The London Interbank Offered Rate (LIBOR) is a globally influential financial benchmark utilized to gauge the rate at which the most creditworthy international banks borrow from one another in the Eurodollar market. Often considered the Eurodollar equivalent of the federal funds rate, LIBOR historically served as a critical reference point for setting interest rates on various financial products, including loans, mortgages, and derivatives.
LIBOR Explained
LIBOR is determined through daily submissions by a panel of global banks, which report the rates they expect to pay if borrowing from other banks. The process, traditionally managed by the Intercontinental Exchange (ICE), involves calculating an average rate, excluding the highest and lowest submissions to mitigate bias.
Types of LIBOR
LIBOR is published for five currencies and seven different maturities:
- Currencies: USD, EUR, GBP, JPY, CHF
- Maturities: Overnight, 1 week, and 1, 2, 3, 6, and 12 months
Calculation Methodology
- Daily submissions from a panel of banks
- Median average of the middle rates (excluding extremes)
- Published around 11:45 am London time
Historical Context
First launched in 1986 by the British Bankers’ Association (BBA), LIBOR rapidly became embedded in financial contracts worldwide. Over the decades, it has underpinned trillions of dollars’ worth of loans, bonds, and derivatives.
LIBOR Scandal
In the early 2010s, investigations revealed manipulations by several banks submitting false rates to benefit their positions or appear more creditworthy. This led to substantial fines and a shift in the rate-setting process’s oversight to ICE in 2014.
Transition Away from LIBOR
Due to reliability concerns and the deterministic nature of submissions, LIBOR is being phased out, with target cessation dates extending through 2023. Alternative reference rates like the Secured Overnight Financing Rate (SOFR) in the United States and the Sterling Overnight Index Average (SONIA) in the United Kingdom are being adopted.
Applications of LIBOR
LIBOR’s influence extends across various sectors:
- Loans and Mortgages: Interest rates for adjustable-rate mortgages, business loans, and personal loans often reference LIBOR.
- Derivatives: A cornerstone in the valuation of interest rate swaps and options.
- Bonds: Many floating-rate notes rely on LIBOR as a base.
Comparative Analysis
| Feature | LIBOR | Federal Funds Rate | SOFR |
|---|---|---|---|
| Benchmark Use | Global | United States | Transitioning US Dollar |
| Basis | Interbank lending | Central bank overnight | Repo market transactions |
| Maturities | 7 distinct timelines | Overnight | Overnight |
Related Terms
- Eurodollar: Deposits held in US dollars in banks outside the United States.
- Federal Funds Rate: The interest rate at which depository institutions trade federal funds with each other overnight.
- SOFR: A broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
FAQs
Why is LIBOR being phased out?
Due to the difficulty in sustaining a robust and accurate rate amid decreased interbank lending and past manipulation scandals.
What are the alternatives to LIBOR?
Alternatives include SOFR, SONIA, and the Euro Short-Term Rate (ESTER).
How does LIBOR impact my mortgage?
For adjustable-rate mortgages tied to LIBOR, shifts in LIBOR can affect monthly payments as the interest rate adjusts.
What happens post-LIBOR?
Financial contracts referencing LIBOR will need amendments to link to new benchmark rates, or fallback provisions will dictate alternative processes.
References
- ICE Benchmark Administration. “ICE LIBOR.”
- Federal Reserve. “Transition from LIBOR.”
- Financial Conduct Authority (FCA). “LIBOR Transition.”
Summary
The London Interbank Offered Rate (LIBOR) has played an essential role in international finance as a benchmark for short-term interest rates. Despite its waning influence due to manipulation issues and the emergence of alternative rates, its historical significance and impact on various financial instruments remain profound. The ongoing transition to more stable and transparent reference rates like SOFR is a milestone in enhancing financial market integrity and reliability.
