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What is LIBOR? Why Is It Going To Be Replaced and By Whom?

Editor, TRANSFIN
Jun 19, 2021 3:48 AM 6 min read
Editorial

It would be an understatement to say that the world has seen quite a few changes over the past one-and-a-half years. 

Yet another change, and perhaps the most meaningful one in the world of finance in recent times that we expect to see soon, is the replacement of LIBOR or the largely accepted global benchmark interest rate for banks. The LIBOR rates will no longer be published after December 31st 2021. 

Meanwhile, financial regulators and institutions have been racking their brains to settle on an alternative to LIBOR, a standard that will hopefully replace its predecessor and forgo its flaws whilst ensuring a smooth transition.

Let us see what LIBOR is and what role it plays in modern financial systems. And why it is being replaced. 

A LIBOR of Loans

LIBOR stands for the London Interbank Offered Rate. Global financial markets were undergoing significant changes in the 1970s and '80s with the introduction of new market instruments (especially rate-based products) like interest rate swaps, foreign currency options, forward rate agreements etc. 

While this was positively diversifying financial markets, it also brought more headaches for bankers who were worried that growth from these instruments could go unchecked and become erratic if they weren't standardised by some measure. So, in October 1984, the British Bankers' Association (BBA) set up an interest settlement rate which was refined and formulated into the LIBOR in 1986

What the LIBOR essentially does is fix the average interest rate at which major global banks borrow unsecured loans from each other. Consequently, it acts as a global standardised reference for short-term unsecured borrowing in the interbank market.

It is based on five currencies - Dollar, Euro, British Pound, Japanese Yen and Swiss Franc. It serves seven different maturity periods - overnight/spot next, one week, one month, two months, three months, half year and one year. 

So the combination of five currencies and seven maturities effectively gives rise to 35 different LIBOR rates which are calculated every business day.  

For years, LIBOR has been called the world's most important number because of how it influences close to $260trn of loans and derivatives. But due to a number of factors that include outdated metrics of calculation, scandals involving LIBOR's manipulation and the fact that the underlying market from which LIBOR is derived now has much lower usage volumes, it is on its way out.

 

How Is LIBOR calculated?

Historically, LIBOR has been calculated by something called a trimmed mean approach. 

Every day, 18 international banks submit the rates that they think is ideal for unsecured borrowing and lending from each other. To avoid any extremities, 25% of the highest- and lowest-quoted rates are eliminated. The remaining rates are averaged and rounded to five decimal places. The process is repeated for the five currencies and seven maturities to issue the 35 LIBORs at the beginning of each business day. 

The aim is to maintain stability and uniformity of bank rates across the world so that fluctuations in the rate are not tied to a single market but to the global market. 

 

How LIBOR Affects You and I?

LIBOR is used to set the rates on a wide range of financial products, primarily those which are based on interest rates. 

These are typically complex derivative products such as interest rate swaps, interest rate futures, options, swaptions, collateralised debt obligations (CDOs), collateralised mortgage obligations (CMOs) etc. But in the Western markets, even syndicate and retail loans see some benchmarking against the LIBOR. 

In India, LIBOR's impact on retail loans and products should ideally be muted. However, it certainly would impact overseas corporate and syndicated loans and other derivatives-related activities. 

The biggest impact, perhaps, will be seen on the Mumbai Interbank Forward Offer Rate (MIFOR) which derives its value partly from LIBOR. MIFOR acts as an important benchmark in the interest rate and currency swap markets and therefore, the role played by MIFOR itself may need re-evaluation. 

India is essentially a “LIBOR-taker” as it relies on the LIBOR rates for a large number of trade contracts much like several other regions. The biggest task perhaps for the RBI is to adapt its existing systems to a new benchmark and find the smoothest possible way to do so, a task which sounds more straightforward than it is. 

 

LIBOR Rates - 30 Year Chart

Source: Macrotrends

 

Why Leave the LIBOR?

Quite simply, global markets have become bigger and increasingly more complex while the methodology for calculating LIBOR has remained largely unchanged. 

When the economic meltdown of 2008 happened, banks grew reluctant to lend to each other because it became clear that the mortgages were failing and securities backed by them weren't properly insured.

So everyday, the LIBOR-setting banks estimated higher rates to discourage lending which caused loans and other financial products to become more expensive. Even the rate slashing measures introduced by central banks did little to counter this in the short-term. 

Then in 2012, a series of findings showed that some of the banks which were parties to LIBOR-setting back then were deliberately low-balling their desired borrowing rates to avoid looking desperate for cash. As a result, LIBOR, which is supposed to reflect the global banking health, showed that the banking system was faring better on paper than it did in practice at the height of the 2008 financial crisis. 

At the centre of this price-fixation were multiple banks - including Barclays, Deutsche Bank, Rabobank, UBS, RBS etc. The banks would submit their desired LIBOR rates and claim that these were lower than the actually charged rates, which was untrue. A lower rate means lower risk of default and hence it is a healthier indicator for the bank compared to another bank with a higher rate. 

Owing to these malpractices, the Intercontinental Exchange (ICE) took over the task of oversight on LIBOR from the BBA, its founding agency. The number of banks on whose estimates the LIBOR was calculated also decreased from 200 to less than 20. This resulted in a significant decline in the sample size for calculating LIBOR - a key factor which effectively meant that qualitative judgement was superseding statistical significance.  

A cocktail of outdated methodology, declining statistical relevance and shades of unethical manipulation have all collectively taken the gloss off of LIBOR and paved the way for its successor. 

 

The Line of Succession

Ever since the shortcomings of LIBOR became known, there has been a concerted call from industry bodies and regulatory agencies to switch to other metrics for interest rate determination. 

So far, the frontrunner amongst replacements is the Secured Overnight Financing Rate (SOFR) which is being tapped by many of the banks and regulators. One advantage of SOFR is its basis on the existing loans and asset rates in the market. LIBOR was largely based on what banks estimated, not what they actually used for lending which was, perhaps, responsible for the opacity behind its fixation. 

Let's put it this way - SOFR relies on “transaction data'' whereas LIBOR partially relies on “expert judgement”. Another big difference is that SOFR is based on US Treasuries so in effect, it is “risk-free” while LIBOR still has a built-in risk premium as it represents borrowing rates for banks. 

But given the 40+ years of reliance of global financial markets on LIBOR, many are slow and unmotivated to switch to alternatives. Empathising with this unfamiliarity, JP Morgan Chase and Bank of America recently created a new rate using the Bloomberg Index which is very similar to LIBOR.

While many countries have local currency-driven reference rates, SOFR appears to be in the pole position to become the dominant global benchmark rate.   

 

The Post-LIBOR World

As per The Wall Street Journal, loans tied to LIBOR have been increasing rather than declining over the last year. This explains the recent increase in regulatory warnings convincing banks to switch to LIBOR alternatives. But the process is slow and uncertain. Many even expect the post-LIBOR world to be governed by multiple rates instead of one despite perhaps SOFR being the current front-runner. 

And then there is the uncertainty about proper fallbacks to absorb the impact of a massive shift from LIBOR to other standards, if it happens at once. It could trigger a sudden rise in interest rates and require amendments of thousands of contracts which isn't conducive to say the least. 

In fact, there is also a growing debate on the need for a global standard interest rate like LIBOR which ties the financial fate of the whole world together so that when one tumbles, so do the others like a pack of cards. For the time being, however, LIBOR is still the lingua franca of the global financial markets. 

FIN.
 

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