Libor: Past, Present and Future
J. Bains, A. Bhatti, O. Dagogo, M.K.M. Lo, G. Mroziewicz
Introduction
The British Banker’s Association London Interbank Offered Rate, known as ‘BBA Libor’ or simply just ‘Libor’ is the primary benchmark used by banks, securities houses and investors to gauge the cost of unsecured borrowing in the London interbank market. Libor is set daily for 10 major currencies and for 15 maturities (length of time to repay debt), ranging from overnight to 12 months. It is published by Thomson Reuters on behalf of the BBA, to whom 16 major banks submit their data on the cost and price of lending to each other. Every day, the BBA surveys a panel of banks, by asking “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?” Contributor banks are selected based on; scale of market activity, credit rating and perceived expertise in the currency concerned. Submissions are based upon the lowest perceived rate at which a bank could go into the London interbank money market and obtain funding in reasonable market size, for a given maturity and currency. Thomson Reuters then crunches this data by taking a trimmed average of the collected figures by removing the outliers at the top and bottom of the range (highest and lowest 25%). The whole process begins at 7.00am each day and is published at 11.30am GMT. It is a market convention to quote all Libor rates as an annualised interest rate. For example, if an overnight Sterling rate from a contributor bank is given as 3%, this does not indicate that a contributing bank would expect to pay 3% interest on the value of an overnight loan. Instead, it means that it would expect to pay 3% divided by 365.
BBA Libor was first created in the
1980s when it became apparent that a number of banks were trading in relatively new market instruments such as forward rate agreements, interest rate swaps and foreign currency options. Demand grew for an accurate measure for the real rate at which banks could borrow money from one another and in 1984 the banks asked the BBA to devise a benchmark to act as a reference for these new instruments in order to bring a measure of uniformity into the market. The BBA worked together with the Bank of England as well as other parties to produce the BBA standard for interest rate swaps otherwise known as the BBA Interest Settlement Rates (BBAIRS) terms which later led to the creation of the BAA Libor. In 1986, the Libor initially fixed rates for three currencies; the British pound sterling, U.S. dollar, and Japanese yen. In the years that followed this increased to 16 currencies and after a number of these currencies merged to form the euro in 2000 there remained 10 currencies.
Libor is the primary benchmark along with the Euro Interbank Offered Rate (Euribor) for short term interest rates globally. It influences the level at which lenders set rates on loans, especially mortgages, to consumers/businesses and impacts how much they are willing to lend. It is therefore written into standard derivative and loan documentation and is used to measure strain in money markets as well as a gauge of market expectation for future central bank interest rates. Similarly it also acts as the basis for settlement of interest rate contracts on many of the world’s major futures and options exchanges.
Libor underpins about $10 trillion in loans to consumers and companies and at least $350 trillion in derivatives and other financial products are tied to the
Libor. Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it and during the financial crisis people looked at the rate for a measure on the confidence of the banking sector.
The
scandal:
how
did
it
happen?
It would be an understatement to say that the on-going Libor scandal is generating greater scrutiny on financial institutions and fuelling a sense of pervasive distrust in the financial services sector. The current scandal roots back as early as 2005, with evidence of Barclay’s attempt to manipulate Libor at the request of derivative traders. According to a report by the FSA there were over 250 requests by Barclays to fix Libor and Euribor between 2005 and 2009.
To understand the Libor one must not only see it as a benchmark for what banks are willing to lend to each other but also consider its relationship to other financial instruments. The importance of Libor is such that a change in one basis point can determine the direction of vast sums of money. But the matter of money is not the only reason why Barclays (and other contributors) became involved in rate fixing. During the financial crisis of 2007-08, liquidity concerns put banks at the centre of scrutiny and Libor was considered a trustworthy measurement of a bank’s performance. As a result, many bulge-bracket banks had a big incentive to reduce their offer rates lower than the true market rate; to portray a healthier image of the bank’s credit quality and its ability to raise funds.
By mid-2008, among the British and American authorities, there was a
general consensus that the rate setting process needed to be reviewed and amended. Libor’s integrity was doubted by the public, with an article in the Wall Street Journal claiming that bankers and traders were, ‘expressing concerns that the London inter-bank offered rate, is becoming unreliable’; this form of media attention caused ‘dramatic increases in the Libor fixings’. The two days surrounding the aforementioned article gave rise to the 3-month Libor increasing by 17 bps. Once again, later in the year, when the veracity of Libor returned to the spot light, the 1-year Libor increased 21 bps.
Under mounting pressure from market participants and the media, the BBA decided to take action by voicing their concern to Barclays; the New York Fed provided solutions to eradicate the attraction of misreporting, however this was easily circumvented as there was no formal or convincing evidence of actual misreporting. The BBA ultimately stated that the current process of submission will remain the same. In addition to this, the BBA drafted a document asserting the method of setting the Libor rate and requested banks to have their rate submission audited.
The recent developments have proven that Barclays (amongst others) continued to tamper with their rates through tacit forms of collusion. They illegally broadcasted their future offer rates to other contributors in such a way so that as a group they could post similar rates in order to favour their existing investments. Acting alone Barclays would have had a negligible effect on shifting Libor, but by working as part of a cartel they were able to collectively exert more pressure on the rate.
undertakes a certificate of deposit with another party. They may lend at a floating rate and use the Libor as a benchmark. This would have the effect of front-running the other party as Barclays would be able to influence the outcome of the transaction. Similar situations would occur with derivatives such as Forward Rate Agreements (or Futures contracts). In order to assess the winner of any derivative, the agreed rate needs to be compared to an industry recognised actual rate at the time of maturity, the difference between the two rates determines who pays whom. Barclays used the Libor to influence the outcome of the contract upon maturity and pocket the profits made from the contract for difference. Their influence on the rate may have been as little as 1bp, but due to the volume of derivatives that utilise Libor as their benchmark, this equates to a huge potential gain.
With continuous investigations being directed towards Barclays and for fear of being caught, in June 2012 they decided to admit to their wrong doings and co-operate with the FSA. The underlying motive was to minimise fines and remove the risk of facing criminal charges with senior management. All these factors have led to investigations and resignations of various board members; more specifically the resignation of Barclays CEO Bob Diamond and Chairman Marcus Agius. Furthermore, Barclays was fined $200m by the Commodity Futures Trading Commission, $160m by the United States Department of Justice and £59.5m by the Financial Services Authority. The discovery phase of the scandal is on-going and has already led to various accusations of government officials and other Investment Banks. The deputy governor of the Bank of England, Paul Tucker, has faced
allegations that he was encouraged to manipulate rates but vehemently denies such accusations.
Implications of Libor Scandal
and Fixing
The U.S. has been worried about manipulation of Libor since the financial crisis of 2007 and have long been in favour of changing it to a new benchmark rate. The recent scandal has confirmed the concern from the U.S. on U.K. regulator and has impacted the reputation of U.K. regulators significantly. This has led to a global concern that the Bank of England might not have the ability to effectively regulate and control the banks. The growing distrust has created doubts on Interbank Offered Rates around the world. The European Central Bank (ECB) is currently re-thinking the use of Euribor, the Japanese banking industry is checking its Tibor, the Monetary Authority of Singapore is examining Sibor and the Hong Kong Association of Banks also said it would review the way it calculated its Hibor. Regulatory agencies around the world have all started to re-examine their own rates and procedures; this could potentially lead to an entirely new benchmark rate and increased regulations.
Needless to say, the Libor scandal has severely damaged the reputation of the banks and the banking sector as a whole. For Barclays, its desire to establish a responsible and sustainable image has been dealt a damaging blow. The culture of the bank that has been portrayed to the public and the government has left a bad impression, fuelling fresh concerns over their ability to adhere to regulations internally. The company’s share price, as the news broke, dropped 17%, this was
equivalent to more than £3 billion of its value.
The loss of some of Barclays senior management team cannot be underestimated as the impact on the bank will be felt in every department. The combination of public and political pressure has already cost Barclays CEO (Bob Diamond) and COO (Jerry del Missier) and head of Nomura Holdings Kenichi Watanabe their jobs; they will not be the last. As Barclays rushes to find a new CEO and management team, the ability of the new senior management will be scrutinised heavily in the eyes of the shareholders. This may also set an example that political pressure could force CEOs in banks to resign and give greater power to the regulatory agencies; setting a dangerous precedent.
For the wider banking sector, the other banks that are currently under investigation could potentially face the same fate as Barclays, in addition to a huge fine. One should not forget that Barclays did not act alone, and by coming forward themselves they have avoided the possible huge penalties others will have to pay. This potentially enormous fine might give these banks an extra hit in addition to the already slumping market in Europe. For banks that are not involved in this scandal, they may still face even stricter regulations and a potential change of benchmark rate.
In addition to making a good impression on its financial health, Libor fixing helped the banks to make profit. As a rough estimate, an assumption of 1 bp understatement each day for 4 years translates into a potential profit of $6 billion. While this may not affect the general public, mortgages however could be affected from the scandal as some variable rate mortgages tracked
Libor. However, most mortgages track the lender's standard variable rate and the best rate thus will not be directly affected by Libor. In any case, the Libor fixing lowered the rate and this should have been beneficial to those paying Libor tracking mortgages. On the other hand, fixing Libor indirectly affects borrowers, such as companies that may increase their borrowing cost if it is related to Libor and this increased cost could be passed on to the customers.
The Future of Libor
In the wake of the scandal, significant doubt has been cast over the future of Libor as an accurate and fair basis for money market instruments. Plans have already been made for a meeting on the 9th September 2012 in Basel where Mervyn King, Governor of the Bank of England, along with Mark Carney, Governor of the Bank of Canada, and a host of other supervisors, regulators and treasuries will meet to discuss the alternatives to Libor. Ben Bernanke, chairman of the U.S. Federal Reserve has recently expressed his doubt over the current Libor system, backed by a growing support for a market based rate; “one strategy would be to switch to a market-based indicator…repo rates, the OIS index and potentially Treasury bill rates”.
If estimated costs e.g Libor, Euribor are maintained instead of actual borrowing costs then there is a significant call to reduce the number of ways those costs can be fixed. One proposition is to increase the number of banks involved in setting Libor rates i.e. by increasing the number of participants, the effect any one or group of banks can have is reduced. The shortcoming of this approach is that even if there are more participating banks, the minimum rate at which they
can lend is the minimum rate at which they can borrow that money from another source. Governments are excluded from this rate, hence the minimum rate at which most banks can borrow is set by a handful of the very largest banks that can afford to lend at the lowest rates. Hence whilst including more participants seems to solve the problem, it would in some ways have no effect on the ease at which one or several large banks could fix the rate.
Replacing Libor with a market indicator would surely be a difficult transition to make considering how deeply entrenched it has become as a global benchmark in the derivative world. The idea of using OIS rates is popular but there is a doubt over whether it would give a true reflection of borrowing costs. OIS rates are the expected average of the floating overnight rates, however this rate would not be the same for some banks as for others. U.S. banks have the ability to easily access Federal Reserve dollars in their ‘discount window’ but banks outside of the U.S. do not have the same, hence would post higher OIS rates.
Repo rates are another popular suggestion, however some are worried they are not truly a reflection of unsecured interbank lending. Repo rates are set on the basis of a security’s quality and the positions of both parties, similarly repo rates are almost always short term so would not be able to fully replace Libor rates over all time lengths. On the 16th July 2012 the NYSE London International Financial Futures Exchange launched a possible replacement for Libor; the DTCC GCF ( is an index based on actual futures contract prices. For short-term funding this could prove a more reliable indicator as the market is very liquid and transparent. By using these
exchange-based contracts the rates are visible and more difficult to fix.
A very different alternative to replace Libor is the Repurchase Overnight Index Average Rate (RONIA) which is the weighted average rate for overnight transactions. The belief is that after Lehman’s collapse and the bursting of the credit bubble, secured lending is here to stay and will play a much larger role in the future; RONIA uses a standard collateral as its base, government bonds. It is very similar to the Sterling Overnight Interbank Average Rate (SONIA), the main difference being that it is a secured lending index. SONIA based trades are unsecured and as a result only liquid (at present) up to approximately 3 years, however due to the use of RONIA as a potential hedging tool against securities it would be far more liquid in the long term. Using this rate would represent an actual borrowing cost as requested by the market, and the issue of it being a secured lending rate could be overlooked in the face of growing popularity for secured lending as standard.
Arising out of the aftermath of this recent Libor scandal is an almost guaranteed amendment to the basis of derivative bets; whether that be a revamped Libor or a new market set rate. The possible options are vast and various and any changes would have huge implications on the current trading system. The reality of the situation is that Libor was a system that initially worked until a breaking mechanism was eventually found. In history this pattern of creating and breaking has played itself out over and over again, and will surely continue to, however it is the frequency at which this occurs and the immediacy of which such actions can be caught that matter. Any changes/replacements to Libor will have
to be robust and transparent enough to deter any fixing, but the mechanism simple enough to identify any manipulation. In a market that trades trillions of pounds a day, all eyes are on Basel.
REFERENCES
References
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Key Rate". Retrieved July 23, 2012 from The Wall Street Journal: Mollenkamp, Carrick; Whitehouse, Mark.
[3] Taibb, M. (2012, July 3), Why is Nobody Freaking Out About the LIBOR Banking Scandal. Retrieved July 2012, from Rolling Stone, http://www.rollingstone.com/politics/blogs/taibblog/why-is-nobody-freaking-out-about-the-libor-banking-scandal-20120703.
[4] DTCC, U. S. (2012, July 18), "NYSE Liffe launches futures on GCF repo index" Retrieved July 2012, from Futuresmag, http://www.futuresmag.com/2012/07/18/nyse-liffe-launches-futures-on-gcf-repo-index.
[5] James R. (2012, June 15), "Ronia ready to take on OIS and Libor" Retrieved June 2012, from Total Derivatives Limited, http://www.wmba.org.uk/images/docs/total_derivatives_ronia.pdf.
[6] Leong R. & McCrank J. (2012, June 13), "New futures contract looks to take on Libor" Retrieved June 2012, from Chicago Tribune, http://articles.chicagotribune.com/2012-07-13/business/sns-rt-us-banking- libor-rival-reposbre86c0vg-20120713_1_libor-repo-transaction-futures-contract.
