Takeaways
- The LIBOR, or London Interbank Offer Rate, was a highly centrally cited interest rate.
- The LIBOR was first established in 1986 by the British Bankers’ Association (BBA).
- The LIBOR is being phased out of economic use, with the last uses scheduled in 2024.
- The Secured Overnight Financing Rate (SOFR) will essentially replace the LIBOR.
- The LIBOR was scrutinized in 2014 when member banks were found manipulating rates.
Millions of financial contracts are executed daily with an interest rate as part of the contract. Cross-border bankers needed a benchmark interest rate to set interest rates for various financial products worldwide—from student loans and mortgages to complex derivatives. Enter the London Interbank Offered Rate, or LIBOR, which historically played an indispensable role in the global financial market as the defacto reference rate for many credit products.
The LIBOR represented the average rate at which global banks lent to one another. It impacted large global banks, local lenders, and individual personal finances.
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What Is the LIBOR?
The LIBOR was calculated across five currencies: the U.S. dollar, British pound, euro, Japanese yen, and Swiss franc, and for seven different maturities ranging from overnight lending to a twelve-month term. As a result, the LIBOR provided a comprehensive spectrum of benchmarks for short-term interest rates. Its broad applicability made it an essential tool for financial instruments, including bonds, consumer lending rates, and adjustable-rate mortgages.
For decades, the LIBOR was an integral variable in financial modeling, financial security risk assessment, and investment valuation. Banks and credit unions used the LIBOR to quickly price loans and deposits, set future payment obligations, and manage interest rate risk fluctuation. By referencing the LIBOR, businesses could mitigate the risk associated with financing, which provided stability and predictability to their financial operations.
Importantly, LIBOR's implications affected individual financial decisions. For example, a change in the LIBOR could influence your monthly payment amount for an adjustable-rate mortgage, directly impacting your household budget. Similarly, shifts in the LIBOR could increase future payments for students taking out student loans with variable rates, significantly altering financial planning and monthly expenses.
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How the LIBOR Worked
The LIBOR was the reference interest rate at which global banks lent to one another on a short-term basis. It was foundational because it offered consistent interest rates for banks to price loans in the interbank market. The interbank market is essential for banks that borrow funds to ensure liquidity requirements. It offers a "base rate," to which banks add an additional interest rate to generate a lending profit.
The LIBOR was vital to the financial ecosystem because it provided a transparent rate for these transactions that anyone could cite. Rates were determined for five currencies:
- U.S. Dollar (USD)
- Euro (EUR)
- British Pound Sterling (GBP)
- Japanese Yen (JPY)
- Swiss Franc (CHF)
Participating banks submitted interest rates covering seven different terms on which they would lend capital to other banks. These interest rates didn't necessarily need to be pegged to actual transactions but were essentially the bank's best guess. They prepared these interest rates for shorter-term financing terms, starting at the overnight offering and professing up to the interest rate they would charge for a one-year unsecured note.
The LIBOR was calculated daily by polling banks, asking at what rate they could borrow funds from one another on an unsecured basis in the interbank market (e.g., short-term loans). After discarding these submissions' highest and lowest quarters, the resulting interest rates were averaged to calculate that day's LIBOR rates.
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History of the LIBOR
A Greek banker first created the LIBOR in 1969 when he arranged an $80 million syndicated loan from Manufactures Hanover to the Shah of Iran. The funding costs of the loan were tied to the newly created LIBOR. The banks that submitted their information to determine the LIBOR began using this information as a reference rate for other clients. In 1986, the British Bankers' Association (BBA) formally took control of the process.[1]
The introduction of the LIBOR was driven by the necessity for an accurate measure of the average rate that could be used for loans and derivatives between banks globally. Initially, it started with just three currencies but has since expanded as the financial markets grew.
However, more recently, the LIBOR has faced a headwind of controversy. It became a focal point during the financial crisis of 2007-2008. Questions were raised about its reliability and transparency after several banks were found manipulating rates to profit from trades or make their financial position appear more robust than it was. This scandal led to significant fines for involved institutions and a loss of trust in the LIBOR, prompting discussions about its future and the development of alternative rates.
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Understanding the LIBOR
For decades, LIBOR was a foundational element of the global financial system, impacting the price of trillions of dollars' worth of transactions worldwide. Since its widespread adoption in the mid-1980s, LIBOR has been used as a benchmark to set interest rates for various financial products, including mortgages, loans, and derivatives.
The rate provided a consistent, transparent standard that facilitates agreement on terms within financial contracts, streamlining processes and reducing the need for prolonged negotiation between parties.
However, significant scandals have challenged the LIBOR's integrity. It was discovered that some banks manipulated their rate submissions during the financial crisis of 2007-2008, aiming to profit from trades or appear more creditworthy than they were. These manipulations undermined trust in the LIBOR and prompted extensive investigations by U.S. and foreign regulators. The institutions involved paid up to $3.5 billion in fines, leading to an erosion of confidence among regulators, investors, and financial institutions that previously used the LIBOR.
In the wake of these scandals, banking regulators and financial institutions have tried to transition to a more reliable, transparent, and robust benchmark strategy. This new transition seeks to rely on rates that more accurately reflect the underlying market conditions and are less susceptible to manipulation.
For example, the Federal Reserve has endorsed the Secured Overnight Financing Rate (SOFR) as the preferred alternative to the LIBOR in the United States.[2] Unlike the LIBOR, the SOFR is based on actual transactions in the U.S. Treasury repurchase market. It is a reference interest rate based on the cost of borrowing cash overnight, collateralized (secured) by U.S. Treasury securities.
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The New York Fed publishes the Secured Overnight Financing Rate on its website daily at 8:00 a.m. E.T. [3]
The transition from LIBOR to SOFR and other alternative rates marks a significant shift in global finance. The U.S. adoption of the SOFR represents a move towards a more transparent and resilient system. Because the SOFR is grounded in a deep, active market with many participants, it should minimize potential manipulation. The adoption of the SOFR is part of a broader trend towards enhancing the stability and transparency of financial benchmarks.
This evolution from the LIBOR to alternative reference rates, like the SOFR, has taken many years to achieve. The process involved costly market updates, legal adjustments, and updates to existing financial contracts.
You need to understand the implications of these changes on the products and agreements you use. The good news is that we are now in a more secure and transparent financial market framework, restoring trust and stability in financial benchmarks that underpin many financial contracts worldwide.
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How Did ICE Calculate the LIBOR?
In 2014, the administration of LIBOR transitioned from the British Bankers Association to the Intercontinental Exchange (ICE). The ICE LIBOR was a “polled” rate, which was calculated by surveying representative banks each business day. Just before 11:00 a.m. GMT, each bank submitted the rates at which they believed they could borrow funds unsecured from other banks. These submissions reflected the banks’ perception of their borrowing costs, not actual transaction prices.
After the rates were collected, the “trimmed arithmetic mean” of the bank's submissions was calculated.[4] The highest and lowest quartiles (25%) were removed to eliminate outliers, and the rest were averaged.
The calculation of the LIBOR aimed to be objective, relying on submissions based on estimates rather than actual transactions. This methodology was at the core of some manipulation issues that historically plagued LIBOR, leading to the scandals above.
ICE is being compelled by the UK Financial Conduct Authority to publish the 1-, 3-, and 6-month USD LIBOR using an unrepresentative “synthetic” methodology. Ice will cease publication of this methodology after September 30, 2024.[5]
Transitioning Away From LIBOR
The transition away from LIBOR to alternative reference rates, such as the Secured Overnight Financing Rate (SOFR), involves considerable complexity due to the vast number of products tied to it, including mortgages, student loans, and derivatives.
These reference rates are typically based more closely on actual transactions, which should reflect more accurately market conditions and reduce the potential for manipulation.
Smart Summary
The LIBOR plays a waning role in the financial system, but understanding how it works can help you navigate the world of finance. As the economic world transitions towards more transparent and reliable alternatives, like the Secured Overnight Financing Rate, keeping informed will ensure you are prepared for how these changes might affect your money.
You Might Also Like:
(1) New York Fed. LIBOR: Origins, Economics, Crisis, Scandal, and Reform. Last Accessed January 16, 2025.
(2) Securities and Exchange Commission. What You Need to Know About the End of LIBOR. Last Accessed January 16, 2025.
(3) New York Federal Reserve. Secured Overnight Financing Rate Data. Last Accessed January 16, 2025.
(4) Intercontinental Exchange. LIBOR: Frequently Asked Questions. Last Accessed January 16, 2025.
(5) ICE Benchmark Administration Limited. LIBOR. Last Accessed January 16, 2025.
