well. The decades-old method will be shifting, and that parallels an act of change in your end when it comes to the preparation of your financial contracts, and updates in terms of mortgages, loans, and debts.
If the migration is not done well, you risk your organisation to a massive shock that can result in inconsistent financial records. Most banks are still in the process of transition and are still wading through the issue. Needless to say, this can be a complex transition for firms like you, especially that it entails quite a handful of changes.
Let D&V Philippines help you stay on top of these tax and accounting changes. As we course through financial updates, it’s important to have a team who can take care of your compliance with the law and that’s where we come in. Leave the F&A work to us while you focus on what you do best.
Grab your copy of our whitepaper D&V Philippines’ Premium Solutions for UK Accounting Firms to know how we can assist your finance and accounting back-office better, or contact us today to have a consultation with our experts.