Libor

What it is

The London Interbank Offered Rate (LIBOR) is a short-term benchmark interest rate. From 01/02/14 it has been compiled by the Intercontinental Exchange (ICE). Every day, just before 11am London time, contributor banks, of which there are between 11 and 17, submit the rate at which they think they can borrow in the interbank market in reasonable size and for the currency and maturity in question. There are five currencies and seven maturities giving a total of 35 daily rates, each being an arithmetic average, after outlying high and low quotes have been removed. The rates are quoted to five decimal places and published at 11.55am London time.

Because these rates are benchmarks they are used in the interest calculations for products linked to LIBOR. These include interest rate swaps and floating rate notes. Interest being calculated on an Actual/365 (GBP) or Actual/360 basis (USD).

A benchmark

LIBOR represents the cost of money. It is influenced indirectly by central banks through monetary policy and in-turn it influences the rate on retail and commercial loans and deposits made by banks.

Although LIBOR is posted daily the cost of interbank money (LIBOR during the day) can change with the ebb and flow of supply and demand in the market place.

LIBOR is a key input in pricing and valuing trades and is an input in the models used. However, the 2007/8 crisis demonstrated that LIBOR rates are not risk free interest rates. They reflect the risk in the banking system. When this increases LIBOR rates rise in relation to “risk free” rates like the Overnight Index Swap Rate (OIS). For this reason, the difference between LIBOR and the OIS rate for a similar term can reflect sentiment about the strength or weakness of the banking system. OIS have therefore been integrated into pricing and valuation models.

Fixing

The use of LIBOR as a benchmark to calculate interest payments (particularly for derivatives) means the integrity of LIBOR is crucial. This was brought into question by two episodes.

The first was during the 2007/8 crisis where it has been reported that banks posted artificially low LIBOR rates to “demonstrate” that their credit standing was not in question.

The second was where bank traders were submitting LIBOR rates that were either slightly too high or too low. This was as an attempt to influence the posted rate which would then be used for interest calculations. The banks in question benefiting from their own market positions vis a vis LIBOR. This was subject to regulatory investigation culminating in fines and procedural changes with ICE taking over responsibility for the benchmark.

First Published by Barbican Consulting Limited 2017