London interbank offered rate libor

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• Interest Rate
• Floating Rate
• Benchmark Rate
• Financial Instrument
• Derivatives
• Money Market
• Credit Risk
• Repurchase Agreements
• Securities
• Central Banks
• Loans
• Fixed-Income
• LIBOR Scandal
• SOFR
• Financial Stability

What Is London Interbank Offered Rate (LIBOR)?

The London Interbank Offered Rate (LIBOR) was a global benchmark rate used for short-term unsecured borrowing between major banks. It served as a critical reference point for setting interest rates on various financial instruments and consumer financial products worldwide. LIBOR falls under the broader financial category of financial benchmarks and reference rates.

LIBOR was calculated for five currencies—U.S. Dollar (USD), Euro (EUR), British Pound Sterling (GBP), Japanese Yen (JPY), and Swiss Franc (CHF)—and seven different maturities, ranging from overnight to one year, resulting in 35 different rates published each business day.

#⁶⁴# History and Origin
The need for a uniform measure of interest rates emerged in the 1980s with the growth of interest rate-based financial products like interest rate swaps and forward rate agreements. In⁶², ⁶³ response, the British Bankers' Association (BBA) established the BBA Interest Rate Settlement Rates (BBAIRS) in 1984, which officially became BBA LIBOR in January 1986. In⁵⁹, ⁶⁰, ⁶¹itially, LIBOR was published for three currencies: the US Dollar, Japanese Yen, and British Sterling.

O⁵⁷, ⁵⁸ver time, LIBOR became an integral part of the global financial system, underpinning hundreds of trillions of dollars in financial contracts. Ho⁵⁵, ⁵⁶wever, following the global financial crisis of 2007-2008, concerns about its vulnerabilities and potential for manipulation came to light. Th⁵³, ⁵⁴ese concerns culminated in the LIBOR scandal, which revealed that some banks had manipulated their rate submissions for profit or to appear more creditworthy. Th⁵²is widespread misconduct led global regulators to initiate reforms and ultimately phase out LIBOR. Th⁵⁰, ⁵¹e UK Financial Conduct Authority (FCA) announced in 2017 that it could not guarantee LIBOR's existence beyond 2021, accelerating the transition to alternative rates.

#⁴⁸, ⁴⁹# Key Takeaways

• LIBOR was a widely used benchmark interest rate for short-term interbank lending.
• It was calculated based on submissions from a panel of major global banks.
• LIBOR served as a reference rate for a vast array of financial products, including loans, mortgages, and derivatives.
• Concerns about its susceptibility to manipulation led to a global effort to transition away from LIBOR.
• LIBOR was largely phased out by June 30, 2023, with the Secured Overnight Financing Rate (SOFR) becoming the dominant replacement for U.S. dollar-denominated contracts.

#⁴⁷# Formula and Calculation
LIBOR was not a single calculated rate in the way a yield is. Instead, it was an average derived from submitted rates. Each weekday morning, a panel of major banks would submit the rate at which they believed they could borrow funds, unsecured, from other prime banks in the London money market for various maturities and currencies.

T⁴⁵, ⁴⁶he calculation process, administered by the ICE Benchmark Administration (IBA), involved collecting these submissions. For each currency and maturity, the highest and lowest quartile (25%) of submissions were discarded, and the remaining rates were averaged to determine the daily LIBOR. Th⁴⁴is methodology aimed to mitigate the impact of outlier submissions.

Interpreting the LIBOR

LIBOR was interpreted as a key indicator of the health and stability of the global banking system and the cost of interbank borrowing. A rising LIBOR often suggested increasing credit risk or a tightening of liquidity in the financial markets, as banks perceived a higher risk in lending to one another. Co⁴³nversely, a falling LIBOR could indicate improving market confidence and lower borrowing costs.

Analysts and market participants used LIBOR to assess the funding costs of financial institutions, to price floating-rate instruments, and as a gauge of overall market sentiment. Its significance extended to influencing the expectations for future central bank interest rate decisions.

Hypothetical Example

Consider a multinational corporation, "Global Corp," that needed to borrow funds for a new project. In the past, they might have taken out a one-year, USD-denominated corporate loan with an interest rate tied to LIBOR. For instance, the loan agreement might state "LIBOR + 2%," meaning the company would pay the prevailing one-year USD LIBOR rate plus an additional 200 basis points.

If the one-year USD LIBOR was 0.50% at the time of an interest rate reset, Global Corp's interest rate for that period would be 2.50% (0.50% + 2.00%). As LIBOR fluctuated, so too would Global Corp's interest payments. This structure made the loan a floating-rate obligation, with its cost directly linked to the interbank borrowing market as reflected by LIBOR.

Practical Applications

Historically, LIBOR was used extensively across various sectors of finance:

• Corporate and Consumer Loans: Many adjustable-rate mortgages, student loans, and corporate loans had their interest rates tied to LIBOR, meaning their payments would adjust periodically based on changes in the LIBOR rate.
• ⁴¹, ⁴² Derivatives Market: A significant portion of the global derivatives market, including interest rate swaps, forward rate agreements, and options, referenced LIBOR for pricing and settlement.
• ⁴⁰ Securities and Bonds: Floating-rate notes and certain asset-backed securities and fixed-income products were also often benchmarked against LIBOR.
• ³⁸, ³⁹ Financial Planning and Valuation: Professionals in financial planning and asset valuation used LIBOR as a proxy for short-term interest rates in various models and analyses.

T³⁷he widespread use of LIBOR meant that its movements directly impacted borrowing costs for businesses and individuals, as well as the valuation of financial products globally. The transition away from LIBOR to new rates, particularly SOFR in the U.S., has required significant adjustments across these applications. Th³⁵, ³⁶e U.S. Federal Reserve, through the Alternative Reference Rates Committee (ARRC), played a significant role in guiding this transition and promoting the adoption of SOFR. The ARRC was a group of private-sector entities convened by the Federal Reserve Board and the Federal Reserve Bank of New York, working to ensure a smooth shift away from USD LIBOR.

#³³, ³⁴# Limitations and Criticisms
Despite its widespread adoption, LIBOR faced significant limitations and criticisms, primarily due to its susceptibility to manipulation and its reliance on expert judgment rather than actual transactions. The most prominent criticism materialized in the LIBOR scandal, which began to surface around 2012. It³² was discovered that some panel banks had colluded to submit artificially low or high rates to benefit their trading positions or to project an image of greater financial stability during the 2008 financial crisis. Th²⁹, ³⁰, ³¹is misconduct undermined the integrity of the benchmark and shook public trust in the financial system.

T²⁸he scandal led to substantial fines for numerous banks and raised serious questions about the ethical behavior within financial institutions. Fu²⁷rthermore, LIBOR's reliance on "expert judgment" submissions, particularly during periods of market stress when actual interbank lending volumes decreased, made it vulnerable and less representative of real market conditions. Th²⁶e lack of a robust, transaction-based methodology was a key factor in regulators' decision to replace LIBOR. Re²⁴, ²⁵cent developments have even seen UK courts overturning some convictions related to the LIBOR scandal, highlighting the complexity and ongoing scrutiny of the cases involved.

##²³ London Interbank Offered Rate (LIBOR) vs. Secured Overnight Financing Rate (SOFR)
LIBOR and SOFR are both benchmark interest rates, but they differ fundamentally in their underlying methodology and the type of borrowing they represent.

The primary confusion between LIBOR and SOFR stems from their shared role as reference rates for financial products. However, SOFR's transaction-based nature, rooted in the deep and liquid U.S. Treasury repurchase agreements market, makes it a more robust and reliable benchmark rate compared to LIBOR's reliance on polled estimates.

#¹⁰, ¹¹, ¹²# FAQs

Why was LIBOR phased out?

LIBOR was phased out primarily due to concerns about its integrity and susceptibility to manipulation, which became evident during the LIBOR scandal. Its reliance on subjective bank submissions rather than actual transactions made it vulnerable and less representative of true borrowing costs. Re⁸, ⁹gulators worldwide pushed for a transition to more robust, transaction-based alternative reference rates.

#⁶, ⁷## What replaced LIBOR?
The primary replacement for U.S. dollar (USD) LIBOR is the Secured Overnight Financing Rate (SOFR). Ot⁵her jurisdictions have adopted their own alternative rates, such as SONIA (Sterling Overnight Index Average) in the UK and EURIBOR (Euro Interbank Offered Rate) in the Eurozone.

#⁴## How does the end of LIBOR affect consumers?
For consumers, the end of LIBOR primarily impacts existing financial products, such as adjustable-rate mortgages, student loans, and other loans that were previously tied to LIBOR. These contracts have transitioned to alternative rates, most commonly SOFR, according to fallback language in their agreements or through legislative action. Co¹, ², ³nsumers with these products may see their interest rate calculations change, but the transition was designed to be as orderly as possible to minimize disruption.