The London Interbank Offered Rate (LIBOR) was an influential benchmark interest rate at which major global banks lent to one another in the interbank market for short-term loans. LIBOR served as a globally accepted key benchmark interest rate until scandals and questions regarding its credibility led to its eventual phase-out.
According to both the Federal Reserve and U.K. regulators, LIBOR was phased out on June 30, 2023, and was replaced by the Secured Overnight Financing Rate (SOFR). SOLAR one-week and two-month USD LIBOR rates being stopped from publishing after Dec 31, 2021, marked the first phase out action.
Key Takeaways
- LIBOR was a benchmark interest rate for short-term loans between major global banks.
- Administered by the Intercontinental Exchange (ICE), it was derived from a survey of how much banks charged each other for short-term loans.
- Its calculation used a method called the Waterfall Methodology.
- Due to scandals and methodological flaws, LIBOR became less reliable and was eventually replaced by SOFR.
Understanding LIBOR
LIBOR was the average interest rate at which global banks could borrow from each other. It encompassed five major currencies, including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc. These applied across seven different maturities: overnight/spot next, one week, and one, two, three, six, and 12 months.
ICE calculated LIBOR each day by asking major global banks to provide loan rate estimates. After eliminating the highest and lowest figures, ICE published the trimmed average rate. This daily figure influenced various consumer and commercial loans worldwide including credit cards and adjustable-rate mortgages.
How Was LIBOR Calculated?
A designated panel of global banks participated in the LIBOR calculation. Auxiliary levels known as Waterfall Methodology were in place to articulate an accurate rate based on transactions and expert judgment when adequate data was absent.
- Transaction-Based Level: Weighted average transactions recorded near 11:00 a.m. London time.
- Transaction-Derived Level: Based on internal transaction data.
- Expert Judgement: Applied when insufficient transaction data was available.
Uses of LIBOR
LIBOR was employed across distinct financial products:
- Interbank products: Forward rate agreements (FRAs), interest rate swaps, and futures.
- Commercial products: Floating rate certificates of deposit, variable rate mortgages, and syndicated loans.
- Hybrid products: Collateralized debt obligations (CDOs) and mortgage obligations (CMOs).
- Consumer loans: Mortgages and student loans.
Its widespread use made it an insightful gauge of market expectations, health of the banking system, and more. Derivatives trading and various financial instruments were contingent on LIBOR rates.
Phasing Out LIBOR
Despite its extensive application, LIBOR underwent intense scrutiny after the 2012 rate-rigging scandal, leading regulators to revoke its status by 2023. Reformed systems like SOFR, utilizing transaction-based rates, aimed to combat the conjecture inherent in LIBOR’s existing mechanism.
SOFR, replacing LIBOR, applies to dollar-denominated loans and is built on actual transactions in the U.S. Treasury market. Nevertheless, other global regions are considering unique alternatives tailored to their markets.
Examples of LIBOR-Based Products & Transactions
One straightforward example is a floating-rate bond at LIBOR + 0.5%, leading to variable interest payments based on LIBOR changes. Another instance is an interest rate swap between Paul, earning variable LIBOR-based interest on his investment, and Peter who prefers variable interest based on his fixed investment returns.
Conclusion
LIBOR, once a definitive benchmark, fell under question post-2012 scandal due to manipulation concerns. As many financial institutions phase it out in favor of SOFR and other benchmarks, it reminds us of the critical role integrity plays in financial systems and the importance of continually robust, data-driven benchmark methodologies.
Related Terms: SOFR, Ameribor, benchmark interest rates, LIBOR replacement, financial scandals.
References
- Intercontinental Exchange. “LIBOR”.
- Intercontinental Exchange. “USD LIBOR Methodology”, Page 2.
- Intercontinental Exchange. “USD LIBOR Methodology”, Page 7.
- Federal Reserve Bank of New York. “Staff Reports – LIBOR: Origins, Economics, Crisis, Scandal, and Reform”, Page 1.
- Intercontinental Exchange. “ICE LIBOR Evolution”, Page 3.
- Intercontinental Exchange. “ICE LIBOR Evolution”, Page 4.
- Council on Foreign Relations. “Understanding the Libor Scandal”.
- Wall Street Journal. “Study Casts Doubt on Key Rate”.
- Reuters. “Federal LIBOR Legislation: Five Things Financial Market Participants Need to Know”.
