In the current increasing interest rate environment, the debate about the controversial but nevertheless important benchmark has sparked off again. This is why, we thought it relevant to provide in the following article a refresher on the history and functioning of the London Interbank Offered Rate, as well as examine the possibility of the newly introduced indices to replace the long-lived LIBOR.
LIBOR is the short term interest rate that banks in the London’s money market are ready to borrow funds from each other on an unsecured basis. It is computed as an average of the quote submissions by the major players in the interbank market in each of the five currencies – USD, EUR, GBP, CHF, JPY, with maturities that range from overnight to 12 months.
In general, the benchmark rates provide a sense of stability in the financial markets for two main reasons. Firstly, the indexation of contracts to a benchmark rate for pricing these financial contracts helps to reduce complexity and promote standardisation. These range from lending rates, to mortgage and auto loans. Secondly, benchmark rates are also used to deal with balance sheet items as a discount rate. Here, for instance, we can use the discount rate in valuations for accounting purposes and for pricing instruments in the derivatives market. On the whole, as referenced by the Intercontinental Exchange Benchmark Administration (IBA) administering LIBOR since 2014, the total value of contracts using LIBOR as a benchmark rate is around $350tr. There are no comprehensive data about the exact number of contracts relying on LIBOR or the total notional, however it is estimated that IRS account for more than $220bn, exchange-traded interest rate futures for more than $30bn and FRA (forward rate agreements), syndicate loans and floating rate notes for another $50bn. Tens of billions of dollars of adjustable rate home mortgages depends on LIBOR, but it is impossible to come out with numbers here.
Scandal and Changes
One of the most significant scandals in the world of the financial markets hit the industry in 2008 – the manipulation of LIBOR by traders of an array of banks, some of which include Deutsche Bank, Barclays and UBS. This was made possible due to the way in which the rate is calculated. Indeed, the panel of banks is asked to provide the rate at which they would borrow funds in the interbank market prior to 11 am London time every day, for which the average is calculated. The scandal, however, saw bankers colluded while submitting their quotes, making moves that helped them gain enormous profits in other derivatives instruments.
However – since the scandal – the administration of the rate was moved from British Bankers’ Association to IBA. Furthermore, several revisions to the calculation of LIBOR were proposed. In the article of October 2016, our colleagues have discussed in great detail the methodology behind LIBOR, so we encourage you to have a look at it for a deeper analysis. However, the key point here is the construction of a rate based on actual data – the number of transactions among the players in the market. This has not been fully implemented as of yet, and the system of using so-called banks’ expert judgement, in the form of voluntary quotes, prevails (in 2015 only 30% of submissions were based on transaction volume). And largely due to the fact that interbank lending has decreased significantly following the financial crisis, the number of players has been increased to additionally include central banks, sovereign wealth funds, corporations, other non-bank financial institutions. Last but not least, the manipulation of the rate has been recognized as a criminal offence, in order to deter any attempt of repeating past mistakes.
Libor OIS Spread Widening
In 2016, Libor rose in response to money-market reforms, as the repatriation of cash held overseas brought U.S. firms to pull money from foreign dollar funds. Another possible reason is that the financial system is re-adjusting to a world of less Federal Reserve infused liquidity as the central bank unwinds its balance sheet and proceeds with tapering.
In 2017, Libor-OIS spread reverted back to lower level (15-20 bps), just to rise again at the beginning of 2018, and currently it’s sitting at 60 bps, but this time analysts see no stress coming from basis swaps, which means that banks are not facing counterparty risks right now. Higher funding costs naturally follow higher LIBOR, which are expected to be compensated with higher revenues coming from increased fixed-income volume.
One might wonder where this unexpected rise comes from, as other indicators of financial stress did not rise as much as LIBOR. The answer could be in how the FED is tightening its balance sheet: indeed, the rolling-off of assets result in over-supply of Treasuries, which – if not welcomed by liquidity on the other side of the book – leads to higher yields of Treasuries and higher LIBOR. Tapering does not influence OIS directly and that’s why it’s unchanged.
Recognition of the long-term unsustainability of the current LIBOR is leading countries to seek for alternatives. In fact, in July 2017 the CEO of the Financial Conduct Authority Andrew Bailey proposed year 2021 as the date by which market is highly advisable to transition to a new stable benchmark.
Whatever the new benchmark rate will be, the following are some of the potential risks associated with substitution of the currently existing rate. One of them is that liquidity may dry up in the LIBOR market, and given the high volumes of LIBOR-referenced contracts, a possibility of a systemic risk will loom. In addition, a certain consensus will have to be agreed upon so that compensating spread between LIBOR and the new benchmark rate is fair and reflective of the original interest rate and credit risk embedded within LIBOR. Finally, rolling over the contracts with maturities ahead of the replacement would present an enormous challenge.
The rate however will still have to be kept in the coming years to serve as a reference rate before new benchmark is developed.