Introduction to LIBOR

Introduction:

Speaking in simple terms, when you approach a bank for a loan, they charge you an interest rate, e.g. for getting a loan of $50,000, bank XYZ charges you 3.5% interest. Where do you think this 3.5% comes from? Credit card companies also charge you an interest rate if you do not pay your dues. Where does the interest rate come from?

All of those numbers come from LIBOR. Speaking with more finance jargons, when you enter an interest rate swap agreement, payment from Party A to Party B is based on a fixed-interest rate and payment from Party B to Party A is based on a variable-interest rate. For example, Bank ABC will tell XYZ that it will pay XYZ 4% of a notional amount while XYZ will tell ABC that it will pay ABC (LIBOR+1.5) % of the same notional amount.

Approximately $350 trillion of outstanding business in different maturities is dependent on LIBOR. It is also used to understand the health of the banking system and predict the future central bank rates.

People use LIBOR to hedge against their risk and to maintain a moderate risk portfolio but how and when they do it will be a little too complicated for this post.

So, now that we understood how important LIBOR is and what it does to the world economy, let us have a look at what exactly it is.

What is LIBOR:

The London Interbank Offered Rate (LIBOR) is the average interest rate at which major global banks borrow from one another. It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.

The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day. The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.

How is LIBOR calculated:

The ICE Benchmark Administration (IBA) has constituted a designated panel of global banks for each currency and tenor pair. For example, 16 major banks including: Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS constitute the panel for U.S. dollar LIBOR. Only those banks that have a significant role in the London market are considered eligible for membership on the ICE LIBOR panel. The selection process for this is held annually.

Every morning, before 11 a.m. GMT, IBA asks the respective panels one question, “At what rate would you be ready to lend or borrow funds to other banks”. Consequently, then the banks send their answers for each of the 7 maturities, confidentially.

As of April 2018, the IBA submitted a new Waterfall Methodology for determining LIBOR. It suggested using a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology for determining LIBOR.

- First Transaction-Based Level: Taking volume-weighted average price of all eligible transactions that the panel bank has given higher weighting for transactions closer to 11:00 am London Time

- Second Transaction-Derived Level: If the panel bank does not have enough eligible transactions to make a Level 1 submission, take submissions based on transaction-derived data from panel bank.

- Third Expert Judgment Level: If the panel bank fails to make level 1 and 2 submissions, it submits a rate at which it could finance itself with reference to unsecured, wholesale funding market.

IBA then calculates the LIBOR rate using Trimmed Mean. This doesn’t consider the numbers in highest and lowest quartiles, but averages the remaining numbers so that LIBOR is not skewed.

Thomson Reuters then publishes the LIBOR rates along with the contributing rates that banks had provided, by 11:45 am.

Now that you know how it is calculated, let’s take a look at how we are affected by it.

Case Scenario:

Let us say the LIBOR rate increases, which means banks want more interest if they are lending to some other banks. Thus, if Bank ABC wants to borrow money from Bank XYZ, then because of increase in the LIBOR rate, ABC will have to pay more e.g. 2%. Now customers who are planning to take out loans from ABC will have to pay a higher interest rate e.g. 5%. The 3% difference here is the commission that ABC will keep with them.

Now let us have a look at the problems with LIBOR and its calculation.

What is wrong with LIBOR:

What do you think can happen when you select a small number of banks and ask them to decide the LIBOR rate? Consider a scenario where you are reading through the wedding registry of a couple who are into games. You would find items like Xbox, PS4 – essentially, they will try to obtain gifts in their favor.

That is exactly what happened in 2012. LIBOR lost its credibility after banks including Barclays, Deutsche and UBS were fined for manipulating LIBOR submissions. Banks have been reluctant to submit quotes based on inactive markets with the risk of exposure to litigation.

LIBOR is also less of a robust, transactions-based market interest rate which makes LIBOR potentially unsustainable. Therefore, the future of LIBOR beyond 2021 is uncertain.

As USD LIBOR is used in large volume, and its lack of sustainability can be a threat to the financial institutions and their systems. To prepare in advance, many countries have come up with an alternative reference rate. For example, U.S. has come up with SOFR, U.K. with SONIA, Japan with TONAR etc.