What is LIBOR: History, Calculation, and Transition to SOFR

Introduction

Did you know LIBOR was one of the most accepted global benchmark rates, influencing trillions of dollars in contracts around the globe? Established in the 1960s, the London Interbank Offered Rate (LIBOR) was set as a benchmark interest rate on Eurodollar deposits held by London banks. For four-plus decades, LIBOR was a key standard for setting the interest rates charged on adjustable-rate loans, mortgage loans, and corporate debts.

In the last decade, LIBOR has faced several scandals that affected its reputation. Effective January 2022, LIBOR is not used to issue new loans in the U.S. It is replaced by the Secured Overnight Financing Rate (SOFR), which is a benchmark interest rate for derivatives and loans in USD. Experts consider SOFR to be a more accurate and secure pricing benchmark.

In this blog, we will understand what LIBOR is, what led to it being phased out as the benchmark rate, and how SOFR is replacing LIBOR in the US.

What is the London Interbank Offered Rate (LIBOR)?

The London Interbank Offered Rate (LIBOR) was the benchmark for setting the interest rates at which international banks offered financial products. It dictated the rate at which banks lent short-term loans and determined rates for adjustable-rate mortgages, asset-backed securities, and credit default swaps.

LIBOR rates were calculated for five currencies: the U.S. Dollar, the U.K. Pound, the Japanese Yen, the Euro, and the Swiss Franc. Reported for seven maturities and five currencies, there were 35 LIBOR rates, with the 3-month U.S. dollar rate being the most commonly utilized. Post-2008 financial crisis, LIBOR manipulation was seen as one of the key reasons leading to the crisis; this has resulted in LIBOR being phased out as the benchmark rate and replaced by the Secured Overnight Financing Rate (SOFR).

A Brief History of LIBOR 

As the market for interest rate based products expanded in the 1980s, the necessity for a standardized measure of interest rates across financial institutions became apparent. In response, the British Bankers’ Association (BBA), representing the banking and financial services sector, established BBA interest-settlement rates in 1984.

This initial framework underwent further refinement, leading to the introduction of BBA LIBOR in 1986. Serving as the default standard LIBOR rate for transactions within the global financial community, BBA LIBOR streamlined dealings between financial institutions, both domestically and internationally.

Over time, LIBOR underwent several transformations, including its transition from BBA LIBOR to ICE LIBOR in February 2014 following the Intercontinental Exchange’s administration takeover. Moreover, changes in currency occurred, with new currencies introduced while others were phased out or integrated, particularly after the introduction of euro rates. The 2008 financial crisis prompted a significant reevaluation of LIBOR, resulting in the reduction of several maturities for which rates were calculated.

LIBOR scandal

Following the 2008 recession, a sharp decline in economic activity was noticed and regulators became wary of over-relying on LIBOR, as they were based on global banks’ estimates and not on actual transactions. The drawback of this level of independence was exposed in 2012 when a lot of financial institutions were found manipulating their LIBOR rates. 

LIBOR’s association with controversies includes rate-rigging scandals among the major lending institutions, particularly involving practices related to interbank borrowing rates. Allegations were made that banks manipulated the benchmark rate to accommodate traders’ orders, helping them adjust the underlying rates in a way that would enable them to manipulate the prices of various financial securities. 

Another major problem that came with LIBOR was the manipulation related to credit default swaps (CDS). As the CDS rates were determined using LIBOR, these were manipulated by financial institutions and used to insure against risky mortgages and subprime mortgage defaults. As the real estate market crashed, poorly insured mortgages exposed the banks leading to bankruptcy declaration by major banks. This resulted in banks that were setting LIBOR rates, increasing the rate day by day, increasing the cost of loans and reducing interbank lending which escalated the crisis further. 

How Is LIBOR Calculated?

The LIBOR rates were calculated based on the rates submitted by 18 major global banks. These rates were not based on actual transactions but were rates that banks assumed they could pay if they had to borrow money from other banks on the interbank lending market. To strengthen and standardize the calculation, the Intercontinental Exchange (ICE) Benchmark Administration (IBA) introduced the waterfall methodology in 2018. 

Under this methodology trimmed mean average was used which was an important criterion when it came to LIBOR calculation. This was the safeguard measure undertaken to remove extreme highs and lows that could skew the rate calculations. This involved the IBA removing the four highest and lowest rate submissions and then taking an average of the other submissions to determine the LIBOR rate. 

What is the current LIBOR rate?

In the table below you will find the most recent and historical LIBOR (London InterBank Offered Rate) interest rates.

Uses of LIBOR

LIBOR serves as a key benchmark in various financial transactions worldwide. Here are five of the common uses of LIBOR:

1. Loan Pricing: Banks and financial institutions use LIBOR as a reference rate for setting interest rates on loans, including mortgages, student loans, and corporate loans.
2. Derivatives Contracts: LIBOR is widely used as a reference rate for pricing and settling interest rate derivatives, such as interest rate swaps, futures, and options.
3. Financial Instruments: Many financial instruments, such as bonds, floating-rate notes, and commercial paper, are tied to LIBOR, influencing their yields and returns.
4. Investment Portfolios: Investors and fund managers use LIBOR-linked securities to diversify their portfolios and manage interest rate risk.
5. International Transactions: LIBOR facilitates cross-border transactions and investments by providing a standardized benchmark for measuring interest rate exposures across different currencies and markets.

How SOFR Is Replacing LIBOR in the U.S.?

With strict banking regulations coming into being after the financial crisis, there was a drastic reduction in interbank borrowing and trading, which further impacted the reliability of LIBOR. With new rules that required banks to not share any interbank data after 2021, there was an increasing demand worldwide to identify an alternative rate. 

In 2017, the Federal Reserve (Fed) brought together an Alternative Reference Rate Committee, which selected SOFR as the new benchmark interest rate for all USD trades. 

SOFR is a benchmark interest rate for derivatives and loans (denominated in US Dollars) that has replaced LIBOR. It utilizes real transaction data, making it less prone to bias and hence preferred by regulators. SOFR captures the cost of borrowing on an overnight basis and in a manner that is secure. On average, $900 billion worth of FX trades during the day are used for the quotation of SOFR. 

On November 30, 2020, the Fed announced LIBOR’s retirement. By the end of 2021, banks were ordered to stop using USD LIBOR as the reference rate in all contracts. June 30, 2023, marked the retirement of LIBOR with the cessation of all LIBOR rates and the selection of SOFR as the new USD benchmark rate

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FAQs

1) What does LIBOR stand for?

LIBOR stands for the London Interbank Offered Rate. It’s the average interest rate at which major London banks lend to one another on the international interbank market for short-term loans, influencing various financial products and contracts globally.

2) What is a 3-month LIBOR?

The 3-month LIBOR is a key benchmark interest rate reflecting the average rate at which major banks in London offer unsecured loans to each other for three months. It serves as a widely used reference rate for various financial products and contracts globally.

3) Is LIBOR reliable?

While LIBOR was once considered reliable, scandals revealed manipulation, undermining its credibility. This led to a global transition to alternative benchmarks like SOFR. Consequently, LIBOR’s reliability has been questioned, prompting the need for more transparent and trustworthy reference rates.