For decades, LIBOR, the London Interbank Offered Rate, served as a cornerstone of the global financial system. Specifically, as a benchmark interest rate, it influenced trillions of dollars in financial contracts across the globe. In this guide, we will explore LIBOR’s history in detail, examine the timeline and impact of the LIBOR scandal, and discuss its uncertain future.
What was LIBOR?
LIBOR represented the average interest rate at which major global banks lent to one another in the international interbank market for short-term loans. Calculated daily, LIBOR covered five key currencies (USD, EUR, GBP, JPY, CHF) and seven maturities: overnight, one week, and one, two, three, six, and twelve months.
History of LIBOR
LIBOR’s roots go back to the late 1960s when it began appearing in syndicated loans and floating rate notes. However, it was officially established in 1986 by the British Bankers’ Association (BBA), now part of UK Finance, to create a standard benchmark for the financial industry. Over time, LIBOR evolved into the reference rate for a wide array of financial products, from mortgages to bonds and derivatives.
How LIBOR was calculated
Each day, a panel of banks actively submitted their estimated borrowing rates to the Intercontinental Exchange (ICE). Next, to calculate the daily LIBOR rate for each currency and maturity, ICE removed the highest and lowest quartiles of the submitted rates. Then, it averaged the remaining rates to determine the final rate. This process aimed to prevent manipulation and provide an accurate reflection of the interbank lending market.
Calculating LIBOR in numbers – an example
Suppose there were 8 banks on the panel, and they submitted the following 1-month USD LIBOR rates (in percentages):
1.00, 1.02, 1.06, 1.07, 1.08, 1.09, 2.00, 2.02
Steps:
- Firstly, discard the highest and lowest 25%:
- Remove the lowest two rates: 1.00, 1.02
- Remove the highest two rates: 2.00, 2.02
- Then, average the middle 50%:
- Remaining rates are: 1.06, 1.07, 1.08, 1.09
- Finally, calculate the average:
- (1.06, 1.07, 1.08, 1.09) / 4 = 1.075%
Therefore, the 1-month USD LIBOR rate would be 1.0752%.
Impact of LIBOR
LIBOR has had a profound impact on the global financial system:
| Introduced in | Framework name | Purpose |
|---|---|---|
| 1988 | Basel I | Focused on setting minimum capital requirements for banks based on the riskiness of their assets. It required banks to maintain a minimum capital ratio of 8% of their risk-weighted assets. |
| 2004 | Basel II | Built upon Basel by incorporating more detailed risk assessment methods. It introduced three main pillars: minimum capital requirements, supervisory review, and market discipline. This allowed for a more risk sensitive approach to capital requirements. |
| 2008 | Basel III | Introduced after the 2008 financial crisis, further strengthened the regulatory framework |
| 2023 | Basel IV | To address shortcomings in the existing regulatory framework |
No guide to LIBOR would be complete without looking at the Scandal and Reforms
In 2012, the LIBOR manipulation scandal, known as Liborgate, shook the financial world. It revealed that several banks had colluded to manipulate the rate for profit. Moreover, this was not an isolated issue; traders and managers at some of the world’s largest banks systematically altered borrowing rates. As a result, the scandal led to hefty fines for the banks involved and a severe loss of confidence in LIBOR. In response, regulators introduced reforms, added tighter oversight, and encouraged a shift toward alternative reference rates.
How the Libor scandal unfolded
Concerns raised
Barclays employees actively raised concerns with regulators, including the British Bankers’ Association, the FSA, and the Federal Reserve Bank of New York. They reported that other banks were dishonestly submitting low interbank rates, sparking further investigation…
Lehman Brothers
LIBOR rates spike after the collapse of Lehman Brothers
Investigations begin
Britain’s Financial Services Authority (FSA) launches an investigation into Barclays
Charles Schwab
Discount brokerage and money manager, Charles Schwab, file lawsuits accusing 11 major banks of conspiring to manipulate LIBOR.
Enforcement
Barclays bank is fined millions. The US regulator, the CFTC fining $400 million and British regulator, the FSA, fining £59.5 million.
Investigations continue
A joint NY-Connecticut investigation of LIBOR send subpoenas to RBS, HSBC Holding, JPMorgan, Deutsche, Barclays, UBS and Citi.
Wheatley Review
The Wheatley Review of LIBOR is published with a 10 point plan for comprehensive reform of LIBOR
German Lawmakers
Deutsche faces sceptical German lawmakers. Barclays says it fired five employees.
Arrests follow
The first three arrests are made in the scandal. Days later, UBS is fined $1.5 billion to settle charges of rigging.
$1.2bn (£740m) in combined fines to the US Department of Justice (DoJ) and the Commodities Futures Trading Commission
£160m to the UK’s Financial Services Authority (FSA)
59m Swiss francs (£40m) to the Swiss Financial Market Supervisory Authority
An example of a LIBOR message central to the Libor scandal reveals manipulation efforts
An example included in a ‘statement of facts’ paper from the US Department of Justice gives an idea of what was happening.
On Friday, March 10, 2006, a Barclays Dollar swaps trader located in London (“Trader-1”) sent an e-mail to a Barclays Dollar LIBOR submitter (“Submitter-1”) stating: “Hi mate[.] We have an unbelievably large set on Monday (the IMM). We need a really low 3m [3-month] fix, it could potentially cost a fortune. Would really appreciate any help, I’m being told by my NYK [counterparts in New York] that it’s extremely important. Thanks.”
Then, on Monday, March 13, 2006, at approximately 7:48 a.m., Trader-1 wrote to Submitter-1: “The big day has[] arrived…My NYK were screaming at me about an unchanged 3m LIBOR. As always, any help wd [would] be greatly appreciated. What do you think you’ll go for 3m?”
Submitter-1 responded, “I am going 90 altho[ugh] 91 is what I should be posting.” Trader-1 replied in part: “I agree with you and totally understand. Remember, when I retire and write a book about this business your name will be in golden letters….” Submitter-1 replied, “I would prefer this not be in any books!” Barclays’s 3-month Dollar LIBOR submission on March 13, 2006 was 4.90%, which was a rate unchanged from the previous trading day and was tied for the lowest rate submitted.
Challenges and considerations
In response to the scandal, financial regulators around the world took action, launching an ambitious project to transition away from LIBOR. Their primary focus became restoring integrity and reliability to the rate-setting process.
Key steps in transitioning away from LIBOR
- Strengthening benchmark regulations: In 2013, the International Organisation of Securities Commissions (IOSCO) introduced new principles for financial benchmarks, focusing on transparency, reliability, and robustness. Adopted globally, these principles work to enhance the integrity of rate-setting processes and ensure trustworthy benchmarks.
- Developing Alternative Reference Rates (ARRs): In response to LIBOR’s phase-out, financial authorities worldwide actively developed Alternative Reference Rates (ARRs). Unlike LIBOR, ARRs use actual transaction data, making them more robust and resistant to manipulation. Key examples include:
- SOFR (Secured Overnight Financing Rate): The US replacement for USD LIBOR administered by the New York Fed.
- SONIA (Sterling Overnight Index Average): The UK’s replacement for GBP LIBOR, administered by the Bank of England.
- ESTER (Euro Short-Term Rate): The Eurozone replacement for EUR LIBOR, published by the European Central Bank (ECB).
- TONA (Tokyo Overnight Average Rate): Japan’s replacement for JPY LIBOR, administered by the Bank of Japan.
- SARON (Swiss Average Rate Overnight): Switzerland’s replacement for CHF LIBOR, managed by SIX Group.
- Phased Transition Plan: The transition from LIBOR to ARRs has followed a structured, phased approach. The UK’s Financial Conduct Authority (FCA) announced LIBOR would cease at the end of 2021, with select tenors available until mid-2023 to allow a smoother transition.
For over three decades, LIBOR has played a pivotal role in the global financial system, influencing a wide range of financial products and markets. However, as this guide to LIBOR reveals, past manipulation and shifting market dynamics make the transition to alternative reference rates essential for ensuring market integrity and stability. Understanding LIBOR’s history, its impact, and the transition process is crucial for successfully navigating the future of global finance.
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