What is the LIBOR rate?
LIBOR is one of those terms that tends to lose quite a few people in a discussion. However, it is just another piece in the alphabet soup of financial lingo. It stands for London Inter-Bank Offered Rate and is a benchmark interest rate based on the interest rates at which certain banks can lend unsecured funds to one another on that particular day. These banks are literally asked “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?”[1]. So why should you even care, especially since a significant portion of LIBOR was phased out at the conclusion of 2021? Well, as of 2013, LIBOR was incorporated in more than $300 trillion in financial contracts, including futures, variable-rate mortgages, and student loans[2]. Other sources estimated closer to $800 trillion in financial contracts. So, LIBOR affects quite a few people, even your average individual.
How is it calculated?
Now, there is more to calculating LIBOR than just asking banks at what rate they could borrow funds. Since there would be very obvious moral hazard involved if a panel bank’s opinion were the only factor, the calculation actually follows what is called a waterfall methodology. Essentially, this waterfall methodology ensures that a rate will be published no matter what. The first level is where the rate is calculated based off of a sufficient amount of eligible transactions. For these transactions a volume weighted average price is calculated with transactions booked closer to 11:00 am London time receiving higher weightings. If the panel bank does not have enough eligible transactions, then they must go down to level 2 where the rate is derived from the transaction data available. This involves using historical data of eligible transactions and weighting them with respect to their time from 11:00 am on the applicable day. Finally, if there is not enough data available to calculate the LIBOR rate after both levels 1 and 2 are exhausted, expert judgement (level 3) is used. All three levels are supposed to be compliant with the IBA’s (ICE Benchmark Administration) rules. Also, a diagram of this waterfall method can be seen below.
Each panel bank must do this for each currency they are required to submit for. In total, there were five different currencies for LIBOR (U.S. Dollar, Euro, Swiss Franc, Pound Sterling, and the Japanese Yen) as well as each currency have seven different tenors reported (overnight, one week, one month, two months, three months, six months, and one year) leading to 35 different rates to be reported each applicable London business day. A table consisting of the individual panel banks and which currencies they had to report can be seen below.
Once every panel bank has submitted their rates, a trimmed average is taken for each currency-tenor pair. The top and bottom quartiles are trimmed, and the rest of the submitted rates are averaged for the daily LIBOR rate.
What are eligible transactions and counterparties
As noted in the above section, the waterfall methodology is used for the eligible transactions of the panel banks, so what are some examples of transactions that are eligible? Remember that LIBOR is for unsecured funding markets, therefore eligible transactions would include things like unsecured time deposits, commercial paper, and certificates of deposit.
Also, transactions have two sides, so only eligible transactions with certain counterparties can be used. Examples of eligible counterparties include other banks, sovereign wealth funds, central banks, government entities, non-bank financial institutions, and a few others. More information on both eligible transactions and counterparties can be found in the USD LIBOR Methodology paper by the IBA linked in the reference section of this post.
So which Levels are actually being reported?
Due to an array of scandals over the past couple decades LIBOR has been getting phased out. Only the USD LIBOR is calculated with this panel bank waterfall methodology now and the amount of tenors went down to five (overnight, one month, three months, six months, and one year). Also, the Japanese Yen and the pound sterling synthetic LIBOR rates are set to end at the conclusion of 2022. The other LIBOR currency-tenor pairs were to no longer be used as of January 1st, 2022, and even the USD one is set to end after June 30th, 2023. This 18-month transitions period is to aid in the transition of financial contracts based on LIBOR over to their new benchmarks.
So, with the hierarchy for the waterfall method explained above, we know there are different levels where the LIBOR rates can be submitted. Therefore, it is important to know the composition of these rates, meaning at which levels they are actually reported because then we can understand how they are being decided. For example, above is bar graph of the USD tenors with their percent composition of each level the panel banks had submitted their rates.
In the bar graph, the light blue (bottommost) is for level one submissions, the black (middle) is for level two submissions and the dark blue (topmost) is for level three submissions. As you can tell, there is a lot of dark blue, meaning that most of the submissions from panel banks were based on expert judgment rather than actual transaction data. For example, the Overnight/Spot next rate for USD had about 60% of its submissions from level one and the rest come from level three, however its 12-month rate had about 80% of its submissions be level three submissions and the rest form level two. Interestingly, the USD LIBOR was the currency with the most of its submissions based on transaction data or data derived from historical transactions (levels one and two), the Swiss Franc on the other hand, was almost exclusively decided by level three submissions (expert judgement). The bar graph for the rest of the currency-tenor pairs can be found at “ICE LIBOR Evolution” paper by the Intercontinental Exchange linked in the references.
A possible reason for so little of the submissions being based on transactions could be from a lack of volume of eligible transactions, making it necessary to decide upon expert judgement. The panel banks just do not borrow in the unsecured markets as much as they used to, causing there to be an insufficient amount of transaction upon which to calculate LIBOR. This concept is reinforced by sections in Joseph Wang’s book Central Banking 101. This is one reason why the global financial system is transitions away from LIBOR towards alternative benchmarks which are based upon real transaction data.
Uses of LIBOR
So why is some interest rate formulated over in London subject to a blog that has be mostly about the Federal Reserve up to this point? As you can infer from there being five different currencies in which LIBOR was published, LIBOR itself is global in scope. It is used as a benchmark rate for many different financial contracts, and not just the ones that are institutional in nature. LIBOR was used by many financial institutions as a benchmark for consumer financial products as well such as variable rate mortgages and credit cards. To the point that some contracts will explicitly state that their rate is “LIBOR + x%”, where “x” is the premium, they add to LIBOR to ensure they profit. For these loans/lines of credit, your interest rate moves in tandem. Other examples of financial contracts that could be directly linked to LIBOR include government debt, corporate debt, auto loans, student loans, and over half of the United States’ flexible-rate mortgages[6].
History
The history of LIBOR is a quite interesting one. As one can expect by a majority of the panel bank submissions coming from expert judgment, and the banks having a direct interest in manipulating the rates, that is exactly what happened. LIBOR’s history is one of scandal and conflicts of interest. Now, is this the reason for the systems transition away from it? Possibly, but probably not the only reason. A study of the history of money and banking reveals that scandal and conflicts of interest are essentially synonymous with money and banking, but that is not the purpose of this post. For our purposes here, we will just discuss the origins of LIBOR and some insights into its recent scandals and manipulations, leaving the moral judgements to the reader.
Origins of LIBOR
The origins of LIBOR go back to the late 1960s where it was created to aid in syndicated loan transactions as well as increase the transparency of their pricing. However, with the immense growth of the loan market and the advent of new financial instruments, especially derivatives, a consistent and reliable benchmark interest rate was necessary. This resulted in the British Banker’s Association (BBA) to take control over LIBOR in 1986, causing the rate to be published as “BBA LIBOR” from January 1986 to January 2014[7]. Starting in February 2014, the ICE Benchmark Administration Limited (IBA) assumed the administrator role for LIBOR. The change in administrators was due to the belief that LIBOR should be run by a private organization with a “rigorous tender process” from an independent committee. The IBA was recommended and accepted to fulfill this role[8].
Other changes that happened during the evolution of LIBOR include adjustments to the membership to be a panel bank for each currency, introducing and removing different currencies throughout the years including consolidating currencies into the Euro when it was established, as well as changing of the survey question asked to the panel banks asked each applicable London business day.
LIBOR’s manipulation
Recall above bar graph of the USD panel bank submission levels. Consider that the majority of all tenors, excluding the overnight/spot next tenor, were level three submissions which are based on expert judgement rather than data based upon or derived from actual transactions. Also, remember that LIBOR is used as a benchmark rate for many different financial contracts, the same financial contracts that the panel banks themselves profit from. Therefore, the panel banks have an incentive to manipulate to LIBOR rate to their benefit, which is exactly what they did. International investigations in the early 2010s revealed that these manipulations of LIBOR were in fact taking place by some of the biggest players, possibly even as early as 2003. The culprits on the list include Deutsche Bank, Barclays, the Royal Bank of Scotland, as well as others[9].
Essentially, the banks would manipulate LIBOR so that their traders could profit from trading the derivative which were pegged to the benchmark rate. Due to this trading, more than a hundred traders and brokers were fired or suspended and billions of dollars in fines were paid. The total amount of fines ended up being around $9 billion for rigging the benchmark rate, but keep in mind that this is the same rate that underpins multiple hundreds of trillions of dollars in financial contracts globally, so judge that fine how you will[10].
As an example of the manipulation, swaps traders at a bank would ask the employees of their bank that submitted the rates to provide figures that would be beneficial towards the traders. Therefore, the banks essentially fixed the rates so that their own traders (therefore their bank) would profit. Now, since LIBOR is an average of the applicable submissions of panel banks, an individual bank’s submission did not completely fix the rate, however it could definitely influence the average and possibly move it in a beneficial direction, especially with multiple panel banks doing the same thing.
Besides just influencing the rate to the benefit of their traders, some panel banks also reported that they could borrow money at more inexpensive rates to make the bank appear less risky. This would be especially beneficial during times of turmoil, such as the GFC.
In response to this manipulation of LIBOR, legislation was passed including the creation of the Financial Conduct Authority (FCA), which is a centralized government agency with the power to investigate into and regulate financial markets including LIBOR. Also keep in mind that a lot of this manipulation occurred before and during the global financial crisis of 2007-2008, which saw an influx of multiple pieces of legislation that made participation in unsecured lending (what LIBOR measures) unattractive for commercial banks. Therefore, interbank lending in unsecured money markets have decreased significantly, virtually disappearing[11].
The strengthening of LIBOR
On top of the new legislation regulating LIBOR, the IBA developed a code of conduct for the panel banks that established a framework within which the panel banks must operate and submit their rates. This code of conduct provides guidelines for the submission as well as governance requirements for the panel banks so that they remain compliant.
Working in tandem with the code of conduct, the IBA also maintains an oversight committee for LIBOR which is responsible for reviewing the submission methodology, overseeing any changes to the benchmark, and ensuring the Code is up to date and the panel banks remain compliant. This LIBOR oversight committee consists of some panel banks, entities that use LIBOR for their contracts, members of the IBA and other “relevant experts”[12]. Representatives of major central banks (the Fed and the Bank of England for example) also sit on the committee as observers.
The end of LIBOR?
You may have noticed I used past tense with regards to certain parts of LIBOR throughout this piece. That is because those aspects were phased out as of the end of 2021. As announced by the FCA, the following currency-tenor pairs ceased to be published after December 31st, 2021:
- CHF and EUR – all tenors
- USD – 1 week and 2-month tenors
- GBP and JPY – overnight/spot next, 1 week, 2 months, and 12 months
The remaining tenors are set to cease after June 30th, 2023, giving the market time to find or create alternative benchmarks relative to their industry. However, allegedly the majority of the market participants that have engaged with the IBA have asked them to identify a framework to enable the continued publication and use of LIBOR, likely due to its foundational role in global finance. Its cessation would lead to very interesting secondary consequences for consumers as various forms of adjustable-rate consumer debt are tied to LIBOR, so seeing a transition to a new benchmark would have effects that cannot be known until the nuances of the new (possible) benchmark are ironed out.
To your wealth and future,
James Forsythe
For more on the monetary system:
https://jamesdforsythe.com/category/monetary-system/banking-system/
[1] Intercontinental Exchange, “ICE LIBOR Evolution” April 25th, 2018. Pg. 4
https://www.theice.com/publicdocs/ICE_LIBOR_Evolution_Report_25_April_2018.pdf
[2] D. Hou, D. Skeie, “LIBOR: Origins, Economics, Crisis, Scandal, and Reform”, Federal Reserve Bank of New York Staff Reports, Staff Report No. 667, March 2014. Pg. 2
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr667.pdf
[3] https://www.theice.com/iba/libor
[4] Intercontinental Exchange, “ICE LIBOR Evolution” April 25th, 2018. Pg. 8
[5] Intercontinental Exchange, “ICE LIBOR Evolution” April 25th, 2018. Pg. 19
[6] https://www.cfr.org/backgrounder/understanding-libor-scandal
[7] Intercontinental Exchange, “ICE LIBOR Evolution” April 25th, 2018. Pg. 4
[8] Ibid. Pg. 5
[9] https://www.cfr.org/backgrounder/understanding-libor-scandal
[10] Ibid.
[11] Central Banking 101, Joseph Wang, New York 2020
[12] Intercontinental Exchange, “ICE LIBOR Evolution” April 25th, 2018. Pg. 6
Not cited but helpful
ICE Benchmark Administration, “USD LIBOR Methodology”, https://www.theice.com/publicdocs/USD_LIBOR_Methodology.pdf
