The London Inter-Bank Offered Rate or LIBOR is an interest rate, released on a daily basis by the Intercontinental Bank Exchange (ICE). LIBOR signifies the daily interest rate at which banks around the globe provide short term loans to each other. For a better understanding of the various aspects of LIBOR, let’s start at the very beginning.
The rapid development of the market for products based on interest rates led to the need for uniformity among financial institutions.
In 1986, there were only three currencies with their rates fixed under LIBOR. These were the British pound sterling, the Deutsche mark and the US dollar. Till the creation of the euro, this list included 16 currencies.
Following the merger of several European currencies to form the euro in 2002, the LIBOR currencies were reduced to ten.
The reforms of 2013, under the Wheatley Review, reduced the list to five currencies, the euro, Swiss franc, Japanese yen, and the US dollar. As of 2019, LIBOR is calculated for these five currencies and seven maturity rates, including overnight, one week, one month, two months, three months, 6 months and 1 year, making it a total of 35 rates per day.
Most often, LIBOR rates are closely correlated with short-term Treasury rates. However, during times of financial crisis, the rates tend to sharply rise, while Treasury rates decline. A key example of this was during the 2008 credit crisis.
There is a specific group of banks assigned to each currency and tenure pair in the LIBOR panel. The ICE Administration considers only banks that play an active role in the London market as eligible.
To calculate LIBOR for a particular pair, member banks are asked what rate they would charge for a loan of a particular tenure.
Once the responses of all the banks are recorded, the calculation is done through the trimmed average method.
For this, the highest and lowest four values of interest are discarded. Then, the average of the remaining values is computed, which becomes the LIBOR for the day, for the currency-tenure pair under consideration.
ICE Benchmark Administration releases LIBOR rates every day at 11:45 am GMT.
LIBOR is one of the most important global benchmarks for short-term interest rates. In fact, derivatives and financial products worth more than $350 trillion are linked to this rate, especially the US dollar-denominated rates. LIBOR is usually considered the floating rate for future contracts, swaps, student loans, mortgages and corporate funding. It is also referred to while establishing the settlement price for interest rate futures contracts, which is used by companies to hedge against interest rate exposure.
So, keeping track of LIBOR can provide insight into the expectations of central banks and other important organisations regarding interest rates, going forward.
There are various ways to calculate LIBOR for an informed trading decision. An easy and quick way to determine market interest rate is to check quoted currency forwards and futures. This is because a forward contract is priced based on spot and a LIBOR (or comparable) contract for the specific maturity in question. What this means is:
Forward price = spot rate – interest rate differential of the currency pair.
For instance, if there is a 3% difference between two currencies in terms of their respective 12-month interest rates, the forward price on a 12-month forward contract would be discounted by 3%.
In addition, short-term interest rates give a fair idea of the market expectations of futures rates and even allow you to calculate the potential rise or decline in the rate that the market expects. This can help make informed trading decisions.
Although LIBOR panel members had earlier been accused of malpractice and manipulation of interest rates, the biggest controversy was witnessed in 2012.
A prominent newspaper, The Financial Times, published a report on July 27, 2012, in which a former trader disclosed that LIBOR manipulation by banks had been actively going on since 1991.
Subsequently, in September 2012, Barclays was slapped with a fine of £290 million as punitive action for its attempts to manipulate LIBOR rates. Employees who were directly involved in rate rigging were also punished. In addition, investigations were carried out against several other banks for their role in the manipulation.
The main motive behind this malpractice was to increase the profits of traders who had invested in LIBOR-based financial securities. Traders requested the banks to keep the interest rates at low levels and banks provided false rates to the BBA for LIBOR calculation.
As a result of this scandal, the control over LIBOR was transferred from BBA to the ICE Benchmark Administration.
UK’s Financial Conduct Authority announced on July 26, 2017, that it is considering removal of LIBOR by the end of 2021. The main reason cited for this was that in the current global market scenario, banks have slowly moved away from providing loans to each other. Since LIBOR is calculated using these loan transactions, a change in lending trends will make it difficult to calculate LIBOR accurately.
So, a global and reliable substitute for LIBOR is being searched for by the Bank of England as well as by the central banks of other countries, so that the existing system can be phased out.