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Legal Aspects of International Finance > LIBOR > Flashcards

LIBOR Flashcards

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1
Q

What is LIBOR?

A

The market cost of money, as represented by the average interest rate for unsecured interbank lending.

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2
Q

Who is LIBOR Calculated By and For?

A

Thomson Reuters, for the ICE Benchmark Administration.

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3
Q

As of 2018, How is LIBOR Calculated?

A

Using the Waterfall Methodology, which is a, “standardized, transaction-based, data-driven, layered method.”

Investopedia.

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4
Q

Prior to the data-driven 2018 approach, what were prime banks asked to determine LIBOR?

A

“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?”

Houe & Skeie | LIBOR – Origins, Economics, Crisis, Scandal, and Reform [2]

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5
Q

What is Problematic about the way in which LIBOR was Surveyed?

A

The, “[k]ey phrases… pertaining to timing and size are highly subjective and open to interpretation.”

Houe & Skeie | LIBOR – Origins, Economics, Crisis, Scandal, and Reform [2]

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6
Q

What is the ICE LIBOR Panel?

A

The group of globally-influencial banks which comprise the LIBOR survey sample.

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7
Q

Why was LIBOR Important?

A

If functioned as both a financial/economic benchmark and as a reference interest rate.

Houe & Skeie | LIBOR – Origins, Economics, Crisis, Scandal, and Reform [3]

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8
Q

How is LIBOR’s Reference Function both Practical and Impractical?

A

Due to its incorporation of external risk premia, LIBOR can either help firms who are exposed to such risk or hinder those who are not.

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9
Q

Why is LIBOR Authoritative?

A

By representing the rate at which the, “most financially sound institutions are able to obtain funding on a short-term basis,” LIBOR embodies the lower bound for lending terms.

Houe & Skeie | LIBOR – Origins, Economics, Crisis, Scandal, and Reform [3]

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10
Q

What are the Inherent Problems with LIBOR? (SMIG)

A
  1. Suppositional Nature (prior to 2018).
  2. Moral Hazardousness (prior to 2018).
  3. Interbank Market Illiquidity during Crises.
  4. General Interbank Market Illiquidity.
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11
Q

How is LIBOR Suppositional in Nature?

A

Because of the methodology’s subjective framing, the figure produced tends not to accurately reflect real-world lending practices.

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12
Q

How is LIBOR Morally Hazardous?

A

Because the rate depended on and applied to Panel Banks, they had an incentive to underreport funding costs and thereby cheapen their cost of capital and present financial soundness.

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13
Q

Why is LIBOR Weak during Crises?

A

The interbank market dries up almost completely in crises, making LIBOR highly inaccurate and manipulable during such times.

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14
Q

What has Interbank Unsecured Lending fell in Popularity? (RARS)

A
  1. Onerous Regulatory Requirements, e.g. Basel III’s LCR.
  2. Availability of Alternative Credit.
  3. Growth of Repo Markets.
  4. Securitization’s rise in popularity.
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15
Q

What are the Main Alternatives to LIBOR?

A
  1. Overnight Index Rates (OIRs).
  2. Overnight Index Swaps Rates (OISs).
  3. Repo Rates (RRs).
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16
Q

What is an Overnight Index Rate?

A

A weighted average of overnight unsecured lending rates.

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17
Q

What is the main Advantage and Disadvantage of an Overnight Index Rate (OIR)?

A

It’s overnight purview and extremely short timeframe makes it both very resilient but unextrapolatable over longer maturities.

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18
Q

What is an Overnight Interest Swap Rate?

A

A fixed interest rate swap based on a compounded OIR.

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19
Q

What is the main Advantage and Disadvantage of an OIS?

A

It’s fixed nature allows for extrapolation over longer maturities, but it is only reflects interest rate exposure.

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20
Q

What is a Repo Rate?

A

A weighted average of, “the extent to which the repurchase price of [an] underlying reference security is greater than [its] original sales price.”

21
Q

What is the Main Advantage and Disadvantage of an RR?

A

It caters to an increasingly popular form of interbank lending, but is irreflective of credit exposure and inapplicable to long maturity curves.

22
Q

What are the Primary Concerns regarding LIBOR Alternatives? (AMUSE)

A
  1. Lack of widespread Market Acceptance.
  2. Market dependency on LIBOR.
  3. Unproven performance during crisis times.
  4. Lack of Standardization.
  5. Exculsion of term, credit, and liquidity risk.
23
Q

Why would a Synthetic LIBOR be undesirable?

A

Because there are already, “too few transactions to support a benchmark as robust as [the FCA] would like it to be.”

FCA | Interest Rate Benchmark Reform – Transition to a World without LIBOR [5]

24
Q

For Syndicated Lending in particular, why would a transition Away from LIBOR prove immensly difficult?

A

Because of the bespoke nature of each individual loan and their documentary and administrative obligations.

25
Q

For the Corporate World, what is the Greatest Risk of a LIBOR Transition?

A

A severely hamstrung ability to raise corporate debt finance in the short-to-medium-term.

26
Q

What underlies the Corporate World’s great post-LIBOR risk?

A

The absence of a suitable forward-looking term structure, i.e. an accurate and widely-dependable maturity curve, which also integrates ancilliary risk premia.

27
Q

What is the Sterling Overnight Interbank Average Rate (SONIA)?

A

The risk-free overnight index rate that will eventually replace LIBOR in the UK.

28
Q

How is SONIA calculated?

A

Based on real-world transaction data, it is the trimmed mean of, “the average [interest rate] that banks pay to borrow sterling overnight from other financial institutions.”

McKee & Millar | The Implications of Moving to SONIA [224]

29
Q

What is SONIA’s primary function?

A

To provide a reference interest rate for financial instruments and transactions.

McKee & Millar | The Implications of Moving to SONIA [223]

30
Q

In McKee and Miller’s opinion, what are the characteristics of the ideal Reference Rate?

A
  1. Provides a, “robust, reliable, unbiased and accurate representation,” of interest rates in capital markets.
  2. Provides a benchmark interest rate for extraneous money market transactions, e.g. mortgages or derivatives.
  3. Provides a, “benchmark for term lending and funding.”

McKee & Millar | The Implications of Moving to SONIA [223-224]

31
Q

What is the fatal flaw that SONIA does not share with LIBOR?

A

A, “lack of an underlying market,” which renders the benchmark, “too fragile… to support a sustainable business model.”

McKee & Millar | The Implications of Moving to SONIA [226]

32
Q

LIBOR is forward-looking, while SONIA is backward-looking. What does this mean?

A

LIBOR can be extrapolated to non-overnight tenors, while SONIA cannot.

33
Q

Why is SONIA’s backward-looking character impractical?

A

The payable rate of interest for any given transaction, “cannot be confirmed until the final day of the interest period.” In other words, SONIA virtually cannot apply to maturities longer than a day.

McKee & Millar | The Implications of Moving to SONIA [227]

34
Q

SONIA is a risk-free rate. Why would banks find this undesirable?

A

Risk-free rates do not incorporate important risk premia, e.g. credit or market risk, into their calculations, making them less useful to such lenders.

McKee & Millar | The Implications of Moving to SONIA [227]

35
Q

How does the the Working Group on Sterling Risk-Free Reference Rates recommend orienting SONIA forwards?

A

Through the use of a Compounding-in-Arrears methodology.

36
Q

What is the Compounding-in-Arrears Methodology?

A

A means of extrapolating an overnight interest rate by compounding it over the duration of a given tenor to arrive at an aggregated rate, which is then applied to the prinicipal.

37
Q

Why is Compounding superior to Simple Averaging? (TV-ER)

A
  1. Better reflects the Time Value of money.
  2. More Established as a market practice.
  3. Reduces Risk of liquidity fragmentation.

The Working Group on Sterling Risk-Free Reference Rates | Discussion Paper: Conventions for Referencing SONIA in New Contracts [8]

38
Q

What is the Non-Cummultative Compounded Rate (NCCR) of Interest?

A

For any given day, it is, “the cumulative compounded rate for the prior day subtracted from the cumulative compounded rate for that given day.”

The Working Group on Sterling Risk-Free Reference Rates | Recommendations for SONIA Loan Market Conventions [3]

39
Q

Does interest compound on weekends or holidays?

A

On such days, the rate is held constant from the last working day.

40
Q

What is a Lookback?

A

An offsetting of the interest rate period a given number of business days, i.e. lag, before the interest payment date, so as to afford borrowers time to organize their finances.

41
Q

What is the Benefit of a Lookback?

A

It affords borrowers, “payment certainty,” as well as time to organize their finances.

The Working Group on Sterling Risk-Free Reference Rates | Recommendations for SONIA Loan Market Conventions [3]

42
Q

What is an Observation Shift?

A

The weighting of the, “applicable rate… according to the number of days to which that rate applies in the relevant observation period rather than in the interest period.”

Norton Rose Fulbright

43
Q

Why does the Working Group recommend a Lookback without an Observation Shift?

A

Because it places a greater emphasis on the importance of interest periods, creating greater regularity in the market.

44
Q

What is the Working Group’s recommendation regarding SONIA and the treatment of Margin?

A

That margin be added independently, “after rate compounding.”

The Working Group on Sterling Risk-Free Reference Rates | Recommendations for SONIA Loan Market Conventions [4]

45
Q

Technically speaking, why is excluding Margin from the Compounding calculation advantageous? (BMIC)

A
  1. Enables better Benchmarking and comparison of transactions.
  2. May Misalign risk hedges and their underlying products.
  3. May be Incompatible with a screen rate format.
  4. Decreases the Complexity of the interest payment calculation.

The Working Group on Sterling Risk-Free Reference Rates | Discussion Paper: Conventions for Referencing SONIA in New Contracts [10]

46
Q

Regarding the practice of Prepayment, what does the Working Group recommend and why?

A

That interest be paid alongside principal, so that, “the accuracy of compounded calculations,” be maintained and operational compexities be avoided.

The Working Group on Sterling Risk-Free Reference Rates | Recommendations for SONIA Loan Market Conventions [4]

47
Q

According to the Working Group, how should Interest be distributed between lenders in a Syndicated Loan?

A

Proportionate to the share of the principal owned by the given lenders at the end of a given interest period.

The Working Group on Sterling Risk-Free Reference Rates | Recommendations for SONIA Loan Market Conventions [5]

48
Q

What is the Working Group’s recommendation regarding Secondary Market Transactions?

A

For the seller to pay the buyer, “the all-in rate i.e. SONIA Compounded in arrears plus Margin.”

The Working Group on Sterling Risk-Free Reference Rates | Recommendations for SONIA Loan Market Conventions [5]

Legal Aspects of International Finance (10 decks)

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