What is LIBOR
LIBOR is a benchmark rate that represents the interest rate at which banks offer to lend funds to one another in the international interbank market for short-term loans. LIBOR is an average value of the interest-rate which is calculated from estimates submitted by the leading global banks on a daily basis. It stands for London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.
LIBOR serves as a globally accepted key benchmark interest rate that indicates how much does it costs to the banks to borrow from each other. It is used as the necessary reference rate for transacting in the global markets worth more than $350 trillion and comprises of various financial products that include interest rate swaps, forward rate agreements, mortgages and commerical loans.
London Interbank Offered Rate (LIBOR)
BREAKING DOWN LIBOR
As the market for interest rate based products started to evolve during the 1980s, new products like interest rate swaps, currency derivatives and forward rate agreements started gaining popularity. A need emerged to have a uniform measure of interest rates which could be used across various financial institutes and entities for unified trading in the international market. The British Bankers’ Association (BBA), which is the leading trade association that represents the views of those involved in the banking and financial services industry, decided to set the necessary standards and set up the BBA interest-settlement rates in 1984 which were the predecessor to LIBOR. Further streamlining lead to evolution of BBA LIBOR in 1986. Essentially, the LIBOR became the default standard interest rate for transacting in the interest rate- and currency-based financial dealings between various financial institutes at local and international level.
Owing to its British origin and administration by the BBA, it was previously known as BBA LIBOR. On February 1, 2014, the Intercontinental Exchange (ICE) took over the administration of the LIBOR, changing its name to ICE LIBOR.
LIBOR is now administered by the ICE Benchmark Administration (IBA) and is based on five currencies: the US dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF). The LIBOR serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates being calculated and reported each business day. The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the “current LIBOR rate.”
LIBOR has undergone a lot of changes. While new currency rates have been added, many have been removed or integrated following the introduction of the Euro rates. The 2008 financial crisis saw a significant decline in the number of tenors for which LIBOR was calculated.
How is LIBOR Calculated?
The IBA has constituted a designated panel of global banks for each currency and tenor pair. For example, 16 major banks, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase and UBS AG, constitute the panel for US dollar LIBOR. Only those banks which have a significant role in the London market are considered eligible for a membership on the ICE LIBOR panel, and the selection process is held annually.
LIBOR methodology involves a consensus mechanism, where each of the banks on the panel is required to submit the response to a submission question directly linked to deposit/loan rates that they are using. For example, prior to 1998, the following question was asked to the panel banks:
“At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11 am (GMT)?”
In 1998, the submission question was revised to the following:
“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 am (GMT)?”
The change was enforced to make the submissions a subjective determination of the rate at which a given panel bank could transact.
The responses by the panel banks for various loan maturities in the given currency are confidentially collected between 11:05 AM and 11:40 AM. These responses are essentially the annualized interest rates for unsecured funding for the specified period and specified currency. The IBA calculates the LIBOR rate using a trimmed mean approach applied on all the responses received. Trimmed mean is a method of averaging which eliminates a small specified percentage of the largest and smallest values before calculating the mean. For LIBOR, figures in the highest and lowest quartile are thrown out and averaging is performed on the remaining numbers.
Once the rates for each maturity and currency are calculated and finalized, they are announced/published once a day at around 11:55 am London time by IBA.
Proposed Waterfall Methodology for LIBOR Calculation
In efforts to further strengthen the LIBOR calculation methodology and put in place new governance, monitoring, controls and technology, a new proposal was published by IBA in April 2018. It suggests using a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology for determining LIBOR.
The first transaction-based level involves taking a volume weighted average price (VWAP) of all eligible transactions a panel bank may have, and assigns a higher weighting for transactions booked closer to 11:00 am.
The second transaction-derived level involves taking submission based on transaction-derived data from a panel bank if it does not have sufficient number of eligible transactions to make a Level 1 submission.
The third expert judgment level comes into play when a panel bank fails to make a Level 1 or a Level 2 submission. It will then submit the rate at which it could finance itself at 11:00 am London time with reference to the unsecured, wholesale funding market. The introduction of appropriately framed expert judgment level will ensure that LIBOR submissions can be made even when a panel bank does not have sufficient number of eligible transactions as per the standards set by IBA.
The Waterfall methodology will retain the trimmed average calculation. The testing of rate submission based on the Waterfall methodology has been going on in parallel to the existing process. The transition to the new method will be taken in a phase wise manner, and is expected to be completed by the first quarter of 2019.
Additionally, the defined roadmap also proposes to revise the official definition of LIBOR as follows:
“A wholesale funding rate anchored in LIBOR panel banks’ unsecured wholesale transactions to the greatest extent possible, with a waterfall to enable a rate to be published in all market circumstances.”
In the long run, the practice of submitting responses is expected to be eliminated completely. The Financial Conduct Authority (FCA) envisions that it would no longer be necessary for it “to persuade, or compel, banks to submit to LIBOR” or “to sustain the benchmark through [its] influence or legal powers” after the end of 2021.
Uses of LIBOR
LIBOR is used worldwide in a wide variety of financial products. They include the following:
- Standard interbank products like forward rate agreements (FRA), interest rate swaps, interest rate futures/options and swaptions
- Commercial products like floating rate certificate of deposits and notes, syndicated loans and variable rate mortgages
- Hybrid Products like collateralized debt obligations (CDO), collateralized mortgage obligations (CMO), and a wide variety of accrual notes, callable notes and perpetual notes.
- Consumer loan-related products like individual mortgages and student loans
LIBOR also finds use as a standard gauge of market expectation for interest rates finalized by central banks. It also accounts for the liquidity premiums for various instruments that get traded in the money markets, as well as an indicator of the health of the overall banking system.
A lot of derivative products are created, launched and traded in reference to LIBOR. LIBOR is also used as a reference rate for other standard processes like clearing, price discovery and product valuation.
Examples of LIBOR based Products/Transactions
Simplest example of a LIBOR based transaction is a floating rate bond which pays an annual interest based on LIBOR, say at (LIBOR + 0.5%). As value of LIBOR changes, the interest payment will change.
Then there are interest rate swaps which are contractual agreements between two parties to exchange interest payments at specified time. Assume Paul owns a $1 million investment that pays him a variable LIBOR-based interest rate equal to (LIBOR + 1%) each quarter. Since his earnings are subject to LIBOR values and are variable in nature, he wants to switch to a fixed rate interest payments. Then there is Peter, who has a similar $1 million investment which pays him a fixed interest of 1.5% per quarter. He wishes to get a variable earning, as it may occasionally give him higher payments.
Both Paul and Peter can enter into a swap agreement, where they agree to exchange their respective interest receipts. Paul will now be eligible to receive the fixed 1.5% interest over his $1 million investment from Peter which equals $15,000, while Peter will start receiving (LIBOR + 1%) variable interest from Paul.
If LIBOR is 1%, then Peter will be eligible to receive 2% or $20,000 from Paul. Since this figure is higher than what he owes to Paul, in net terms Peter will get ($20,000 - $15,000) = $5,000 from Paul.
By next quarter, if LIBOR comes down to 0.25%, Peter will be eligible to receive 1.25% or $12,500 from Paul. In net terms, Paul will get ($15,000 - $12,500) = $2,500 from Peter.
Such swaps essentially fulfill the requirement of both the transacting parties who wanted to change the type of interest receipts (fixed and floating).
LIBOR Scandal of Rate Rigging
While LIBOR has been a long established global benchmark standard for interest rate, it has had its fair share of controversies including a major scandal of rate rigging. Prior to 2009, major banks allegedly colluded to manipulate the LIBOR rates. They took into account traders' requests and submitted artificially low LIBOR rates to keep them at their preferred levels. The intention behind the alleged malpractice was to bump up traders’ profits who were holding positions in LIBOR-based financial securities.
Following reporting by the Wall Street Journal, major global banks which were on the panels and contributed to the LIBOR determination process faced regulatory scrutiny. It involved investigations by U.S. Department of Justice as well as by the U.S. parliament. Similar investigations were launched in other parts of the globe including in the UK and Europe. Major banks and financial institutes - including Barclays, ICAP, Rabobank, Royal Bank of Scotland, UBS and Deutsche Bank - faced heavy fines. Punitive actions were also taken on their employees who were found to be involved in the malpractice.
The scandal was also one of the primary reasons for the administration of LIBOR shifting from BBA to ICE.
Though LIBOR is globally accepted, there are other similar regional interest rates that are popularly followed across the globe. For instance, Europe has the European Interbank Offered Rate (EURIBOR), Asian major economy Japan has the Tokyo Interbank Offered Rate (TIBOR), China has Shanghai Interbank Offered Rate (SHIBOR) and India has Mumbai Interbank Offered Rate (MIBOR).