What is LIBOR?

What is LIBOR Rate?

LIBOR Rate (London Inter-Bank Offer) is an estimated rate which is calculated by averaging out the current rate of interest being charged by major prominent banks in London which serves as a benchmark rate for the financial markets domestically as well as internationally where it can change on day to day basis given the changes in certain market conditions.

What is LIBOR?

Components of LIBOR

It is built on five currencies namely the US dollar ($), Euro (€), British pound (£), Yen (¥), and Franc (Fr), and is compiled for seven different maturities:

  1. Overnight
  2. One week
  3. 1 Month
  4. 2 months
  5. 3 months
  6. 6 months
  7. 12 months

Hence, a total of 35 LIBOR rates are calculated on each business day.

Determination of LIBOR

Intercontinental Exchange (ICE) LIBOR panel determines the LIBOR rate. Banks with a remarkable presence in the London financial market form this panel. These institutions are collectively asked about the rate at which they are willing to borrow and lend. The responses for each maturity are sent confidentially. The ICE Benchmark association then calculates the LIBOR using trimmed mean with positioning figures in the highest and lowest quartile and averaging the remaining.

Trimmed Mean Method removes the outliers (a small percentage of highest and smallest values) after arranging all data in descending order. Then the standard arithmetic average is calculated for the rest. Removing outliers polishes the data so that a more realistic solution is derived. This is also known as truncated mean.

Example

Say, a group of 14 member banks propose the following as 1 year LIBOR rates:

Banks1 Year RateBanks1 Year Rate
Bank 13.9Bank 83.2
Bank 23.5Bank 93.6
Bank 33.1Bank 103.7
Bank 43.4Bank 113.8
Bank 52.6Bank 122.9
Bank 62.7Bank 132.5
Bank 72.8Bank 142.8
  • Normal mean= (3.9+3.5+3.1+3.4+2.6+2.7+2.8+3.2+3.6+3.7+3.8+2.9+2.5+2.8)/14
  • = 3.17 %

Calculating 10% trimmed mean

Step 1: Arrange all data in descending order

3.9, 3.8, 3.7, 3.6, 3.5, 3.4, 3.2, 3.1, 2.9, 2.8, 2.8, 2.7, 2.6, 2.5

Step 2: Trimmed 5% of the data from the upper and lower end.

10% of 14= 1.4 ≈ 1

Step 3: New Data set

3.8, 3.7, 3.6, 3.5, 3.4, 3.2, 3.1, 2.9, 2.8, 2.8, 2.7, 2.6

  • New mean = (3.8+3.7+3.6+3.5+3.4+3.2+3.1+2.9+2.8+2.8+2.7+2.6)/12
  • = 3.175 %

The current 1 year LIBOR rate will be 3.175% in this case.

Advantages

  1. LIBOR is now being used worldwide to set loan and deposit rates.
  2. Bankers use London Interbank Offered Rate for hedging interest rate exposure. They place bets on the future direction of LIBOR. Panic struck financial market leads to an increase in LIBOR rates, thus protecting bankers.
  3. London Interbank Offered Rate is a forward-looking rate. It is predefined before the start of the loan and parties to the loan have a better idea of what to expect in the future, which eventually helps them manage their cash flow.
  4. It is used as a benchmark for many other interest rates in different businesses.
  5. London Interbank Offered Rate represents the lowest borrowing rate among big financial institutionsBig Financial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.
  6. London Interbank Offered Rate calculation is believed to be quite accurate and gives a decent idea about future interest rates.

Disadvantages

  • There is a common perception that the method of setting rates is flawed and is prone to manipulations during the slowdown. British bank Barclays was imposed with a fine of $450 million after it agreed to making attempts to manipulate LIBOR.
  • Most banks lend or borrow from each other only for very short periods which are not mostly covered by LIBOR. This difference between the benchmark and actual borrowing rates further puts some doubt into LIBOR’s authenticity.
  • There is significant doubt over whether the London Interbank Offered Rate truly represents the funding costs of banks.

Limitations

  • Most banks borrow or lend for such short periods that it doesn’t come under the purview if LIBOR. Hence, the absence of an underlying active market raises doubt over the sustainability of these benchmarks.
  • After Barclays, Deutsche Bank and UBS were fined for manipulating LIBOR, a number of reforms were implemented. But the entire process still has loopholes and the rates are mere estimates rather than being based on transactions.

Goodbye LIBOR

Following LIBOR manipulations by big banks, reforms emphasizing the submission of LIBOR based on transaction data and market surveillance were implemented. But LIBOR was still found to be very vulnerable. After much deliberation, the UK Financial Conduct Authority announced that LIBOR will be phased out by the end of the year 2021. Till then, panel banks will support to sustain the system to bring about a smooth transition. Alternative risk-free reference rates, based on transactions will be proposed for replacement.

Conclusion

LIBOR rate, defined as a set of daily average rates, is a benchmark interest rate at which global banks borrow from or lend to one another in the international interbank market.

These loans are mostly unsecured. It stands for London Interbank Offered Rate.

These rates are universally accepted as the base interest rate to price loans and other debt instruments by financial institutions worldwide.

LIBOR rate is regarded as the world’s most important number since its origin in the mid-1980s. Its discontinuation in the next three years will bring about crucial changes in the financial market. Currently, it forms the basis of $260 trillion of loans and derivatives (Source: The Economist). Alternatives to LIBOR can be:

  • Secured Overnight Funding Rate (SOFR) for US Dollar;
  • Sterling Overnight Index Average (SONIA) for pound Sterling;
  • Euro Short-Term Rate (ESTER) for Euro;
  • Swiss Average Rate Overnight (SARON) for Swiss Franc; and
  • Tokyo Overnight Average Rate (TONAR) for Japanese Yen.

These rates are risk-free and are based on active market transactions which provide a barrier against manipulations. Alternative rates are published at different times and are also currency specific as against LIBOR.

These differences between LIBOR and its alternatives pose a few roadblocks that can impede its smooth transition. However, no single clear alternative has been identified yet.

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