For more than four decades, the London Interbank Offered Rate (LIBOR) was a significant benchmark for determining interest rates on adjustable-rate loans, mortgages, and corporate debt.
LIBOR has been plagued by scandals and crises over the previous decade. The rate has been replaced with the Secured Overnight Financing Rate (SOFR) as of December 31, 2021, which many experts believe is a more accurate and secure pricing standard.
What is the Significance of LIBOR?
LIBOR is a global benchmark for interest rates. Although it originated in 1969, it was formalized in 1986. It is used as the base for deciding interest rates on loans, savings, and mortgages. It is also used as a base rate for many financial products, such as futures, options, and swaps. A bank, for example, could quote your home loan using LIBOR. They would tell you that you would have to pay the three-month LIBOR rate plus a spread. In that instance, you’d need to find the rate and then add the spread on top. It’s practiced everywhere. It’s a yardstick, and it’s crucial. The LIBOR rate is so widely used in the financial industry that some estimates indicate it is used to benchmark more than $300 trillion in financial products.
Understanding how LIBOR works is not an easy task. But, if we ignore the complexities, it is, after all, a form of reference. And this reference rate must be representative of reality. Banks primarily borrow from one another. As a result, when they lend you money, they must quote a rate based on what they would be expected to pay their other bankers. That’s what the LIBOR is supposed to represent. It is intended to provide people with an approximation of how much it costs to borrow money, and as such, it is computed in the same manner.
How is LIBOR Calculated?
Every day, 18 international banks submit their estimates of the interest rates they would pay if they had to borrow money from another bank on London’s interbank lending market. To avoid skewing the computation due to extreme highs or lows, the Intercontinental Exchange (ICE) Benchmark Administration removes the four highest and four lowest submissions before generating an average.
It’s vital to understand that Libor isn’t based on what banks pay each other to borrow money. Instead, it is based on their submissions about how much they believe they would pay. As a result, banks may submit lower rates and manipulate LIBOR pretty easily.
Previously, a panel of bankers monitored LIBOR in each currency, but scandals showing LIBOR manipulation prompted several national regulators to seek alternatives to LIBOR.
Following the crisis, it became clear that the manipulation had cost governments, corporations, and consumers billions of dollars. The LIBOR had to disappear, and it was decided that the benchmark rate will be phased out by December 31, 2021.
Replacement of LIBOR
Simply put, there is no LIBOR-like worldwide alternative ready to take over right now. As a result, countries will most likely replace it with a slew of alternative rates. For example, SONIA is a benchmark for British pounds, TONA for Japanese yen, and so on. However, the most likely candidate to fill LIBOR’s shoes appears to be SOFR or Secured Overnight Financing Rate, released by the New York Fed. The RBI, for its part, had already asked Indian banks to abandon the Mumbai Interbank Forward Outright Rate (MIFOR), which was based on LIBOR. Meanwhile, Indian banks appear to have heeded the call, and SOFR appears to be the overwhelming favorite.
Also, LIBOR will not vanish into oblivion. Official interest rates will continue to be published, but they will only be utilized for legacy loans. All new financial products must be priced using a new benchmark.