LIBOR or the London Interbank Offered Rate is probably the widely used interest rate curve across various financial instruments. The name can be quite misguiding as the rate is computed and published by the Intercontinental Exchange, popularly known as ICE (an American exchange), and used in multiple countries. LIBOR is not only an underlying rate in various derivative products like Interest Rate Swaps, Cross Currency Swaps, etc. but is also used as a benchmark rate for various financial contracts including term loans. For example, the term loan might have stipulated that interest needs to be repaid at LIBOR three-month rate plus 5% on a quarterly basis, here the LIBOR three-month acts as the benchmark and the 5% is the spread based on the riskiness of the borrower. It is estimated that the LIBOR underpins ~ $250 trillion in financial transactions.
We don't want to deep dive into the mathematics and the computation behind the rates as that is beyond the scope of this article. Keeping all the complicated math and assumptions aside, one can explain LIBOR as the average interest rate at which major global banks borrow from one another. Banks mostly borrow from other banks or in case of urgent needs, from the central bank. The reason lies in the fact that most of the times bank needs liquidity funding for short durations (as short as overnight) and other banks that has excess liquidity can lend at such short notice. So when banks lend money to an external borrower, they'll have to quote a rate based on what they'd be expected to pay their fellow bankers. LIBOR represents an estimate of costs to borrow money. It is based on five currencies including the U.S. dollar, the Euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
Every day, the major global banks quote how much they would charge other banks for short-term loans. To smoothen the average (as the average is highly influenced by the tail events) the highest and lowest figures are ignored, and then the average of the remaining rates is computed. This rate is posted each morning as the daily rate, so it's not a static figure. "Once the rates for each maturity and currency are calculated and finalized, they are announced and published once a day at around 11:55 a.m. London time by the ICE Benchmark Administration (IBA)."
Alas, like all financial instruments/products, LIBOR too has its fair share of scandal. Roughly Between 2003 and 2008, several Barclays traders had actively colluded with their banking colleagues to artificially deflate the LIBOR. This was done to support their own institutions' derivative and trading activities and book huge profits. One must not forget that the LIBOR is not only used for derivative pricing but also extends to consumer loans. Therefore, manipulating the LIBOR indirectly caused a cascade of mispriced financial assets throughout the entire global financial system. Although the scandal came to light in 2012, mind you Barclays were not the only ones to be implicated. Some of the other major players who got caught up were Deutsche Bank, Citigroup, JPMorgan Chase, and the Royal Bank of Scotland. Like all other scandals, this one tainted LIBOR's image and created an atmosphere of mistrust.
What is the common response to a thing that has lost credibility? It's simple, we try to look for alternatives. Hence, the Federal Reserve and regulators in the U.K. decided to phase out LIBOR by June 30, 2023, and replace it with the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021.
Well, it's easier said than done! The decision of moving away from LIBOR will have a huge impact on business valuation and fair value reporting standards. Not to get into the nitty-gritty of fair value reporting but the standards require assets and liabilities to be reported at a fair value which is defined as the value at which two willing, unrelated parties agree to exchange the asset/liability at arm's length considering other factors like the marketability of the instrument, counterparty default, etc. Just imagine a corporate that had entered into a long term with LIBOR as the reference rate, now they have to change the base rate curve which might lead to refinancing the loan at a high or undesirable reference rate.
Agreeing on the alternate rate to be used can be challenging. While there are other considerations like whether the agreement has any fallback clause as to address potential LIBOR replacement rate, and is that language sufficiently clear?. Does the corporate know how it will modify the existing deals that use LIBOR? The parties might have to dissolve the agreements and enter into a new one, thereby resulting in cash settlements in the short run which can cause liquidity issues and escalate the cost of debt in the short run. What about the materiality thresholds that get checked in audit assignments? How to account for the material changes that took place due to the change in the curve?
Probably the bigger question right now is, What's Next? Well, many countries that have a mature financial market have their own rate to fall back to like the Sterling Overnight Interbank Average Rate (SONIA) in the U.K., Tokyo Overnight Average Rate (TONA) in Japan, etc. However, the most likely rate to replace LIBOR across all boards is the SOFR. RBI has issued guidelines and asked the Indian banks to replace Mumbai Interbank Forward Outright Rate (MIFOR), the rate that they actively use and - which itself uses LIBOR as a reference.
But changing the rate is a short-term solution unless one can ensure that the new rates are robust and can't be manipulated. Can that be ensured?
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