LIBOR is an acronym of London InterBank Offered Rate. LIBOR is an indicative average interest rate used on the London money market. The rate is set by a selection of banks known as the panel banks. It is the rate at which these banks are prepared to lend one another unsecured funds. The term LIBOR interest rate is actually a misnomer as there are a number of different LIBOR interest rates. The rate is calculated for 7 different maturities
Overnight/spot next, one week, one month, two months, three months, six months, and twelve months.
and for 5 different currencies
U.S. dollar (USD), Euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss Franc (CHF)
Official LIBOR interest rates are announced on a daily basis at approximately 11:45 a.m. London time by ICE Benchmark Administration (IBA).
For short-term interest rates, financial market observers, especially those involved in FOREX, consider the LIBOR benchmark to be the most important in the world. It is now used as the base rate for a wide range of financial and derivative products such as futures, options and swaps. Banks also refer to this interest rate as the base rate when setting the interest rates for loans, savings and mortgages. It is often treated as the base rate for other products. Many brokerage accounts, including spread betting accounts refer to these rates when assessing interest rate charges for borrowings or when shorting stock. CFD’s on a stock index also make use of the rate. For this reason, LIBOR interest rates are intensely monitored by a large number of professionals and private individuals across the globe.
Background
The 1980’s saw a growing need amongst London’s financial institutions for a lending rate benchmark. During this time, derivative products such as interest swaps and options gained increasing importance. This led to the need for a benchmark rate in order to calculate the prices of these financial products. The British Bankers’ Association (BBA) initiated a number of steps from 1984 onwards which led to the publication of the first LIBOR interest rates in 1986. This was known as “bbalibor” referring to British Bankers’ Association Libor or the trademarked “bba libor“. The resulting rate became known simply as Libor or LIBOR. It is now officially referred to as ICE LIBOR or Intercontinental Exchange Libor.
Calculating LIBOR
On each working day at approximately 11 a.m. London time, the panel banks notify Thomson Reuters of what interest rate they would expect to be able to raise a substantial loan in the interbank money market at that moment for each maturity. Therefore, the LIBOR interest rate measurement is not based on actual transactions. This is due to not every bank borrowing substantial amounts for each maturity every day. Calculations based on observed transactions may produce small or non-existent sample sizes leading to wild fluctuations. After collecting the rates from all panel banks, Thomson Reuters employs what is known as a “trimmed mean” process. This eliminates the highest and lowest 25% of the values. An average of the remaining 50% middle values is then calculated. The result is the official LIBOR (bbalibor) rate.
The ICE Benchmark Administration (IBA) has constituted a designated panel of global banks for each currency and tenor pair. A total of 16 major banks, including familiar names such as Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS constitute the panel for U.S. dollar LIBOR. Only banks that have a significant role in the London market are considered eligible for membership of the ICE LIBOR panel with the selection process being held annually.
More recently, in April 2018 the IBA submitted a new proposal to strengthen the calculation methodology. This involves a standardized, transaction-based, data-driven, layered method referred to as the Waterfall Methodology.
- The first transaction-based level involves taking a volume-weighted average price (VWAP) of all eligible transactions. Panel banks may have assigned a higher weighting for transactions booked closer to 11:00 a.m. request time
- The second transaction-derived level involves taking submissions based on transaction-derived data from a panel bank if it does not have a sufficient number of eligible transactions to make a Level 1 submission.
- The third level requires expert judgment and comes into play when a panel bank fails to make a Level 1 or a Level 2 submission. It submits the rate at which it could finance itself at the request time with reference to the unsecured, wholesale funding market.
The Waterfall Methodology retains the trimmed average calculation.
Update
LIBOR has been in use since the 1980’s. However, in recent years regulatory reforms have begun to reform benchmark rates. Ultimately, these reforms will lead to the replacement of LIBOR as the interbank borrowing rate. U.K. regulators are expected to no longer require banks to publish LIBOR rates after 2021. This new system aims to remove the ambiguity surrounding interest rates that was present under the old methodology. The Secured Overnight Financing Rate (SOFR) is likely to replace LIBOR. The SOFR is also a benchmark interest rate used for dollar-denominated loans and derivative contracts. However, SOFR is based on actual observed transactions in the U.S. Treasury market as opposed to using estimations of borrowing rates.
Currently, alternative risk-free rates are being proposed for the different currencies covered by the LIBOR system
- US Dollar – the US Fed’s Alternative Reference Rates Committee (ARRC) has recommended using the Secured Overnight Financing Rate (SOFR)
- British Pound – the Sterling Over Night Index Average (SONIA)
- Euro – the Euro Short-Term Rate (€STR)
Traders are advised that as this information is subject to change and new proposals are adopted visiting the appropriate regulatory body for additional information is advised.
