The London Interbank Offered Rate (LIBOR) is an index that measures the interest rates at which banks borrow from one another. It based on daily submissions of estimated borrowing rates by a panel of leading global banks. Libor has been called the “world most Important number”. It is being regulated by ICE Benchmark Administration (IBA).
This rate is being used as a measure of the health of the banking system, a benchmark rate for swaps and futures, and a benchmark for pricing interest rates for many non-derivative financial instruments, such as home mortgages, car loans and student loans.
Reasons for Phase Out
On July 27, 2017, Andrew Bailey, chief executive of the U.K. Financial Conduct Authority (FCA), announced in a speech that “after 2021 will no longer compel panel banks to provide submissions for LIBOR.”
This was a turning point in the history of LIBOR, because various currencies (including US dollars, British pounds sterling, Euros, Swiss francs and Japanese yen) has LIBOR the primary benchmarks for rates of interest or for determining other payments used in deposits, derivatives, debt securities and other investments.
Libor Scandal that happened in 2012 is the major reason of replacement. An International investigation into LIBOR revealed a widespread plot or plan by multiple banks which included Deutsche Bank, Barclays, UBS & the Royal Bank of Scotland to manipulate these interest rates for profit earning.
Regulators in United States, UK, and Europe fined banks more than $9 billion for rigging Libor, which underpins over $300 trillion worth of loans worldwide. Since 2015, authorities in both the UK and the United States have brought criminal charges against individual traders and brokers for their role in manipulating rates. The Scandal has eroded public trust in the marketplace and sparked calls for reform of the entire Libor rate-setting system.
Alternatives to Libor-SOFR and SONIA
In 2014, the US Federal Reserve Bank setup the Alternative Reference Rates Committee, to set the interest rates based on real transactions from a robust underlying market. On 22 June 2017, the ARRC named the Secured Overnight Financing Rate (SOFR) as it is preferred alternative reference rate.
SOFR is the average rate at which institutions can borrow US dollars overnight while posting US Treasury bonds as collateral.
It is based on a live market and reflects the current price at which banks can borrow.
SOFR is based on transactions in the Treasury repurchase market, treasuries loaned or borrowed overnight.
It uses data from overnight treasury repo activity to calculate a rate.
In March 2015, the Bank of England also suggested the Sterling Overnight Index Average (SONIA) alternative to LIBOR.
It is the effective overnight interest rate paid by banks for unsecured transactions in the British sterling market.
It as a risk-free reference (RFR) rate
It was established in 1997 by the Wholesale Markets Brokers’ Association in Great Britain.
The transition from LIBOR will bring considerable costs and risks for financial firms as rates are being calculated differ from LIBOR, payments under contracts referencing the new rates will differ from those referencing LIBOR. The transition will change firm’s market risk profiles, requiring changes to risk models, valuation tools, and product design and hedging strategies.