Since 1986 the London Interbank Offered Rate has been used as a major benchmark in the financial world.
It’s used by banks as a component of huge numbers of products and has a tremendous impact on everyday trading activities.
You can understand the trepidation many financial professionals feel when they consider replacing LIBOR.
Follow this guide to learn what LIBOR is and why LIBOR going away has become such a major point of concern.
What is LIBOR?
Many finance professionals will be able to give you an instant quote on the daily LIBOR rate but can’t define LIBOR to save their lives. LIBOR is a benchmark interest rate used to define risk for interbank transfers.
LIBOR is published every day and basically represents how risky large banks think it is to loan money to each other. Most people on the street have never heard about it and would be shocked by how important LIBOR is. LIBOR is generated daily by the U.K. Financial Conduct Authority (FCA).
LIBOR is based entirely on daily surveys completed by large banks around the world. It only takes unsecured loans into account, a type of loan between banks that is fast becoming extremely rare.
LIBOR is one of many measures that meet this need but for decades it has been used by the majority of major banks and trading houses. $350 trillion worth of financial markets rely on LIBOR. That’s trillion with a T.
The widespread use of LIBOR and the dependence of so many major markets make any attempt to replace it a major undertaking.
Is LIBOR Going Away?
During the 2008 financial crisis, LIBOR was brought into the spotlight for a short period of time. Because LIBOR was based entirely on self-reporting by major banks there was significant room for manipulation.
Immediately after the Dow Jones recorded it’s highest single-day fall ever LIBOR also shot through the roof. This reflected the level of risk banks felt existed for interbank trades but didn’t match the interest rate lowering efforts of major government institutions.
There were also many reports of banks manipulating results in their favor. This was especially apparent in derivatives trading. By raising or lowering their reported rates they were able to book major profits fraudulently.
This had the overall effect of chilling lending activities even further. LIBOR’s survey-based total meant that banks with no intention of making interbank loans were also inflating the interest rate. A transaction-based measure using figures from the previous 24 hours would have prevented this.
Several large banks are already making a move away from LIBOR because of the instabilities this exposed.
After this many major regulatory agencies, including the U.S. Federal Reserve and SEC, made a major push to replace LIBOR. In April of 2018, they took the step to establish a new transaction-based system to do so.
All indications are that LIBOR has a real expiration date and probably won’t last past 2021. At that point, the FCA has reported they will no longer have the ability to compel banks to provide them with information.
Why This is Such a Big Deal
As we mentioned previously as much as $350 trillion in financial transactions and markets are based on the LIBOR rate. It’s impossible to overestimate the impact removing this rate is going to have on financial markets.
Just replacing LIBOR as the benchmark rate in all the various software systems at banks and trading houses is a huge undertaking. When you add in the other indicators pegged to LIBOR you begin to see the true scale of the endeavor.
LIBOR is currently used in products such as:
- Interest Rate Swaps
- Interest Rate Futures/Options
- Forward Rate Agreements
- Variable Rate Mortgages
- Certificates of Deposit
- Accrual Notes
- Callable Notes
- Student Loans
This combination of importance in both institutional and personal finance makes the prospect of LIBOR going away very serious.
What’s Replacing Libor
While there is no clear consensus on what will replace LIBOR there are several major contenders. These include Secured Overnight Financing Rate (SOFR) and Sterling Overnight Index Average (SONIA).
The general thought is that any LIBOR replacement must be transactional in nature and include a very wide basis.
SOFR was created by a group of large banks and the Alternative Reference Rate Committee (ARRC). It was designed to be based on actual transactions rather than self-reporting from banks. SOFR uses the actual trades and loans made by major banks from the previous trading day to generate an impartial benchmark.
It was designed to work alongside LIBOR to allow banks the opportunity to slowly transition their systems away from LIBOR. The ARRC cited the massive pool of data used to calculate SOFR. It estimated that more than $800 billion of daily transactions are used.
Because SOFR is transactional there is no ability for banks to manipulate it in their favor. The only effect they could have on SOFR would be to make actual transfers and transactions.
SOFR was created with the goal of eventually replacing LIBOR for all U.S. benchmarking needs.
SONIA was set up by the Bank of England to help stabilize the overnight rates of Sterling trades between banks. It’s been in existence since 1996 and is based entirely on transactions between banks of unsecured Pound Sterling loans.
It doesn’t have the same pool of transactions to draw upon as SOFR does but it is still considered a very good transaction based benchmark. It has been expanded since it’s creation and is used as the benchmark rate for a wide range of index funds and transactions.
Sooner Rather Than Later
With a transition this massive it’s important to take steps now rather than later on down the line. The tremendous amount of money involved makes this a priority. When you also factor in the number of systems and indexes benchmarked using LIBOR it becomes apparent how big a deal LIBOR going away is.
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