Key Takeaways
- Benchmark rate for unsecured interbank borrowing.
- Used in trillions of dollars in financial contracts.
- Calculated from trimmed average of bank estimates.
- Phased out due to manipulation and declining transactions.
What is London Inter-Bank Offered Rate (LIBOR)?
London Inter-Bank Offered Rate (LIBOR) was a global benchmark interest rate indicating the average cost at which major banks could borrow from each other unsecured. It underpinned trillions of dollars in financial contracts and was critical in global macroeconomics.
Established in 1986, LIBOR served as a reference for a wide range of financial instruments until its phaseout in 2021 due to reliability concerns.
Key Characteristics
LIBOR had several defining features that made it central to financial markets:
- Multiple Currencies and Tenors: Published for five currencies and seven maturities, from overnight to 12 months.
- Calculated by Panel Banks: A panel of major banks provided daily borrowing rate estimates, which were averaged after removing outliers.
- Influential Benchmark: Affected pricing for adjustable-rate mortgages, corporate loans, and credit default swaps.
- Dependence on Estimates: Relied on bank submissions rather than actual transactions, raising manipulation risks.
- Transition to Alternatives: Replaced by risk-free rates following regulatory reforms aimed at improving market integrity.
How It Works
Each weekday, a panel of banks submitted the interest rates at which they believed they could borrow funds unsecured in the interbank market. The highest and lowest submissions were excluded to reduce distortion, and the trimmed average of the remaining rates set the official LIBOR for various maturities.
This process influenced interest rates on numerous financial products, requiring you to understand its calculation if engaging in debt instruments or derivatives. The transition from LIBOR to alternative benchmarks like the Secured Overnight Financing Rate (SOFR) reflects efforts to base rates on actual market transactions rather than estimates.
Examples and Use Cases
LIBOR's reach extended across many sectors and financial products, impacting global markets and companies:
- Airlines: Delta and American Airlines used LIBOR-linked loans to finance fleet expansions.
- Bond Investments: Many bond funds, such as those tracked in BND, historically referenced LIBOR for floating rate bonds.
- Investment Strategies: Investors often considered LIBOR rates when evaluating the best low-cost index funds with exposure to interest rate movements.
Important Considerations
With LIBOR's phaseout, you must adapt to new benchmarks that emphasize transparency and transactional data. Markets now rely on rates like SOFR, which better reflect actual lending conditions.
Understanding LIBOR's limitations, including susceptibility to manipulation, helps explain regulatory shifts and highlights the importance of monitoring open market operations and other central bank activities influencing benchmark rates.
Final Words
LIBOR was a key global benchmark for short-term interest rates, but its reliance on bank estimates led to significant reforms and eventual phase-out. Review your contracts to identify any LIBOR exposure and plan for transitions to alternative benchmarks like SOFR or SONIA.
Frequently Asked Questions
LIBOR was a benchmark interest rate reflecting the average cost at which major global banks believed they could borrow from each other without collateral. It was widely used to set rates on various financial products worldwide.
Each weekday, a panel of major banks submitted estimated borrowing rates for different loan terms. The highest and lowest submissions were removed, and the average of the remaining rates became the official LIBOR.
LIBOR underpinned approximately $300 trillion in financial instruments including mortgages, corporate loans, and derivatives, making it one of the most influential reference rates globally.
LIBOR's decline was driven by fewer actual interbank transactions and scandals involving rate manipulation during the 2008 financial crisis. Regulators recommended replacing LIBOR with alternative risk-free rates.
LIBOR was formally launched in 1986 by the British Bankers' Association to provide a transparent benchmark for interbank lending rates, building on practices from the 1970s and earlier syndicated loans.
LIBOR was published in five major currencies—USD, GBP, EUR, JPY, and CHF—across seven different borrowing terms ranging from overnight to 12 months.
LIBOR served as the primary benchmark for adjustable-rate mortgages, corporate debts, asset-backed securities, credit default swaps, and floating rate loans.
