What is LIBOR?

LIBOR Rate (London Interbank Offer) is an estimated rate which is calculated by averaging out the current rate of interest being charged by major prominent banks in London which serves as a benchmark rate for the financial markets domestically as well as internationally, where it can change on day to day basis given the changes in certain market conditions.

It is used as a benchmark for interest rate swaps, mortgages, and currency rate swaps. It is calculated by taking estimates submitted by leading banks in London and averaging them. It is published on a daily basis by the New York Feds daily on their official website at 8 AM ET.

• The LIBOR Rate (London Interbank Offered Rate) is an actual rate at which banks can borrow from each other rather than an estimated rate.
• It serves as a benchmark rate for the domestic and international financial markets and is subject to daily fluctuations due to changes in market conditions.
• The Intercontinental Exchange (ICE) LIBOR panel decides the LIBOR rate, which comprises banks with a notable position in the London financial industry. 
• The interest rate each of these institutions is willing to borrow and lend at is collected and used to determine the LIBOR rate.

London Interbank Offered Rate or LIBOR is a globally accepted benchmark interest rate that shows the borrowings between the leading banks. LIBOR rate is published on a daily basis by the New York feds based on the averages calculated from the estimates submitted by leading banks in London.

These rates are universally accepted as the base interest rate to price loans and other debt instruments by financial institutions worldwide.

LIBOR rate is regarded as the world's most important number since its origin in the mid-1980s. Its discontinuation in the next three years will bring about crucial changes in the financial market. Currently, it forms the basis of $260 trillion of loans and derivatives (Source: The Economist). Alternatives to LIBOR can be:

• Secured Overnight Funding Rate (SOFR) for US Dollar;
• Sterling Overnight Index Average (SONIA) for pound Sterling;
• Euro Short-Term Rate (ESTER) for Euro;
• Swiss Average Rate Overnight (SARON) for Swiss Franc; and
• Tokyo Overnight Average Rate (TONAR) for Japanese Yen.

These risk-free rates are based on active market transactions, which provide a barrier against manipulations. Alternative rates are published at different times and are also currency-specific against LIBOR.

These differences between LIBOR and its alternatives pose a few roadblocks that impede its smooth transition. However, no single clear alternative has been identified yet.

Following LIBOR manipulations by big banks, reforms emphasizing the submission of LIBOR based on transaction data and market surveillance were implemented. But LIBOR was still found to be very vulnerable. After much deliberation, the UK Financial Conduct Authority announced that LIBOR would be phased out by the end of the year 2021. Panel banks will support sustaining the system to bring about a smooth transition. Alternative risk-free reference rates based on transactions will be proposed for replacement.

Let us understand the components that dictated the interest rates between banks before the LIBOR replacement was introduced through the discussion below.

It is built on five currencies, namely the US dollar ($), Euro (€), British pound (£), Yen (¥), and Franc (Fr), and is compiled for seven different maturities:

1. Overnight
2. One week
3. 1 Month
4. 2 months
5. 3 months
6. 6 months
7. 12 months

Hence, a total of 35 LIBOR rates are calculated on each business day.

Intercontinental Exchange (ICE) LIBOR panel determines the LIBOR rate. Banks with a remarkable presence in the London financial market form this panel. These institutions are collectively asked about the rate they are willing to borrow and lend. The responses for each maturity are sent confidentially. The ICE Benchmark association then calculates the LIBOR using trimmed mean with positioning figures in the highest and lowest quartile and averaging the remaining.

After arranging all data in descending order Trimmed Mean Method removes the outliers (a small percentage of highest and smallest values). Then the standard arithmetic average is calculated for the rest. Removing outliers polishes the data so that a more realistic solution is derived. This is also known as the truncated mean.

Let us understand the concept of LIBOR rate in depth with the help of a couple of examples.

Example #1

Say, a group of 14 member banks propose the following as one year LIBOR rates:

• Normal mean= (3.9+3.5+3.1+3.4+2.6+2.7+2.8+3.2+3.6+3.7+3.8+2.9+2.5+2.8)/14
• = 3.17 %

Calculating 10% trimmed mean

Step 1: Arrange all data in descending order

3.9, 3.8, 3.7, 3.6, 3.5, 3.4, 3.2, 3.1, 2.9, 2.8, 2.8, 2.7, 2.6, 2.5

Step 2: Trimmed 5% of the data from the upper and lower end.

10% of 14= 1.4 ≈ 1

Step 3: New Data set

3.8, 3.7, 3.6, 3.5, 3.4, 3.2, 3.1, 2.9, 2.8, 2.8, 2.7, 2.6

• New mean = (3.8+3.7+3.6+3.5+3.4+3.2+3.1+2.9+2.8+2.8+2.7+2.6)/12
• = 3.175 %

The current one year LIBOR rate will be 3.175% in this case.

Example #2

In March 2023 the LIBOR rate exceeded 5% for the first time in 15 years. This hike in the interest rate is said to have come about due to the LIBOR transition that is taking place due to unethical and fraudulent practices.

From June 2023, the LIBOR system would cease to exist and would be replaced by SOFR. However, it is a vital benchmark that has exceeded its 15-year limit and reached 5.008% for the first time in two and a half decades.

Let us understand the advantages of the LIBOR rate through the discussion below.

1. LIBOR is now being used worldwide to set loan and deposit rates.
2. Bankers use London Interbank Offered Rate for hedging interest rate exposure. They place bets on the future direction of LIBOR. Panic-struck financial markets lead to an increase in LIBOR rates, thus protecting bankers.
3. London Interbank Offered Rate is a forward-looking rate. It is predefined before the start of the loan, and parties to the loan have a better idea of what to expect in the future, which eventually helps them manage their cash flow.
4. It is used as a benchmark for many other interest rates in different businesses.
5. London Interbank Offered Rate represents the lowest borrowing rate among big financial institutions.
6. London Interbank Offered Rate calculation is believed to be quite accurate and gives a decent idea about future interest rates.

It is also important to consider why it has been heavily criticised and the fact that a major LIBOR transition and a possible replacement is underway. Let us understand the disadvantages through the points below.

• There is a common perception that setting rates is flawed and prone to manipulations during the slowdown. British bank Barclays was imposed with a fine of $450 million after it agreed to make attempts to manipulate LIBOR.
• Most banks lend or borrow from each other only for very short periods, which LIBOR does not mostly cover. This difference between the benchmark and actual borrowing rates further doubts LIBOR’s authenticity.
• There is significant doubt over whether the London Interbank Offered Rate truly represents banks' funding costs.

The system has come under the scanner heavily and has been set to be replaced by other systems. It is important to understand its limitations to be able to fully understand the concept. Let us do so through the explanation below.

• Most banks borrow or lend for such short periods that it doesn't come under the purview of LIBOR. Hence, the absence of an underlying active market raises doubt over the sustainability of these benchmarks.
• Several reforms were implemented after Barclays, Deutsche Bank, and UBS were fined for manipulating LIBOR. But the entire process still has loopholes, and the rates are mere estimates rather than based on transactions.

This has been a guide to LIBOR rate and its meaning. Here we explain how to calculate the LIBOR rate and the practical examples, advantages & disadvantages. You can learn more about corporate finance from the following articles –

• Equity Swaps
• Examples of Derivatives
• Swap Rate
• Line of Credit