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As the Door Shuts on LIBOR, Keep Your Calculation Options Open
Shanin Clark | Sr. Director, Product Management, ACBS, FIS Global
April 02, 2020
The London Interbank Offered Rate (LIBOR) is definitely on its way out and should have left the building entirely by 2022. But as one door shuts, many more are now opening. And for the lending market, that puts a number of different options on the table.
The question is: are you open to the possibilities?
Both the U.S. Federal Reserve and the Bank of England recommend replacing LIBOR or similar interbank offered rates (IBORs) with new interest rate benchmarks such as the Secured Overnight Financing Rate (SOFR) and the Sterling Overnight Index Average (SONIA).
Unlike IBORs, these reference rates are risk free and objective – backed by collateral and based on actual repo trades. However, they can also pose two key problems for lending systems.
First, there’s a timing issue. Some markets, like Switzerland, are publishing their rates in real time, with others sure to follow their lead. But as SOFR and SONIA are published daily, a day in arrears, you’ll never know today’s rate until tomorrow with those benchmarks. So, what rate will you use to accrue interest on a daily basis?
Second, as a lender, you’ll be used to fixing rates for a period of time and applying simple interest calculations. But as the risk-free reference rates will fluctuate from day to day, and they may require you to compound interest accruals – which demands a new kind of calculation.
But as I said, you do have options.
The loan market doesn’t have to follow the central banks’ recommendations; you could, for example, continue to use a simple interest calculation if you prefer. And with SOFR rates the way they are at the moment, not helped by the COVID-19 pandemic, that would give you much the same total over a 30-day period as a compounded interest calculation.
But what if you do choose to take the recommended route? You need to think about how to handle the math – especially if you’re in the syndicated loan market, where you’re sharing interest between lenders.
Sticking with a simple interest calculation makes this easy. When lenders enter a deal in the middle of an interest period, they only need to know how much of the loan is outstanding and what rate it’s accruing at. In their systems, they can usually track the loan and the interest accruals and see exactly what payment to expect from the agent bank at the end of the term, regardless of when they traded in and out.
When you’re compounding interest, things get more complicated, as there are multiple ways to make that calculation. Plus, what if the agent bank wants to prorate interest to lenders in the syndication, based on their ownership percentage on any given day?
The signs are that the syndicated loan market is heading in this direction. The challenge will be to make sure the math aligns for all concerned, as they account for their own positions on a daily basis.
A compounding balance calculation will work well for asset-based lenders, who carry out draws and payments daily, with principals that tend to fluctuate in the middle of an accounting period.
But faced with all these choices, the lending industry has been slow to stand up and declare how it wants to operate in a post-LIBOR world.
Meanwhile, central banks are refining their recommendations. For example, the Federal Reserve is debating the finer points of its proposed Observation Shift calculation model for daily compounding, which aligns accrual calculations with methods used to hedge commercial loan portfolios in derivatives contracts.
Amid all this uncertainty, you need a technology partner who can help you make the best choices for your business. That’s why FIS’ ACBS team is developing our lending systems to support the whole range of options.
We’re already releasing a solution for compounding balances in arrears, and another for simple-interest-with-a-lag calculations. We’re rolling out the rest in phases as the market and its regulators make their final decisions.
As a global technology provider for the whole financial services industry, we can also help prepare your downstream systems for the coming changes and develop interim solutions as you bring those systems up to speed.
Most critically, we’re talking constantly with regulators, lenders and consultants – and playing a proactive role in shaping the industry’s response to LIBOR’s demise.
And that puts our clients in the strongest possible position to stay ahead of the game while keeping their options open.