LIBOR: What is the London Interbank Offered Rate, how is it used? (2023)

What is the London Interbank Offer Rate (LIBOR)?

The London Interbank Offered Rate (LIBOR) is areferenceInterest rate at which major global banks lend to each other on the international interbank market for short-term loans.

LIBOR, which stands for London Interbank Offered Rate, serves as a globally accepted benchmark rate that reflects the cost of borrowing between banks. The rate is calculated and will continue to be published daily by theIntercontinental Exchange(ICE), but due to recent scandals and questions about its validity as a reference rate, it is being phased out.

In line with the Federal Reserve and UK regulators, LIBOR will be phased out by June 30, 2023 and will be replaced byGuaranteed overnight funding rate(SFR). As part of this phase-out, the one-week and two-month USD LIBOR rates will no longer be published effective December 31, 2021.

The central theses

  • LIBOR is the benchmark interest rate at which major global banks lend to each other.
  • LIBOR is managed by the Intercontinental Exchange, which asks major global banks how much they would charge other banks for short-term loans.
  • The fee is calculated using the waterfall method, a standardized, transaction-based, data-driven multi-level method.
  • LIBOR has been the subject of manipulation, scandal and methodological criticism, making it less credible as a benchmark interest rate today.
  • LIBOR will be replaced by the Secured Overnight Financing Rate (SOFR) on June 30, 2023, which will be phased out after 2021.

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London Interbank Offer Rate (LIBOR)

Understand LIBOR

LIBOR is the average interest rate at which major global banks lend money to each other. It is based on five currencies including the US dollarEuro, British Pound, Japanese Yen and Swiss Franc and covers seven different maturities – overnight/spot next, one week and one, two, three, six and 12 months.

The combination of five currencies and seven maturities results in a total of 35 different LIBOR rates that are calculated and reported every business day. The most commonly quoted rate is the three-month US dollar rate, commonly referred to as the current LIBOR rate.

Every day, ICE asks major global banks how much they would charge other banks for short-term loans. The federation takes the highest and lowest numbers and then averages the remaining numbers. This is called a trimmed mean. This rate is published every morning as a daily rate, so it is not a static number. Once the rates are calculated and set for each term and currency, they are announced and published by the ICE Benchmark Administration (IBA) once a day at around 11:55 am London time.

LIBOR is also the basis for consumer credit in countries around the world, so consumers are just as affected as financial institutions. Interest rates on various loan products, such as credit cards, car loans, and adjustable rate mortgages, vary byinterbank rate. This rate change helps determine the ease of lending between banks and consumers.

However, there is a downside to using the LIBOR rate. While lower borrowing costs may be attractive to consumers, they also affect the returns on certain securities. Some mutual funds may be linked to LIBOR, so their returns may decrease if LIBOR fluctuates.

How is LIBOR calculated?

The IBA has formed a designated body of global banks for each currency pair and maturity. For example, 16 major banks, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase and UBS, make up the US dollar LIBOR panel.Only banks that play a significant role in the London market are eligible to join the ICE LIBOR panel, and the selection process takes place annually.

In April 2018, the IBA presented a new proposal to strengthen the LIBOR calculation methodology. He proposed using a standardized, transaction-based, data-driven, and layered method called the waterfall method to determine LIBOR.

  • The first transaction-based level involves taking avolume weighted average price(VWAP) of all permitted transactions a panel bank may have assigned greater weight to transactions recorded close to 11:00 am London time.
  • The second transaction-derived tier involved accepting submissions based on transaction-derived data from a panel bank when there were not a sufficient number of eligible transactions to make a Tier 1 submission.
  • The third level – expert judgment – ​​comes into play when a panel bank fails to submit a Tier 1 or Tier 2 submission. It transmits the rate at which it could be funded at 11am London time with reference to the wholesale market for unsecured financing.

The waterfall method preserves the trimmed mean calculation.

(Video) What is LIBOR (London Inter Bank Offered Rate)? Easy Peasy Finance for Kids and Beginners

The IBA calculates the LIBOR rate using atrimmed meanApproach applied to all responses received. Trimmed mean is an averaging method that eliminates a specified small percentage of the largest and smallest values ​​before calculating the average. For LIBOR, the numbers in the top and bottom quartiles are discarded and the remaining numbers are averaged.

Use of LIBOR

LIBOR is used in a variety of financial products around the world. That includes:

  • Standard interbank products such as forward rate contracts (FRA), interest rate swaps, interest ratefutures,options, eexchanges, where options enable, but do not oblige, the buyer to purchase a bond or interest rate product
  • Commercial products such as certificates of deposit and adjustable rate debentures, adjustable rate mortgages andsyndicated loans, which are loans offered by a group of lenders
  • Hybrid products likesecured debt obligations(CDO), Collateralized Mortgage Obligations (CMO) e uma variedade de Accrual Notes, Callable Notes e Perpetual Notes
  • Consumer loan related products such as individual mortgages and student loans

LIBOR is also used as a standard measure of market expectations for interest rates set by central banks. It takes into account liquidity premiums for various instruments traded on money markets, as well as an indicator of the health of the entire banking system. A lot ofderivativeProducts are created, launched and marketed in relation to LIBOR. LIBOR is also used as a reference interest rate for other standard processes, such ascleaning, pricing and product reviews.

A brief history of LIBOR

With the development of the market for interest-based products in the 1980s, consistent measurement of interest rates became necessary for all financial institutions. The British Bankers' Association (BBA), representing the banking and financial services industry, established the BBA interest rates in 1984. Further simplification led to the development of the BBA LIBOR in 1986, which became the standard interest rate for transactions involving interest and currency-based financial transactions between financial institutions, both locally and internationally.

Since then LIBOR has gone through many changes. The important thing is whenBBALIBOR was changed to ICE LIBOR in February 2014 after the Intercontinental Exchange took over management.

The currencies involved in calculating LIBOR have also changed. While new exchange rates were added, many were removed or incorporated after the introduction of euro rates. The 2008 financial crisis saw a significant drop in the number of terms for which LIBOR was calculated.

Alternatives to LIBOR

Although LIBOR was once accepted around the world, it existsvarious other interest rateswhich are popular all over the world.

For example, Europe has the European Interbank Offered Rate (EURIBOR), Japan the Tokyo Interbank Offered Rate (TIBOR), China the Shanghai Interbank Offered Rate (SHIBOR) and India themumbai interbank price(MIBOR).

LIBOR interest rate manipulation scandal

While LIBOR is a long-established global benchmark for interest rates, it has had its fair share of controversies, including a majorScandal there Price manipulation.

Big banks are said to have conspired to manipulate LIBOR rates. They took traders' requests into account and introduced artificially low LIBOR rates to keep them at their preferred levels. The intent behind the alleged misconduct was to increase the profits of traders holding positions in LIBOR-based financial securities.

(Video) What is The London Inter-Bank Offer Rate (LIBOR)?

Following a 2008 Wall Street Journal report, major global banks that served on boards and contributed to the LIBOR determination process were subjected to regulatory scrutiny.It was an investigation by the US Department of Justice. Similar investigations have been launched in other parts of the world, including the UK and Europe.

Hauptbanks and financial institutionsincluding Barclays, ICAP, Rabobank, Royal Bank of Scotland, UBS and Deutsche Bank faced hefty fines. Punitive actions were also taken against its employees who were found to be complicit in the misconduct.The scandal was also one of the main reasons LIBOR moved from BBA management to ICE.

Benefits of monitoring LIBOR rates

Despite the interest rate scandals, LIBOR rates provide a useful measure of the level of activity in the global economy. A falling LIBOR suggests that it is becoming easier to borrow money, possibly predicting an increase in economic activity. The increase in LIBOR means that it is getting harder to borrow money, which means that trading activity is likely to slow down.

These fees are particularly important to a prospective borrower. When you borrow money from a bank, LIBOR fees may form part of your interest rate. High LIBOR means you may have to pay a higher interest rate on your mortgage or personal loan, while low LIBOR means a cheaper interest rate.

Special Considerations: Phase-out of LIBOR

Although LIBOR has been used since the 1980s, regulatory reforms have begun in recent years to reform interest rate benchmarks and eventually replace LIBOR as the interbank lending rate. UK banks will no longer be required to publish LIBOR rates after 2021.

The new system is intended to replace the prevailing interest rate assumptions in LIBOR and use actual transaction rates instead. Theguaranteed overnight funding rate(SOFR) will replace LIBOR in 2023. SOFR is also a benchmark interest rate used for dollar-denominated loans and derivatives contracts. SOFR differs from LIBOR in that it is based on actually observed transactions in the US Treasury market, whereas LIBOR uses estimates of lending rates.

However, SOFR is likely to be used in the US and UK, but other countries are exploring using their own version of a benchmark rate for when LIBOR expires.

Examples of LIBOR-based products and transactions

The simplest example of a LIBOR-based transaction is a floating rate bond that pays annual interest based on LIBOR, say LIBOR + 0.5%. If the LIBOR amount changes, the interest payment will also change.

LIBOR also applies to interest rate swaps – contractual agreements between two parties to exchange interest payments at a specific point in time. Suppose Paul owns a $1 million investment that pays him a floating interest rate based on LIBOR of LIBOR + 1% each quarter. Since his earnings are subject to LIBOR and variable, he wants to switch to fixed rate payments. Then there's Peter, who has a similar $1 million investment that pays him a flat rate of 1.5% per quarter. He wants variable earnings as he can occasionally receive higher payouts.

Both Paul and Peter can enter into a swap agreement and exchange their respective interest income. Paul receives Peter's 1.5% fixed interest rate on his $1 million investment, which equals $15,000, while Peter receives LIBOR + 1% variable interest from Paul.

(Video) What is the London Interbank Offered Rate (LIBOR)?

If LIBOR is 1%, Peter will receive 2% or $20,000 from Paul. Since this amount is more than what he owes Paul, Peter receives $5,000 ($20,000 - $15,000) net from Paul. If LIBOR drops to 0.25% in the next quarter, Peter will be entitled to 1.25% or $12,500 from Paul. In net terms, Paul receives $2,500 ($15,000 - $12,500) from Peter.

Such swaps essentially meet the requirements of both parties to the operation, who wanted to change the type of interest income (fixed and variable).

Is LIBOR reliable?

While LIBOR was once a reliable benchmark for global interest rates, the 2012 interest rate manipulation scandal raised many questions about its objectivity. Many financial institutions are gradually abandoning LIBOR in favor of other benchmarks such as SOFR.

What is LIBOR today?

The overnight LIBOR rate on August 18, 2022 was 2.31786. The most recent LIBOR rates can be found atWall Street Journal.

What replaces LIBOR?

Several alternative indices have been proposed to replace USD LIBOR. One, Ameribor, reflects the average cost of borrowing for thousands of banks and financial institutions across the United States. Another is the Secured Overnight Financing Rate (SOFR), which is based on the Treasury repo rate. In 2022, the US Congress passed legislation to make SOFR the official replacement for LIBOR in the United States.

the end result

LIBOR, or London Interbank Offered Rate, was a global benchmark that represented interest rates on short-term loans from one bank to another. However, the index came under suspicion in 2012 when some bankers were found to be manipulating the index for their own benefit. Most countries have already phased out LIBOR, and the United States will soon follow suit.

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