After a recent scandal running into billions of dollars, and featuring a mathematically oriented British banker who is now lodged in Jail, the world has decided to give up on a very important number that shook households and corporations alike for decades.
Thanks to the scandal, and Tom Hayes , a famous number will last no more beyond 2021– the LIBOR.
What is the LIBOR?
LIBOR (Intercontinental Exchange London Interbank Offered Rate ) or ICE LIBOR is a benchmark interest rate that some of the world’s leading banks would charge each other for short-term loans and serves as the basis for calculating interest rates on various loans throughout the world.
It is calculated as number produced daily in response to a query on theoretical estimated rates of borrowing , posed to a group of large banks. These estimates are modified by stripping out the highest and lowest quartile estimates and averaging the rest to arrive at the final rate.
LIBOR is administered by the ICE Benchmark Administration (https://www.theice.com/factsheet/libor ) and is based on five currencies: the U.S. dollar (USD), euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF). There are a total of 35 different LIBOR rates each business day.
LIBOR interest rate fixings have been published since January 1st, 1986 and have since become deeply entrenched into the global financial markets.
The most widely used variant applies to borrowing dollars for three months. On July 18, 2018, the day this blog is written, LIBOR was 2.34 percent (During the 2008 crisis this exceeded 5.5%).
The six-month US dollar LIBOR, which was below 1% at the end of December 2015, rose to over 1.3% in December 2016, 1.8% in December 2017, and to around 2.5% in June 2018. This has happened as the US Fed tightening cycle began.
Why is LIBOR Important?
Almost about $350 trillion of international financial products and loans are linked to Libor, with a large chunk of these pegged to the dollar-based benchmark. From the smallest of loans to home borrowers to the largest of international transactions, LIBOR has traditionally served as the basis for decades.
There are other important financial benchmarks, of course — the Federal Reserve’s fed funds rate and the yield on the 10-year Treasury note among them — but Libor has emerged over time as the dominant rate for determining interest payments on almost all adjustable-rate financial products.
The rate is also the rate around which RBI allows corporate to borrow abroad – RBI recently allowed more flexibility in ECB borrowings (https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11267&Mode=0) and the maximum spread that corporates can offer debt to international investors. With bad loans-laden domestic banks turning conservative in lending, India Inc has taken recourse to external commercial borrowings (ECBs) for their funding requirements in the first two months of the current financial year. Total funds raised during this period via ECBs, at $5.264 billion, was 91 per cent higher than in the corresponding year-ago period and almost all of these are linked to LIBOR.
In the last few weeks of Q1FY19, giants like Reliance, Tata Steel, Bharti Airtel have all announced international borrowing programmes worth more than USD Bn all benchmarked to the USD Libor.
The Libor Labor!
Unlike actual transaction based rates like in stock markets, which are based on a public record of buys and sells, the LIBOR rate is something banks report based on their own proprietary observations, making it open to manipulation. Indeed, a recent and major manipulation scandal combined with less interbank lending to determine the rate has led a group comprised of industry participants and regulators to look for an alternative and plan for a transition over the next few years. 2021 is when LIBOR ceases to exist as regulators worldwide search for better options.
While India has its own MIBOR, (http://www.fimmda.org/modules/securitiesApproval/securitiesApproval.aspx?op=mibor) , the US is developing something called Secured Overnight Financing Rate (SOFR) whichis now published each business day by the Federal Reserve Bank of New York. Others have proposed using the Ameribor , which does what Libor is supposed to do: represent the true cost of funds. It is set by open-market transactions on the Chicago-based American Financial Exchange (AFX).
Another option is the BoE’s SONIA (Sterling Overnight Index Average) overnight rate which has joined the battle for global recognition.
The current uncertainty surrounding the transition away from LIBOR and the mechanics of that transition are enormous and too large to quantify for any likely impact. One would however expect reduced liquidity in LIBOR to worsen further once the replacement reference rates have been identified globally thereby making LIBOR nearly useless post the transition date, despite the potential for LIBOR rates to continue to be published.
Title Source: “The British Bankers Association’s London Interbank Offered Rate matters more than any other set of numbers in the world,” Donald MacKenzie , London Review of Books.