What does LIBOR Mean?
LIBOR stands for London Interbank Offered Rate. It is a benchmark for short-term interest rates that represents the average rates at which major or global banks are willing to provide loans to each other. Administered by Intercontinental Exchange or ICE, LIBOR was globally accepted from 1986 to 2000s as a key benchmark for the cost of borrowing between banks. However, due to various scandals and doubts about its integrity and validity as a benchmark rate, on June 30, 2023, it was replaced by the Secured Overnight Financing Rate (SOFR), as per Federal Reserve and Regulations in the United Kingdom.
LIBOR affects both financial institutions and consumers because it sets the rates for various credit products like credit cards, car loans, and adjustable-rate mortgages (ARMs). The daily LIBOR rate was published each morning at around 11:55 a.m. London time by the ICE Benchmark Administration (IBA).
How was LIBOR Calculated?
Submission of Rates:
- Each day, a panel of 18 major international banks submitted their estimates of the interest rate they would pay to borrow from another bank in the London interbank market.
- LIBOR was calculated for 35 different rates each business day, combining five currencies—U.S. dollar, euro, British pound, Japanese yen, and Swiss franc, and seven different maturities: overnight/spot next, one week, and one, two, three, six, and twelve months.
Elimination of Outliers:
- Calculated through a Trimmed Mean Approach to prevent extreme values from skewing the average. The Intercontinental Exchange (ICE) Benchmark Administration removes the highest and lowest quartile (four highest and four lowest submissions) before averaging the remaining rates.
Rate Publication:
- The final LIBOR rate for each currency and maturity was announced daily around 11:55 a.m. London time by the ICE Benchmark Administration (IBA).
- A new method was introduced in 2018 to increase proficiency of LIBOR calculations:
Waterfall Methodology:
- Level 1: Use the volume-weighted average price (VWAP) from eligible transactions, with a preference for those closer to 11 a.m. London time.
- Level 2: Use transaction-derived data if there aren’t enough transactions for Level 1.
- Level 3: If neither Level 1 nor Level 2 data is available, use expert judgment to estimate the rate based on the unsecured, wholesale funding market.
However, it is important to remember that LIBOR is not based on actual borrowing costs. It is based on the banks’ projected rates, meaning that banks could manipulate LIBOR by submitting lower rates.
Uses of LIBOR
- Used for standard interbank products including forwarding rate agreements (contracts for exchanging interest payments based on future rates), interest rate swaps (swap interest payments based on different rates), interest rate futures (contracts linked to future interest rate levels), options and swaptions (right to enter into interest rate swaps or purchase securities).
- Used for commercial products such as notes and floating rate certificates of deposits (vary with LIBOR), variable-rate mortgages (Home loans with interest rates tied to LIBOR), and syndicated loans (granted by lenders, often linked to LIBOR).
- Used for hybrid products such as collateralized debt obligations, collateralized mortgage obligations and accrual notes, callable notes, and perpetual notes.
- Used for consumer loan-related products such as student loans and individual mortgages.
