Vedder Thinking | Articles RIP LIBOR? Recent Developments Relating to the Funding Benchmark Icon
“Rumors of my death are greatly exaggerated.”
—If LIBOR could talk, this is something it might be saying at this time (channeling Mark Twain).
So, what is LIBOR? LIBOR—the London Interbank Offered Rate—is one of the most ubiquitous benchmarks for determining short-term interest rates in bank (and other) lending. LIBOR rates are short-term fixed rates quoted for interest periods of, typically, one, two, three and six months; overnight and 12-month interest periods are also available. Insofar as these rates are set for discrete periods of time, they are good for the duration of those periods and are reset at the end of the respective periods to the then available rates reflecting market conditions. LIBOR rates used in the Aircraft Finance market are Screen Rates posted by, among others, Bloomberg. The determination of LIBOR is managed by the Intercontinental Exchange (ICE), which is the parent of the New York Stock Exchange and a number of other exchanges and markets around the world.
LIBOR rates are produced for five currencies (Swiss Franc, Euro, Pound Sterling, Japanese Yen and U.S. Dollar) with seven maturities quoted for each—ranging from overnight to 12 months, producing 35 rates each business day. These rates provide an indication of the average rate at which a LIBOR contributor bank can obtain unsecured funding in the London interbank market for a given period, in a given currency. Individual LIBOR rates are the end product of a calculation based upon submissions from LIBOR contributor banks.
ICE Benchmark Administration (IBA), which is the body that oversees the rate setting processes, maintains a reference panel of between 11 and 17 contributor banks for each currency calculated. Every contributor bank is asked to base their ICE LIBOR submissions on the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 a.m. London time?” Therefore, submissions are based upon the lowest perceived rate at which a bank could go into the London interbank money market and obtain funding in reasonable market size, for a given maturity and currency. LIBOR rates are quoted as an annualized interest rate.
LIBOR rates are calculated using a trimmed arithmetic mean. Once each submission is received, they are ranked in descending order and then the highest and lowest 25% of submissions are excluded. This trimming of the top and bottom quartiles allows for the exclusion of outliers from the final calculation. The remaining contributions are then arithmetically averaged and the result is rounded to five decimal places to create a LIBOR rate. This is repeated for every currency and maturity, producing 35 rates every business day.
So, what’s the problem with LIBOR? ICE took over administration of LIBOR from the British Bankers Association (BBA) in early 2014, following a rate- fixing scandal involving LIBOR interest rates under the auspices of the BBA. In addition, among the consequences of the 2008 collapse of the financial markets in 2008 in the wake of the Lehman debacle was a near drying up of the short-term London interbank lending market (for, among other reasons, the unwillingness of banks to make loans to one another due to concerns about counterparty credit). The resulting lack of trades at LIBOR required rate quotes to be based on estimated—rather than actual—values. Not only might this lead to market manipulation (which did happen and a number of bankers/traders are spending time in the Big House as a result), but it puts into question the integrity of the benchmark and, given the size of derivatives exposures based on LIBOR,1 there are systemic risks for financial markets if liquidity in LIBOR falls further. As a consequence, regulators in the United States and other countries have been coming around to a view that LIBOR needs to be replaced.
So, what are the regulators doing about it? Taking the lead on finding a replacement for LIBOR is the U.S. Federal Reserve. It established an Alternative Reference Rates Committee (ARRC) for the purpose of developing a new benchmark. On June 22, 2017, the ARRC voted to adopt an interest rate benchmark from the U.S. Treasuries-backed repurchase agreement market (repo) as an alternative to the use of LIBOR. The repo rate was selected over the Overnight Bank Funding Rate (OBFR), an unsecured bank lending rate based on transactions in the federal funds and Eurodollar markets. The ARRC said that the repo was considered the most appropriate rate after considering the depth and robustness of the market as well as other factors including regulatory principles. “I am confident the new reference rate chosen today by the Alternative Reference Rates Committee is based on a deep and actively traded market and will be highly robust,” Federal Reserve Board Governor Jerome Powell said in a statement. “With this choice, the ARRC has taken another step in addressing the risks involved with LIBOR.”
An advantage of repos, according to Reuters, is that the market is large and liquid, with over $600 billion in trades estimated to be made overnight. That compares with around $300 billion trades in the markets backing the OBFR.
So, what does all this mean for LIBOR? Not much, especially in the near and medium term. While the trading of derivatives contracts based on the new rate is expected to begin next year on a voluntary basis, it will likely take several years to build strong liquidity in the product in the derivative markets. Looking past derivatives, it will take—dare I say—decades before the repo rate replaces LIBOR as the new benchmark for broad use as a reference rate for corporate loans (and residential mortgages, credit cards and other purposes). In fact, even the transition in the derivatives market to the repo rate is doubtful in the short term if the underlying lending transactions have not likewise transitioned. To be sure, the trillions of dollars of transactions currently pegged at LIBOR will need to run off and whether the repo rate gains traction in the bank market will necessarily be a function of the degree to which this rate bears a close (if not direct) relation to the cost of funds for banks thinking of using that rate. Accordingly, LIBOR will continue to stay with us a very long time. Cancel the wake.
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1 Reuters reports that private and exchange-traded derivatives based on U.S. dollar LIBOR are about $150 trillion.
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