The London Interbank Offered Rate (“Libor”) is an average of the estimated interest rates that big London banks would charge when borrowing from each other.[1] It is currently the chief benchmark rate for short-term interest rates globally,[2] with over $350 trillion of financial products pegged to the rate.[3] It’s also on its deathbed.[4]
Libor will be phased out by the close of 2021.[5] The reason: a 2012 investigation revealed that multiple financial juggernauts—Deutsche Bank, Barclays, UBS, and the Royal Bank of Scotland to name a few—had been manipulating LIBOR for profit for almost a decade.[6] With Libor’s forced retirement imminent, the financial sector is going to need to find a way to phase in a new rate while keeping the market on track.
How Libor Works
The British Banker’s Association (“BBA”), which in 1986 formulated the rate in response to a growing appetite for syndicated lending, described Libor as “the World’s Most Important Number.”[7] After the 2012 scandal, the Financial Conduct Authority (“FCA”), shifted administration of the daily rate from the BBA to the ICE Benchmark Administration (“IBA”).[8] The IBA is a UK-based, independent subsidiary of Intercontinental Exchange (“ICE”).[9] ICE is a private American exchange operator.[10] Every morning at 11:00 AM, a representative panel of banks submit their estimated borrowing costs to the Thomson Reuters data collection service.[11] After discarding the top and bottom quartiles, the calculation agent averages the remaining figures to determine the rate,[12] now known as ICE LIBOR.[13] Thirty-five ICE LIBOR rates are published each day: a rate is calculated for the U.S. dollar, the British pound sterling, the euro, the Swiss franc, and the Japanese yen at seven different maturities ranging from overnight to one year.[14]
What Went Wrong
Banks colluded to report rates that would benefit themselves and their traders instead of the actual rates at which they were making loans.[15] During the financial crisis, banks deliberately reported lower rates so it wouldn’t appear that they were having trouble borrowing money.[16] After Barclays settled with UK regulators in 2012—to the tune of 290 million pounds[17]— settlement documents evinced that traders had been manipulating the rate to boost their profits.[18] All in all, the cabal of Libor-rigging banks have been slapped with fines totaling about $9 billion.[19]
What Now?
On July 27, 2017, FCA head Andrew Bailey announced that Libor would be scrapped in 2021.[20] “We do not think we will complete the journey to transaction-based benchmarks if markets continue to rely on Libor in its current form,” Bailey said in a speech at Bloomberg’s London office.[21]
“There is a very important question here to which we need a robust answer, namely whether the better approach to transition would be to amend contracts to reference an alternative rate, or amend the definition of Libor through the fallback protocol to replace the current methodology with alternative reference rates.”[22]
The Alternative Reference Rate Committee (ARRC)—a committee of 15 large international banks created at the behest of various U.S. financial regulators to oversee the transition from U.S. Dollar LIBOR to a new benchmark rate—has finally settled on a new benchmark rate.[23] On June 22, 2017, the ARRC voted for a rate derived from an index of Treasury security-backed short-term loans known as repurchase agreements or “repo” trades.[24] The ARRC voted for the repo rate over the Overnight Bank Funding Rate (“OBFR”), an unsecured bank lending rate pinned to transactions in the Eurodollar and federal funds markets.[25]
In an attempt to reduce manipulation of the brand-new rate, it will rather be based on live, actual transactions and published by the Federal Reserve Bank of New York in cooperation with the Office of Financial Research.[26]
Across the pond, there’s support for replacing Libor with the already established sterling overnight index average, or SONIA. The Bank of England administers SONIA, which tracks overnight funding rates for banks and building societies—the UK’s analogs to American credit unions—in the sterling unsecured market.[27] The Bank of England expects SONIA to serve as the new benchmark rate in April 2018.[28] Japan has gone with TONAR, an unsecured overnight borrowing rate and Switzerland has chosen SARON, a rate based on their domestic repo market.[29]
The Hard Part
Getting U.S. financial firms to switch to the new rate won’t be an easy—or quick—task.[30] Libor is deeply imbedded in the financial sector with an estimated $350 trillion of contracts linked to dying rate.[31] Libor underpins everything from mortgages and student loans to instruments like interest rate swaps.[32] In addition, some of the contracts pegged to Libor won’t expire for another fifty years–long after Libor has been discarded.[33]
Furthermore, use of the new rate is expected to start next year on a voluntary basis and will take years for products based on the new rate to build strong liquidity.[34] It will also take some time for the new rate to find purchase in the minds of issuers and investors and some banks may try to keep contributing to Libor past 2021—as some investors may prefer the old rate.[35]
This is why Libor is limping along for another five years: to buy some time for regulators, institutions, and investors to implement and acclimate to the new rate. In the meantime, Libor lives, though its days are numbered.
[1] Liam Vaughn, Libor: The Rise and Fall of ‘The World’s Most Important Number’, Bloomberg (July 27, 2017, 5:00 AM), https://www.bloomberg.com/news/articles/2017-07-27/libor-the-rise-and-fall-of-the-world-s-most-important-number.
[2] James McBride, Understanding the Libor Scandal, Council on Foreign Relations (Oct. 12, 2016), https://www.cfr.org/backgrounder/understanding-libor-scandal.
[3] Liz McCormick & Rachel Evans, Death Knell of Libor Heralds Structured Notes Backed By . . . Libor, Bloomberg Markets (August 22, 2017, 8:48 AM), https://www.bloomberg.com/news/articles/2017-08-22/death-knell-of-libor-heralds-structured-notes-backed-by-libor.
[4]See David Reid, This scandal-hit interest rate used to set mortgages is to end in 2021, CNBC (July 27, 2017, 6:48 AM), https://www.cnbc.com/2017/07/27/scandalous-libor-rate-to-end-in-2021.html.
[5] Id.
[6] McBride, supra note 2.
[7] Vaughn, supra note 1.
[8] McBride, supra note 2.
[9] Id.
[10] Id.
[11] Id.
[12]Id.
[13] Ice Libor, https://www.theice.com/iba/libor (last visited Sept. 22, 2017).
[14] Id.
[15] Chad Bray, Libor Brought Scandal, Cost Billions — and May Be Going Away, N.Y. Times: Dealbook (July 27, 2017), https://www.nytimes.com/2017/07/27/business/dealbook/libor-fca-banks-andrew-bailey.html?mcubz=3.
[16] Vaughn, supra note 1.
[17] Harry Wilson, Barclays hit with £290m fine over Libor fixing, The Telegraph (June 27, 2012), http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9360580/Barclays-hit-with-290m-fine-over-Libor-fixing.html.
[18] Vaughn, supra note 1.
[19] Martin Arnold et al., FCA: Libor to end in 2021, Fin. Times (July 27, 2017, 8:16 AM), https://www.ft.com/content/529f8553-4edd-337a-8046-ad49e578a138?mhq5j=e6.
[20] Id.
[21] Id.
[22] Id.
[23] Katy Burne, Banks Pick New Reference Rate to Replace U.S. Dollar Libor, Wall St. J. (June 22, 2017, 7:01 PM), https://www.wsj.com/articles/banks-vote-on-new-u-s-reference-rate-to-replace-libor-1498163666.
[24] Id.
[25] Karen Brettell, Bank committee selects repo as Libor alternative for swaps, Reuters: #Intel (June 22, 2017, 4:26 PM), https://www.reuters.com/article/us-banks-libor-derivatives/bank-committee-selects-repo-as-libor-alternative-for-swaps-idUSKBN19D2NB.
[26] Joe Rennison, New Treasuries ‘repo’ rate to replace Libor, Fin. Times: OTC Markets (June 22, 2017, 11:01 PM), https://www.ft.com/content/fe1fbf76-5793-11e7-80b6-9bfa4c1f83d2?mhq5j=e6.
[27] Swaha Pattanaik, Breakdown: Killing Libor is a long, messy business, Reuters: #Breakingviews (Aug. 14, 2017, 5:23 AM), http://www.reuters.com/article/us-banks-libor-breakingviews/breakdown-killing-libor-is-a-long-messy-business-idUSKCN1AU0UP.
[28] The SONIA Interest Rate Benchmark, http://www.bankofengland.co.uk/markets/Pages/ benchmarks/sonia.aspx (last visited Sept. 22, 2017).
[29] Pattanaik, supra note 27.
[30] Burne, supra note 23.
[31] Pattanaik, supra note 27.
[32] Id.
[33] Id.
[34] Brettell, supra note 25.
[35] Pattanaik, supra note 27.
