Libor

The London Interbank Offered Rate is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks.^[1] It is usually abbreviated toLibor ( /ˈlaɪbɔr/) or LIBOR, or more officially to BBA Libor (for British Bankers' Association Libor) or the trademark bbalibor. It is a benchmark, along with the Euribor, for interest rates all around the world.^[2][3]

Libor rates are calculated for different lending periods: overnight, one week, one month, two months, six months, etc., and published daily after 11 am (London time) by Thomson Reuters. Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to (and typically higher than) Libor.

Introduction

In 1984, it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps, foreign currency options andforward rate agreements. While recognizing that such instruments brought more business and greater depth to the London Interbank market, bankers worried that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984, the British Bankers' Association (BBA)—working with other parties, such as the Bank of England—established various working parties, which eventually culminated in the production of the BBA standard for interest rate swaps, or "BBAIRS" terms. Part of this standard included the fixing of BBA interest-settlement rates, the predecessor of BBA Libor. From 2 September 1985, the BBAIRS terms became standard market practice.

BBA Libor fixings did not commence officially before 1 January 1986. Before that date, however, some rates were fixed for a trial period commencing in December 1984.

Member banks are international in scope, with more than sixty nations represented among its 223 members and 37 associated professional firms (as of 2008).

[edit]Scope

The LIBOR is widely used as a reference rate for many financial instruments, such as:

• forward rate agreements
• short-term-interest-rate futures contracts
• interest rate swaps
• inflation swaps
• floating rate notes
• syndicated loans
• variable rate mortgages
• currencies, especially the US dollar (see also Eurodollar).

They, thus, provide the basis for some of the world's most liquid and active interest-rate markets.

For the euro, however, the usual reference rates are the Euribor rates compiled by the European Banking Federation, from a larger bank panel. A euro Libor does exist, but mainly for continuity purposes in swap contracts dating back to pre-EMU times. LIBOR is an estimate and not interred in the legally binding contracts of an LLC. It is, however, specifically mentioned as a reference rate in the market standard International Swaps and Derivatives Association documentation, which are used by parties wishing to transact in over-the-counter interest rate derivatives.

Libor is used by the Swiss National Bank as their reference rate for monetary policy.^[4]

[edit]Definition of Libor

Libor is defined as:

The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.

This definition is amplified as follows:

• The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market.
• Contributions must represent rates formed in London and not elsewhere.
• Contributions must be for the currency concerned, not the cost of producing one currency by borrowing in another currency and accessing the required currency via the foreign exchange markets.
• The rates must be submitted by members of staff at a bank with primary responsibility for management of a bank’s cash, rather than a bank’s derivative book.
• The definition of “funds” is: unsecured interbank cash or cash raised through primary issuance of interbank Certificates of Deposit.

For other details of BBA Libor, see the BBA guide: BBA LIBOR explained.

[edit]Technical features

Libor is calculated and published by Thomson Reuters on behalf of the British Bankers' Association (BBA) after 11:00 AM (and generally around 11:45 AM) each day (London time). It is a trimmed average of interbank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. Libor is calculated for 10 currencies. There are eight, twelve, sixteen or twenty contributor banks on each currency panel, and the reported interest is the mean of the 50% middle values (the interquartile mean). The rates are a benchmark rather than a tradable rate; the actual rate at which banks will lend to one another continues to vary throughout the day.

Libor is often used as a rate of reference for pound sterling and other currencies, including US dollar, euro, Japanese yen, Swiss franc, Canadian dollar, Australian dollar, Swedish krona, Danish krone, and New Zealand dollar.

In the 1990s, the yen Libor was influenced by credit problems affecting some of the contributor banks.

Six-month USD Libor is used as an index for some US mortgages. In the UK, the three-month GBP Libor is used for some mortgages—especially for those with adverse credit history.

[edit]Libor-based derivatives

[edit]Eurodollar contracts

The Chicago Mercantile Exchange's Eurodollar contracts are based on three-month US dollar Libor rates. They are the world's most heavily traded short term interest rate futures contracts and extend up to ten years. Shorter maturities trade on the Singapore Exchange in Asian time.

[edit]Interest rate swaps

Interest rate swaps based on short Libor rates currently trade on the interbank market for maturities up to 50 years. In the swap market a "five year Libor" rate refers to the 5 year swap rate where the floating leg of the swap references 3 or 6 month Libor (this can be expressed more precisely as for example "5 year rate vs 6 month Libor"). "Libor + x basis points", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve shifted by x basis points in order to equal the bond's actual market price. The day count convention for Libor rates in interest rate swaps is Actual/360, except for the GBP currency for which it is Actual/365 (fixed).^[5]

On Thursday, 29 May 2008, The Wall Street Journal (WSJ) released a controversial study suggesting that banks might have understated borrowing costs they reported for Libor during the 2008 credit crunch.^[6] Such underreporting could have created an impression that banks could borrow from other banks more cheaply than they could in reality. It could also have made the banking system or specific contributing bank appear healthier than it was during the 2008 credit crunch.

For example, the study found that rates at which one major bank (Citi-group) "said it could borrow dollars for three months were about 0.87 percentage point lower than the rate calculated using default-insurance data."

To further bring this case to light, The Wall Street Journal released another article dealing with this matter titled "U.S. Probe Presents Dilemma over Libor" on Friday, 18 March 2011. The article stated that regulators are focusing on Bank of America Corp., Citi-group Inc. and UBS AG. Making a case would be very difficult because determining the LIBOR rate does not occur on an open exchange. According to people familiar with the situation, subpoenas have been issued to the three banks.

In response to the study released by the WSJ, the British Bankers' Association announced that Libor continues to be reliable even in times of financial crisis. According to the British Bankers' Association, other proxies for financial health, such as the default-credit-insurance market, are not necessarily more sound than Libor at times of financial crisis, though they are more widely used in Latin America, especially the Ecuadorian and Bolivian markets.

Additionally, other authorities have contradicted the Wall Street Journal article. In its March 2008 Quarterly Review, The Bank for International Settlements has stated that "available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings." Further, in October 2008 the International Monetary Fund published its regularGlobal Financial Stability Review which also found that "Although the integrity of the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding."

[edit]Investigation and scandal

On 28 February 2012, it was revealed that the SEC was conducting an investigation into LIBOR abuse, however. ^[6]

Among the abuses being investigated were the possibility that traders were in direct communication with bankers before the rates were set, thus allowing them an unprecedented amount of insider knowledge into global instruments. LIBOR underpins approximately $350 trillion in derivatives. One trader's messages indicated that for each basis point (0.01%) that LIBOR was moved, those involved could net “about a couple of million dollars”.^[7]

On 27 June 2012, Barclays Bank was fined $200m by The Commodity Futures Trading Commission^[8], $150m by the United States Department of Justice^[9] and £59.5m by the FSA^[10] for attempted^[11] manipulation of the LIBOR and EURIBOR rates. The United States Department of Justice stated further that "the manipulation of the submissions affected the fixed rate on some occasions".^[9] [12]

By July 4, 2012 the breadth of the scandal was evident and became the topic of analysis on news and financial programs that attempted to explain the importance of the scandal.^[13]