While many know the term LIBOR, some may not know exactly what LIBOR means, and even more may not know that LIBOR will likely be replaced by the end the 2021.
LIBOR, short for London Interbank Offered Rate, is the benchmark rate that banks will charge each other for short-term loans. Prior to August 2014, the British Bankers’ Association administered LIBOR.
There are different maturity rates that are provided for, including overnight, one week, one month, two months, three months, six months and one year. In addition, LIBOR is quoted in five different currencies including the US dollar, the Euro, the pound sterling, the Swiss franc and the Japanese yen. The ICE Benchmark Administration currently will calculate rates for the different maturities based on the submitted rates by the member banks (anywhere from 11 to 18 banks). This calculated rate is considered LIBOR, and published on a daily basis.
While this is a technical description, LIBOR, practically speaking, is often used as the interest rate, or the basis for calculating the interest rate for loans issued in the United States and worldwide. According to the ICE Benchmark Administration LIBOR Summary issued in 2016, the term LIBOR is referenced in an estimated USD $350 trillion of outstanding contracts, with maturities ranging from overnight to more than 30 years.
In 2012, an investigation into LIBOR was launched, which revealed that certain banks, including Barclays, UBS and Deutsche Bank, to name a few, were manipulating these interest rates to create additional profits for the banks. This was allegedly done by these banks colluding to submit false rates, such that the average calculated for LIBOR would not be an accurate representation of the true lending rates. As a result, the practice hurt individuals and companies that held LIBOR-based lending, and even those with credit cards, as many credit cards have their rates based off LIBOR.
Because of this scandal, the ICE Benchmark Association took over the administration of LIBOR and the calculation of LIBOR rates is now based on the rates of actual transactions recorded, as opposed to rates submitted by the banks.
With LIBOR scheduled to be phased out by the end of 2021, there is concern regarding what will be used as its replacement. With such a large amount of borrowings being tied to LIBOR, the change could have significant impacts.
As of now, there is no final decision regarding the LIBOR replacement. British regulators are currently pushing for the Sterling Overnight Index Average (SONIA) as the LIBOR replacement. One pushback against currently using SONIA is that SONIA only provides an overnight rate, as opposed to rates for different maturities as LIBOR does. In April 2018, SONIA is expected to expand to include a larger number of transactions. However, currently, there are no plans for additional rates beyond the overnight rate.
In the United States, a group of banks the Federal Reserve put together, known as the Alternative Reference Rates Committee, has looked into potential LIBOR replacements, as many officials have lobbied for a replacement to LIBOR to be mandated. The Committee had selected the General Collateral Repo rate (GC Repo rate) to be the replacement and alternative to LIBOR, which is based on transaction level data from a tri-party repo clearing platform, as described by the Federal Reserve Bank of New York. However, no progress has been made regarding this alternative since the selection in mid-2017.
With LIBOR scheduled to be phased out by the end of 2021, individuals and companies with borrowings will need to pay close attention to future decisions made regarding LIBOR replacements, as the replacement chosen could have an impact on interest rates of current loan agreements.