July 28, 2017

The London Interbank Offered Rate, more commonly referred to as LIBOR, is on its way out the door.  Many associate LIBOR with scandals including manipulation and false reporting.  To others, it represents the index to which over $350 trillion of financial products reference.  Technically, LIBOR is the average lending rate of banks in the London interbank market.  However, fraud and collusion have led to the loss of reliability and ultimately the demise of the popular index.

The UK Financial Conduct Authority (FCA) announced yesterday it plans to phase out this 50-year old benchmark by the end of 2021.  The FCA’s head, Andrew Bailey, believes there is no longer a market to support LIBOR.  Moreover, he believes establishing a firm schedule will aid financial institutions to manage transition.  This is part of a global reform of benchmark rates by the FCA.

So what is the impact of the FCA’s decision?  And more importantly, how will it affect your investment portfolio?  Currently, the main impact is the uncertainty this has inserted into the market.  Since no rate has been defined as a specific replacement, financial institutions and investors are left in the dark as to what will occur.  Clearly, new investments introduced to the market will no longer reference LIBOR.  However, it is widely uncertain as to what will happen with the existing products and securities that currently associate with LIBOR.  In the short term, expect increased volatility and even illiquidity in these types of products until the market has clearer direction as to what might be replacing the benchmark index.  With regard to these products, Bailey said it depends on “preparations that users of LIBOR make in either switching contracts from the current basis for LIBOR, or in ensuring that their contracts have robust fallbacks in place that allow for a smooth transition.”

Depending upon your appetite for risk, this uncertainty could create motive to take advantage of uncertainty and capitalize on mispriced products.  Alternatively, it might necessitate avoiding any new purchase of LIBOR-linked investment products until the seas have calmed.