The Use of LIBOR
Quoted as being ‘The World’s Most Important Number’, LIBOR is the reference rate for over $350 trillion worth of financial products at this current moment in time . It is essentially the average interest rate that major banks around the world borrow from one another, thus is ultimately passed down to consumers. If a consumer takes out a mortgage from a bank to pay for a car or home, then the typical interest that the consumer will pay is LIBOR + 3%. The interest rate is usually based on a short-term loan (anywhere between 3 months to 1 year) . It is the reference rate of various financial products that you might be familiar with, such as interest rate swaps, forward rate agreements, mortgages, and commercial loans.
LIBOR interest rates are calculated every day and announced at 11:45 am. Each bank (typically between 11 to 18 banks) submit the interest rate that they are willing to lend to other banks at . They do this for 10 currencies and loans ranging from overnight to a year (the most important being the 3-month LIBOR rate). The top and bottom quartiles of interest rates submitted by banks are discarded, then an average is calculated based on the remaining interest rates. This has been the method used since January 1st1986 and is a true reflection of the confidence banks have in each other’s financial health .
However, following the 27thof July 2018, The FCA’s head, Andrew Bailey, announced that LIBOR would be phased out by 2021 . It has had its fair share of controversy, most notably at the beginning of 2012. Very notable banks were colluding to manipulate these interest rates for profit. Swaps traders often asked those that submitted the LIBOR interest rates to submit rates that would profit traders, rather than the rates that they would pay to borrow money . These rates were continually manipulated depending on the trader’s position. The LIBOR scandal has had a very negative effect on the public’s trust in the marketplace. An example of its impact is the value of deals determined by Libor being revised down from $800 trillion to $450 trillion . Financial institutions were fined heavily and even result in the imprisonment of individuals. Reform in this system was very much needed.
There was a transition of the oversight of Libor being passed from the British Bankers’ Association to the Intercontinental Exchange – ICE . LIBOR rates are now based on actual transactions for which records are kept. As a result, it is much harder for banks to collude and manipulate these rates. Never the less, the need for a new benchmark rate is needed and we are still unsure what this rate (and how we calculate it) will be .
The Secured Overnight Financing Rate (SOFR) is a new US benchmark rate that the Federal Reserve has released. It is a broad measure of the cost of borrowing cash overnight through treasury securities, thus is looking highly likely to be the permanent benchmark in years to come in the US. It is calculated using hundreds of billions of dollars in actual transactions. As real data is being used from the Bank of New York Mellon; SOFR is a much more secured rate meaning lower volatility and lower rates . Currently, this rate sits at roughly 1.8%, whereas LIBOR sat at 2.82% at the end of 2018. As a result, a lower and less volatile rate can restore confidence in the global market. We will soon enough see the rise in transaction volumes .
We have already seen the effects of introducing SOFR. We saw in mid-July a US government mortgage agency issued $6bn worth of bonds with the interest rate SOFR. The world followed suit with a $1bn issuance and Credit Suisse being the first commercial bank to issue debt using SOFR. The only problem is that there are still many financial contracts that are tied up using LIBOR . As a result, may take many years to completely replace and find one benchmark rate worldwide.
I think that it was very surprising that LIBOR has been used for so many years (especially post 2012). In a day and age where the use of analysing large amounts of data is becoming paramount, it is strange that we continue to use such an outdated method based on opinion. I think the FCA’s decision was one to restore confidence in financial institutions. There are still many doubts in these institutions post the financial crash and action has now been taken. It will be interesting to see how long before SOFR is implemented globally, but the thought of cheaper borrowing costs very soon can surely keep consumers optimistic.