The Right Rate? LIBOR's Future is Still Unknown

As supporters of LIBOR plan for its existence beyond 2021, successor is unclear. This article is the first in a series examining various market rate benchmarks.

LIBOR (London interbank offered rate) is an interest rate benchmark which is published daily and considered a reliable rate many banks have used for inter-bank borrowing since 1986. It has dominated the world of finance for everything from home mortgages, student loans, to corporate debt and it's under regulatory pressure.

LIBOR rates are calculated by sending out questionnaires for banks to respond to as part of the analysis to produce the daily short-term borrowing rates. LIBOR is problematic when used as the only rate source because it doesn't average actual borrowing rates, only predictive rates for inter-bank borrowing. With reporting down from 144 banks reporting for nine currencies, to twenty banks reporting for five currencies in 2018, it begs the question whether LIBOR is truly representative.

The problems tied to LIBOR at the onset of the financial crisis led many financial institutions and governments to question if LIBOR is critical to over-night borrowing or credit risk analysis on its own. During the financial crisis certain traders, since barred from the industry, manipulated LIBOR by reporting inaccurate rates to improve their chances of making money.

LIBOR is overseen by Intercontinental Exchange Inc. (ICE) who believes the benchmark will remain beyond 2021 because it would be too costly and difficult for lenders to discontinue using. ICE provides lenders with LIBOR rate quotes that are reflected in written contracts for derivatives, securities, loans and deposits. If a lender switched from LIBOR to another benchmark during a contract term, the contract would need to be rewritten and a price penalty may be applied for the difference between benchmarks. ICE continues to develop the framework to sustain LIBOR as the benchmark even though there is no guarantee it will continue to be published after the end of 2021.

Alternate rate benchmarks in use today include the Federal Reserve's fed funds rate and duration-neutral Treasury notes. There is concern over what will be the standard LIBOR replacement domestically and abroad. Wall Street seems to be less concerned with responding to LIBOR surveys than finding alternate trustworthy rate sources.

For now, we continue to look to our own Federal Reserve rate and the recently introduced Secured Overnight Financing Rate (SOFR) as leading potential replacements for LIBOR. 

Sources:

investopedia.com, "How is LIBOR determined," January 8, 2018

nytimes.com, "The most Important Number in finance Is Going Away.  Wall St. Isn't Prepared," July 19, 2018

Pensions & Investments, "LIBOR replacement to spread headaches," September 17, 2018

Ice Benchmark Administration Limited, "ICE LIBOR Evolution," April 25, 2018

Investopedia.com, "What is the OIS LIBOR spread, and what is it for?" February 21, 2018

Clarusft.com, "SOFR-What You Need To Know," May 16, 2018