LIBOR: Explanation of Interest rate benchmark

What is Libor? (London interbank offered rate)

LIBOR represents the average interest rate at which major banks in London are willing to lend to each other in the international interbank market. Serving as a globally accepted benchmark that indicates borrowing costs between banks

LIBOR rates are calculated for five currencies including the US dollar, the euro, British pound, Swiss franc, and Japanese yen across seven maturities, ranging from overnight to one year.

These rates have historically had a significant impact on financial markets. Used for various financial products, including loans, derivatives, and bonds.

Borrowing Costs

As previously explained, Changes in LIBOR rates directly affect borrowing costs for financial institutions and other market participants. When LIBOR rates increase, it becomes more expensive for banks and corporations to borrow funds, leading to higher interest expenses and potentially tighter credit conditions. Conversely, a decrease in LIBOR rates can reduce borrowing costs and stimulate lending activity.

Derivatives and Swaps

As it serves as a reference rate for a wide range of financial derivatives and interest rate swaps. These instruments are used to manage interest rate risk, speculate on future interest rate movements, or adjust the terms of existing loans. Changes in these rates can impact the valuation of these derivatives and influence trading activity in the market.

Bond Markets

Many bonds, especially floating-rate notes, are linked to LIBOR. When LIBOR rates change, the interest payments on these bonds may be adjusted accordingly. Directly affecting the attractiveness of bonds and their prices. If investors anticipate changes in LIBOR rates, it can lead to increased volatility in bond markets.

Global Financial System

Changes in LIBOR rates can affect the cost of capital and borrowing conditions not only in the United Kingdom but also in international markets. Any disruptions or uncertainty surrounding LIBOR can create systemic risks and have ripple effects throughout the global financial system.

It's worth noting that the impact of LIBOR rates on financial markets has been changing recently. In response to concerns about its reliability and susceptibility to manipulation, global regulators and industry participants are transitioning away from LIBOR.

How is it Calculated?

The IBA receives the submissions from the panel banks, removes outliers, and calculates the average rate based on the remaining submissions. Every day, ICE (Intercontinental Exchange) reaches out to major banks worldwide to inquire about the interest rates they would charge for short-term loans to other banks.

The highest and lowest figures obtained are excluded, and the remaining numbers are used to calculate an average, known as the trimmed average. This average rate is then published each morning as the daily rate, ensuring that it reflects the most recent market conditions and is not a fixed or static figure.

Once it’s calculated its then published daily by the ICE Benchmark Administration (IBA) based on submissions from a panel of selected banks.

Rate Fixing

The calculated LIBOR rates are published each business day and are widely referenced in financial contracts. The rates are typically quoted as a specific tenor (e.g., 3-month LIBOR) and represent the interest rate that a bank would expect to pay to borrow funds for that period.

Are Libor rates still used in the UK?

The Financial Conduct Authority (FCA), which oversees LIBOR, had announced that it would no longer compel panel banks to submit rates for the calculation of LIBOR after December 31, 2021.

The decision to phase out LIBOR was made due to concerns about the reliability and robustness of the rate, as well as a decline in the interbank lending market that LIBOR was intended to reflect.

Meanwhile Regulators around the world, developed alternatives to also step away from LIBOR rates such as SOFR (secured overnight financing rate). As LIBOR rates officially retire on June 30, 2023.