Libor: Explained
BY TIO Staff
|July 30, 2024The London Interbank Offered Rate, or LIBOR, is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves as a globally accepted key reference rate for financial instruments.
LIBOR is administered by the Intercontinental Exchange, which asks major global banks how much they would charge other banks for short-term loans. The rate is calculated using the Waterfall Methodology, a standardized, transaction-based, data-driven approach. The rate is published every business day in five currencies - U.S. dollar, Euro, pound sterling, Japanese yen and Swiss franc, and seven borrowing periods ranging from overnight to one year.
History of LIBOR
The concept of LIBOR originated in the 1980s when it was used for the first time to price an innovative syndicated loan facility, which was also an interest rate swap. The British Bankers' Association (BBA) took over the administration of LIBOR in 1986 and made significant changes to the process by which LIBOR rates were calculated.
However, the BBA's administration of LIBOR ended in scandal when it was revealed in 2012 that banks had been falsely inflating or deflating their rates to profit from trades. The revelation led to a loss of credibility in LIBOR, and the UK government decided to bring the administration of LIBOR under regulatory oversight. In 2014, the Intercontinental Exchange (ICE) took over the administration of LIBOR.
LIBOR Scandal
The LIBOR scandal was a series of fraudulent actions connected to the LIBOR and also the resulting investigation and reaction. The scandal arose when it was discovered that banks were falsely inflating or deflating their rates so as to profit from trades, or to give the impression that they were more creditworthy than they were.
LIBOR underpins approximately $350 trillion in derivatives. It is currently administered by Intercontinental Exchange, which took over the role from BBA in February 2014.
How LIBOR is Calculated
LIBOR is calculated using a trimmed average. This means that after the banks submit their interest rates, the highest and lowest 25% of submissions are excluded from the calculation. The remaining 50% (the middle values) are averaged to create the LIBOR rate.
The calculation is carried out five times for five different currencies (U.S. dollar, Euro, pound sterling, Japanese yen, and Swiss franc), and for seven different maturities (overnight, one week, and one, two, three, six, and twelve months), giving a total of 35 different LIBOR rates.
Contributing Panel Banks
The panel of contributing banks is intended to reflect the range of banks that are active in the London interbank market. The panel includes banks from the United States, Canada, Europe, and Asia. Each bank estimates what it would be charged were it to borrow from other banks. The top and bottom quartiles of these estimates are then excluded, and the LIBOR rate is the average of the remaining estimates.
The panel is reviewed annually to ensure that it continues to be representative of the market it is intended to reflect. The selection of the panel banks is based on the market activity of the banks, and not on their size.
LIBOR and Trading
LIBOR is a significant factor in the world of finance and trading. It is the benchmark rate at which banks lend to each other, and it is used as a reference rate for a wide range of financial products, including derivatives, bonds, loans, and structured products.
For traders, changes in the LIBOR rate can impact the profitability of their trades. For example, if a trader has a position in a financial instrument that is tied to the LIBOR rate, changes in the rate can affect the value of the instrument and the potential return on the trade.
Impact on Forex Trading
In the foreign exchange market, or forex, LIBOR is used as a benchmark for short-term interest rates in various currencies. This can impact forex trading in several ways. For example, if the LIBOR rate for a particular currency increases, it could lead to an increase in the value of that currency relative to other currencies.
On the other hand, a decrease in the LIBOR rate for a currency could lead to a decrease in the value of that currency relative to other currencies. Therefore, forex traders closely monitor changes in the LIBOR rates for the currencies they are trading.
Future of LIBOR
Despite its widespread use, the future of LIBOR is uncertain. Following the scandal in 2012, regulators have been working on developing alternative reference rates. In the United States, the Secured Overnight Financing Rate (SOFR) has been proposed as a replacement for USD LIBOR. In the UK, the Sterling Overnight Index Average (SONIA) is being considered as a replacement for GBP LIBOR.
Transitioning from LIBOR to a new reference rate is a complex process that involves significant changes to the systems, processes, and contracts of financial institutions. Despite the challenges, the transition is necessary to ensure the integrity and reliability of the global financial system.
Challenges in Transition
The transition from LIBOR to a new reference rate poses several challenges. One of the main challenges is the lack of liquidity in the markets for the new rates. This could make it difficult to obtain reliable, transaction-based rates, especially for longer tenors.
Another challenge is the need to amend contracts that reference LIBOR. Many financial contracts, such as loans and derivatives, reference LIBOR and will need to be amended to reference the new rates. This is a complex and time-consuming process that requires the agreement of all parties involved.
Conclusion
LIBOR is a crucial part of the global financial system, serving as a benchmark for short-term interest rates around the world. Despite its importance, the future of LIBOR is uncertain due to the need for a more reliable and transaction-based reference rate.
As the world transitions to new reference rates, it is crucial for traders and other market participants to understand the implications of these changes and to prepare for a post-LIBOR world.
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