The LIBOR is coming to an end, a victim of greed and fraud.
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The end of LIBOR
- The story: By December 2021, an iconic financial market indicator will breathe its last. The "London Inter-Bank Offered Rate (LIBOR)" will meet its end.
- LIBOR details: Every day around lunchtime in London, some of the worlds biggest banks, including American ones, estimate how much it would cost them, theoretically, to borrow money from another bank. They then email that number to the British Bankers Association (BBA), basically a lobbying group in London. The BBA tosses out the high and low estimates, and then averages the rest. That’s LIBOR. This is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves short-term loans with maturities from overnight to 1 year. But is is not limited to that, and also acts as a basis for Corporate and Government Bonds, mortgages, student loans, credit cards, derivatives and other financial products. Clearly, it covers, and impacts, the entire spectrum of financial products and pricing.
- LIBOR functioning - It is administered by the ICE Benchmark Administration (IBA), and regulated by the UK’s Financial Conduct Authority (FCA).
- LIBOR becomes the average interest rate at which major global banks borrow from one another. It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves 7 different maturity periods
- The combination of 5 currencies and 7 maturities leads to a total of 35 different LIBOR rates calculated and reported each business day.
- LIBOR 2012 scandal: In 2012, the global markets were hit by revelations about a massive LIBOR scam. While the target for the U.S. rate is set by the Fed, LIBOR is the average of self-reported interest rates major banks charge one another to borrow money. By colluding to manipulate LIBOR, the banks’ traders made a fortune by betting on assets influenced by the interest rate.
- The Libor scandal was a series of fraudulent actions, and arose when it was found that banks were falsely inflating or deflating their rates so as to profit from trades, or to give the impression that they were more creditworthy than they were.
- Libor underpins approximately $350 trillion in derivatives. So it affected the entire market.
- The mastermind was Tom Hayes, a mathematician and star trader at some of the world’s biggest banks. He was accused, at the end of 2012, of being the central figure in this scandal by both American and British prosecutors.
- LIBOR's death: Following scandals in LIBOR (2012) and questions around its validity as a benchmark rate, it is being phased out. The FCA confirmed in March, 2021 that 26 LIBOR settings will end on December 31, 2021. However, overnight, 1, 3, 6, and 12 Months US Dollar LIBOR settings will end only by June 30, 2023.
- Why significant: Since LIBOR is an indicator of the health of the financial system, and provides an idea of the trajectory of impending policy rates of central banks, and a total of $ 400 trillion of financial products are presently exposed to LIBOR, it is important! India has about $532 billion of external loans which are exposed to LIBOR. A transition away from the LIBOR poses certain challenges for banks and the financial system.
- LIBOR’s credibility was damaged by rate-fixing scandals in 2012. The panel banks submissions were alleged to be inaccurate or manipulated to project market strength.
- After the 2012 Wheatley Review, a number of reforms were introduced to reduce subjective input and make LIBOR a transaction-based benchmark. Thus, IBA became LIBOR’s administrator and FCA the supervisory authority for IBA.
- Alternative reference rates: The Secured overnight financing rate (SOFR) is being widely used as a substitute for LIBOR across the world. It is based on transactions in the US Treasury repo market. While LIBOR is an unsecured reference rate (submitted by banks), SOFR is an overnight secured reference rate. It is secured because it is transaction-based, collateralized and representative of wholesale borrowing. It is administered by the New York Fed that broadly measures the borrowing cash overnight with US treasuries as collateral. Other Benchmarks rates - (1) CHF - SARON; (2) EUR - ESTER; (3) GBP - SONIA (Already in use since March 31, 2021); (4) JPY - TONA. All these are having an overnight tenor as opposed to LIBOR which had a tenor from overnight to 1 year.
- Limitations of SOFR: Since it is based upon the repurchase (repo) markets, it is at the repo markets mercy. In September 2019 a spike in repo rates resulted in SOFR soaring from 2.14% to 5.25% in a single day.
- Summary: There are complexities involved in the shifting from LIBOR to another regime, and there may be a lot of volatility in the financial markets as the deadline arrives. The RBI has issued relevatn circulars giving the road map to the transition.
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