Farewell, LIBOR

What is LIBOR?

LIBOR stands for London Interbank Offer Rate. It’s a benchmark interest rate for global banks to lend short-term money to each other via an international interbank market. The rate is calculated and published each day by the Intercontinental Exchange (ICE). LIBOR is offered in 5 major currencies: USD (US Dollar), EUR (Euro) , GBP (British Pound, Sterling) , CHF (Swiss Franc) and JPY (Japanese Yen), with seven different maturities: overnight(Spot/Next), 1 week, and 1, 2, 3, 6 and 12 months. The most commonly quoted rate for USD is the 3-month LIBOR, and for JPY is 6-month LIBOR.

LIBOR comes from bank quotes for short term lending, but its usage is much wider. LIBOR offers a benchmark for interest rate derivatives, of which the most important ones are interest rate swaps (IRS). In a vanilla IRS, one party, called the payer of the swap (or simply payer), pays a fixed rate through a period of time in exchange for a floating rate, and the floating rate can be derived from LIBOR (Usually LIBOR itself). Another kind of swap is called cross-currency swap (CCS), in which a party pays floating rate for one currency (say USD 3-month LIBOR), in exchange for floating rate for another currency, usually adding a value called basis spread (say JPY 3-month LIBOR + 50bps). And we have more complicated products such as swaptions, which give you a right, but not obligation to enter into a swap in the future.

Besides the standard interbank products introduced above, the LIBOR is also used in commercial products such as syndicated loan, and hybrid products such as CDOs (Collateralized Debt Obligations), CMOs (Collateralized Mortgage Obligations), and a wide variety of accrual notes, callable notes, and perpetual notes.

Before 2008, it was a common practice to use LIBOR as the discount rate, which allows you to calculate the present value of cash received in the future. The financial crisis called an end to this practice, and nowadays the market convention is to use OIS (Overnight Index Swap) rate or curves linked to specific CSAs (Credit Support Annex).

How is LIBOR calculated?

LIBOR is currently based on submissions from Contributor Banks (panel banks) that are determined through the use of a standardized, transaction based Waterfall Methodology introduced by IBA. The so-called "waterfall methodology" contains the following three levels:

• 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 (GMT).
• The second transaction-derived level involved taking submissions based on transaction-derived data from a panel bank if it does not have a sufficient number of eligible transactions to make a Level 1 submission.
• The third level—expert judgment—comes into play when a panel bank fails to make a Level 1 or a Level 2 submission. It submits the rate at which it could finance itself at 11:00 a.m. London time with reference to the unsecured, wholesale funding market.

The ICE will calculate a trimmed mean from the data collected. The published rate in respect of each currency and tenor combination is the arithmetic mean of each Contributor Bank’s contributions in respect of that currency and tenor (after trimming upper and lower values), rounded to five decimal places. Each Contributor Bank's contribution carries an equal weight in the calculation, subject to the trimming.

The contributors are listed as follows:

Why will LIBOR be suspended?

LIBOR quotes will be suspended in the end of 2021, but why?

LIBOR comes from the contribution of global banks, and thus is prone to market abuse. Major banks allegedly colluded to manipulate the LIBOR rates. They took traders' requests into account and submitted artificially low LIBOR rates to keep them at their preferred levels. The intention behind the alleged malpractice was to bump up traders’ profits who were holding positions in LIBOR-based financial securities. In the past 10 years, the were at least 15 cases in which major banks, including UBS, J.P. Morgan Chase, Citi and Barclays, manipulated the LIBOR by giving false quotes. In each case, the culprit bank faced  fine worth hundreds of millions of dollars (or euros).

(Wall Street Journal: Bankers Cast Doubt On Key Rate Amid Crisis, https://www.wsj.com/articles/SB120831164167818299, the first research report on LIBOR scandal)

(New York Times: Deutsche Bank to Pay $2.5 Billion Fine to Settle Rate-Rigging Case, https://www.nytimes.com/2015/04/24/business/dealbook/deutsche-bank-settlement-rates.html, a recent case happened in 2015, in which Deutsch Bank paid 2.5 billion dollars fine)

The LIBOR scandals are the primary reason why LIBOR will be suspended. The new system is designed to replace the conjecture surrounding interest rates that was predominant under LIBOR and instead use actual transaction rates.

What are the replacements?

• USD: The Fed is promoting the Secured Overnight Financing Rate (SOFR) to replace LIBOR. Not like LIBOR, SOFR is based on real transactions, and it's "secured", collateralized by U.S. Treasuries (and thus can be considered risk-free). However, its lack of a credit component is a hurdle to wider adaption. SOFR is only quoted as overnight rate.
• EUR: The EUR market has long using another IBOR-like rate called EURIBOR, which can continue beyond 2021. (However, EURIBOR is also vulnerable to market abuse. In 2016, Credit Agricole, HSBC and JP Morgan were fined 485 million EUR for manipulating EURIBOR fixing. See the Financial Time report: https://www.ft.com/content/a01af56e-b9aa-3a00-a6ef-e7b24c83ee38)  There's also a short-term equivalent for EUR called ESTR (Euro Short Term Rate). ESTR draws on money-market transitions which shows the overnight unsecured rate for EUR.
• GBP: The Bank of England has overseen SONIA(Sterling Overnight Index Rate), a replacement of LIBOR, since 2016. SONIA measures the rate paid on unsecured overnight funds.
• CHF: Switzerland also has another benchmark besides LIBOR called SARON (Swiss Average Rate Overnight). It's based on overnight rates in the CHF repo market. The Swiss National Bank used LIBOR as a guideline to monetary policy until 2019, and now it switches to SARON.
• JPY: The JCB is leaning on two rates: TORF (Tokyo Term Risk Free Rate) and TIBOR (Tokyo Interbank Offer Rate). Nikkei's Quick began to publish prototype reference rates in May. In 2017, a reform on TIBOR bolstered the reliability and transparency or this IBOR-like rate.

What about other IBOR-like rates?

SGD (Singapore Dollar), HKD (Hong Kong Dollar), and AUD (Australian Dollar) doesn't use LIBOR as their benchmarks, but have IBOR-like rates published by local entities respectively. Thus, they face the same problem as LIBOR and looking for reform. In Singapore, financial services are adopting SORA (Singapore Overnight Rate Average) to replace SOR(Singapore-dollar Swap Offer Rate). In Australia, the AONIA (Australian Overnight Index Average) is gaining traction despite a reform in 2018 for BBSW (Bank Bill Swap Rate). In Hong Kong, the Treasury Market Association is promoting HONIA (Hong Kong dollar Overnight Index Average), and the Monetary Authority said they prefer to have a multi-rate approach, in which HIBOR(Hong Kong dollar Interbank Offer Rate) will co-exist with HONIA.

References

[1] 一般社団法人 金融財政事情研究会 「第2550回 金曜例会」資料 https://www.fsa.go.jp/policy/libor/kinzaikinyoureikai20200124.pdf

[2] Bloomberg Markets Volume 29 Issue 4, Libor's Legacy: A Guide to the World's New Benchmarks

[3] ICE, ICE LIBOR, https://www.theice.com/iba/libor

[4] Andrew Lesniewski, Interest Rate and FX Models