by Barbara Balcon
What is LIBOR?
First published in 1986, the London Interbank Offer rate (LIBOR) is the interest rate at which funds are offered for sale in the Eurodollar market, which is the market for U.S. dollar-denominated funds held outside of the United States, either at foreign banks or at overseas branches of American banks.
This market, oddly enough, was fathered by the Soviet Union: in the early 1950s, the Soviets feared an expropriation by the American government of the dollar deposits they held at U.S. banks and therefore decided to move them to Europe (London). At the same time, they wanted the dollar to remain the currency in which the balances were denominated, given that it was the standard for international transactions.
It was named after the geographical location of the banks where the deposits were held, and it has nothing to do with the Euro as a currency. Nowadays the definition includes all non-U.S. banks.
The main reason behind the ever-increasing popularity of the Eurodollar market is that it offers a convenient rate to both lenders and borrowers, compared to their domestic market. This is made possible by the willingness to accept a narrower spread between interest paid on deposits and the one earned on loans by multinational banks (compared with American banks) and by favourable regulations.
The origin of the LIBOR is said to go back to the late sixties, when the Shah of Iran took out a syndicated loan from the London branch of Manufacturers Hanover. The mind behind the operation was a Greek banker, who determined the interest rate for the loan as the average of reported funding costs by a number of reference banks.
The LIBOR rate is currently computed for five currencies (euro, US dollar, British pound sterling, Japanese yen and Swiss franc) and for seven maturities (one day, one week, one month, two months, three months, six months and twelve months).
How is LIBOR computed?
The computation of the rate was initially carried out by the British Bankers’ Association (BBA Libor), but in 2013 the responsibility for its administration was conferred to the ICE Benchmark Administration (ICE). This happened after the LIBOR scandal (2012), which will be discussed below.
Before the transition to the waterfall methodology (completed in April 2019) a panel of major banks was surveyed daily with the question “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 11.00 am?”. Then a trimmed average of the answers was computed and published between 11.00 and 12.00 am. It is relevant to note that the result was not dependent on actual transactions.
The new methodology is more complex and it takes into account transaction-derived data and experts’ judgment. At the first level, which is transaction-based, a volume-weighted average price (ration of the average value traded over the relative volume) is computed, with higher weights for transactions which take place closer to 11.00 am. A transaction-derived level follows with, among others, time-weighted historical eligible transactions adjusted for daily market movements, linear interpolation. Lastly, market and transaction data-based expert judgement comes into play, in compliance with the bank’s own internally approved procedure.
The outcome of the procedure is published for each of the 35 currency and tenor combinations at 11:55 am London time on each applicable London business day.
Why does LIBOR matter?
LIBOR is considered to be the most important benchmark for short-term interest rates worldwide. This is because this rate is used as a base for many derivatives contracts (financial instruments whose value depends on an underlying asset or group of assets) such as interest-rate futures (a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset at a locked-in price) or swaps (future exchanges of cash flows). LIBOR is also a benchmark for commercial products like floating-rate mortgages and student loans.
In addition to its role as a benchmark, LIBOR can also be considered as an indicator of the health of the banking system and of market expectations about central bank interest rates and liquidity premiums in the money markets.
The LIBOR scandal
As one might easily guess, the procedure used to determine LIBOR prior to the implementation of the waterfall method left the door open to manipulation by the panel banks (the number of institutions included in the panel varied over time, but it was always under 20). In fact, a major collusion aimed at maximizing profit by setting the rate artificially high or low was uncovered in 2012.
Back in 2008 an article by The Wall Street Journal addressed concerns about the possibility that banks were keeping the rate low in order to appear more solid than they actually were, but its claims were dismissed by a number of institutions, including the Bank for International Settlements and the International Monetary Fund. However, two years later, the view of the WSJ was supported by a study, according to which the reason for the alteration was, instead, profit on assets linked to the rate. It has been later revealed that some central banks were aware of the issue but did not take action immediately. Regulatory investigations started in 2011, followed by the U.S. Congress and by the U.K. Serious Fraud Office in 2012. Various banks, including Barclays, Royal Bank of Scotland, Deutsche Bank, J.P. Morgan, Lloyds and the broker R.P. Martin were pleaded guilty in court and fined up to billions of dollars. Many of Barclays’ top executives resigned and various traders were convicted, notably Thomas Hayes (UBS), who used to openly ask brokers to manipulate the rate.
Why a transition away from LIBOR?
There are various reasons behind the decision to shift away from LIBOR. The main one is that the number of panel banks keeps decreasing over time, thus affecting the reliability of the sample. Moreover, even after the 2013 reform, the computation methodology was deemed to be outdated and after the scandal the rate maintained a negative reputation which might have played a role in the decrease of its popularity.
What will substitute LIBOR?
LIBOR’s dollar-denominated replacement is the Secured Overnight Financing Rate (SOFR), which has been published since April 2018 by the New York Federal Reserve.
It is based on the transactions in the U.S. Treasury repurchase (repo) market. Repurchase agreements are similar to collateralized loans (they are not exactly the same because they always involve the actual purchase of the asset): one of the parties sells to the counterpart a high-quality collateral – U.S. Treasuries in this case – and then buys it back at a higher price, often after just one day.
There are relevant differences between the two rates. SOFR relies entirely on real transaction data and it is exclusively overnight. Another aspect which is worth noting is that, while LIBOR took into account a certain level of risk, SOFR is considered to be a risk-free rate, due to the nature of U.S. Treasury repos. In terms of currency, other rates similar to SOFR, but published independently, have been introduced, including SONIA for the United Kingdom and ESTER for the European Union.
What are the rates now?
LIBOR follows closely the Federal Funds rate, which is the interest U.S. banks charge each other for overnight uncollateralized loans. As of November 13, 2019, the FedFunds rate is equal to 1.55% and the target set by the Federal Reserve is in the rage between 1.50% and 1.75%. LIBOR stands at 1.54%. Its evolution from the beginning of 2019 is plotted in the first chart. It is easy to note the rate cuts delivered by the Fed on August 1, September 18 and October 30 affected both LIBOR and SOFR. On September 16 the repo rate soared as high as 10% and the Fed reacted by injecting liquidity in the market, however a complete explanation of this event is beyond the scope of this article.
When and how will the transition take place?
The official deadline for the dollar-denominated LIBOR is the end of 2021. However, it does not mean that necessarily all LIBOR rates will cease being computed and published after that date and it is also possible that it will fall out of use early, specifically if the number of panel banks falls under four.
At the moment the various rates coexist, and new contracts based on SOFR or its equivalents have already been underwritten, but not all of those linked to LIBOR have reached maturity. Some experts argue that there exists a part of the market which is still not aware of the deprecation of LIBOR, while the most educated players have swiftly changed course.
What does this change imply?
Forecasting all the consequences of a major change like this is a complex matter and the relevance of this transition is enormous, given the aforementioned importance of LIBOR as a benchmark. Furthermore, the possibility of an anticipated retirement has to be taken into account and adequate fallback clauses should be included into contracts. If this goal is not achieved in time, there could be serious consequences, even if the players that could be responsible for such an event (panel banks and regulators) are supposed to have an interest in ensuring a frictionless transition.
Given the complexity of derivatives contracts and the differences between LIBOR and SOFR, it is likely that the markets will require time to adapt and overcome setbacks, including the difficulties of updating contracts, in terms of finding an agreement and dealing with red tape.
Other concerns address the fact that the new rates are not forward looking, the market infrastructures are not always developed enough and the lack of term rates.
According to the Bank of England, firms need to understand exposure and risk, actively reduce their reliance on LIBOR, and engage with transition efforts.
Will this be enough to win over the fear of heading full steam into uncharted territory before it is too late?