What is LIBOR and why is it Going Away?

What is LIBOR?

The London Interbank Offered Rate (LIBOR) is a reference rate, and over time since the 1980s has become the dominant rate for most adjustable-rate financial products. A group of banks (panel banks) voluntarily report the estimated transaction cost for unsecured bank-to-bank borrowing terms ranging from overnight to one year for various currencies.

The number of currencies and maturities has fluctuated over time, but LIBOR is currently produced across seven maturities: overnight/spot, one week, one month, two months, three months, six months and one year. LIBOR rates are produced for the American dollar, the British pound sterling, the European euro, Japanese yen, and the Swiss franc, resulting in the current 35 rates.[1][2] The aggregated calculations behind the rates are supposed to reflect the average of what banks believe they would have to pay to borrow currency or the cost of funds for a specified period. However, because the contributions are voluntary, and the rates submitted are a subjective assessment of probable cost, LIBOR indices do not reflect actual transactions.

LIBOR rates became heavily used in trading in the 1980s, officially launched by the British Bankers Association (BBA) in 1986 and regulated by the Financial Conduct Authority (FCA), the independent UK body that regulates financial firms, since April 2013.[3] Until 2014, LIBOR was developed by a group of UK banks, under the BBA. The Intercontinental Exchange Benchmark Administration (ICE) took over administration of the rate in 2014 in an effort to give the rate credible internal governance and oversight – ICE created third-party oversight, which resolved the BBA’s inherent conflict of interest in generating a sound rate while also protecting its member institutions.

Why is LIBOR Going Away?

International investigations into LIBOR began in 2012 and revealed widespread efforts to manipulate the rates for profit, with issues discovered as far back as 2003. The investigations resulted in billions of dollars in fines for involved banks globally and jail time for some traders. More recently, in October 2018, a Deutsche Bank trading supervisor and derivatives trader were convicted of conspiracy and wire fraud in relation to LIBOR rigging.[4]

The scandal challenged the validity of LIBOR and deterred panel banks from continuing their involvement in LIBOR generation. Because LIBOR rates are collected by voluntary contribution, the number of banks contributing, and therefore also the number of underlying transactions, have waned in recent years. In July 2017, Andrew Bailey, Chief Executive of the FCA announced that LIBOR rates would only be formally sustained by the FCA through the end of 2021, due to limited market activity around LIBOR benchmarks and the declining contributions of panel banks. The FCA has negotiated with current panel banks for their agreement to continue contributing data towards LIBOR rate generation through the end of 2021.[5]

Even without the challenge of collecting contributions from panel banks, many regulators have expressed concerns with the representative scale of LIBOR and related issues of instability. The market of products referencing LIBOR dwarfs the transactions that LIBOR is supposed to represent. The New York Fed approximated that underlying transaction volumes for USD LIBOR range from $250 million to $500 million, while exposure for USD LIBOR as of the end of 2016 was nearly $200 trillion.[6]

What Solution are Regulators Proposing?

In 2014, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York (New York Fed) convened the Alternative Reference Rates Committee (ARRC) in order to identify best practices for alternative reference rates and contract robustness, develop an adoption plan, and create an implementation plan with metrics of success and a timeline. The Committee was created in the wake of the LIBOR scandals, with the intention of verifying some alternatives, though no formal change in LIBOR was announced until 2017. The Federal Reserve reconstituted this board to include a broader set of market participants in March 2018 with the updated objective of developing a transition plan away from LIBOR and providing guidance on how affected parties can address risks in legacy contracts language that reference LIBOR.

In June 2017, the ARRC announced the Secure Overnight Financing Rate (SOFR) as its recommended alternative rate, and the New York Fed began publishing the rate on April 3, 2018. In October 2017, the ARRC adopted a “Paced Transition Plan” with specific steps and timelines designed to encourage use of its recommended rate.[7]

The transition away from LIBOR impacts most institutions dealing in floating rate instruments. Stay updated with the RiskSpan blog for future LIBOR updates.

Footnotes