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London Inter-Bank Offered Rate (LIBOR)
LIBOR stands for London Interbank Offered Rate. The London Interbank Offered Rate (LIBOR) 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 as a globally accepted key benchmark interest rate that indicates borrowing costs between banks. The rate is calculated and will continue to be published each day by the Intercontinental Exchange (ICE).
In the 1980s, Interest rate-based products began evolving in the market. In 1984, The British Bankers’ Association (BBA)—which represented the banking and financial services industry—set up BBA interest-settlement rates.
Further streamlining led to the evolution of BBA LIBOR in 1986.
LIBOR is calculated using the following methodology:
- Waterfall Methodology: For each currency and maturity, LIBOR was calculated as the average rates provided by each of a panel of banks that submitted for that currency. A panel varied from 11 to 16 banks.
- Transaction-based Methodology: The first transaction-based level involves taking a volume-weighted average price (VWAP) of all eligible transactions a panel bank may have assigned a higher weighting for transactions booked closer to 11:00 a.m. London time.
How it works
- It is announced and published by the ICE Benchmark Administration (IBA).
- 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 seven different maturities.
- The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day.
- The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.
Uses of LIBOR
- It is used in various financial products. Standard interbank products like forward rate agreements (FRA), interest rate swaps, interest rate futures, options, and swaptions.
- Commercial products like floating rate certificates of deposits and notes, variable rate mortgages, and syndicated loans, it is a loans offered by a group of lenders.
- Hybrid products like collateralized debt obligations (CDO), collateralized mortgage obligations (CMO), and a wide variety of accrual notes, callable notes, and perpetual notes
- Consumer loan-related products like individual mortgages and student loans
Alternatives to LIBOR
- India has the Mumbai Interbank Offered Rate (MIBOR). Europe has the European Interbank Offered Rate (EURIBOR), Japan has the Tokyo Interbank Offered Rate (TIBOR), China has Shanghai Interbank Offered Rate (SHIBOR)
Phasing Out LIBOR
- Although LIBOR has been used since the 1980s, regulatory reforms have begun in recent years to reform benchmark rates and ultimately replace LIBOR as the interbank borrowing rate.
- The secured overnight financing rate (SOFR) will replace LIBOR in 2023. The SOFR is also a benchmark interest rate used for dollar-denominated loans and derivative contracts.
Secured Overnight Financing Rate (SOFR)
- The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London Interbank Offered Rate (LIBOR).
- SOFR is based on transactions in the Treasury repurchase market and is seen as preferable to LIBOR since it is based on data from observable transactions rather than on estimated borrowing rates.
- While SOFR is becoming the benchmark rate for dollar-denominated derivatives and loans, other countries have sought their own alternative rates, such as SONIA and EONIA.
Current status in India
The Reserve Bank of India issued an advisory to banks and other RBI-regulated entities, emphasising the need to take steps to ensure a complete transition from the London Interbank Offered Rate (LIBOR) from July 1, 2023.
