The End of LIBOR

LIBOR’s reign as “The World’s Most Important Number” is almost over and the banking world is in for a period of transition as a result. The problem isn’t because of dwindling usage, but because of issues in the way it has been calculated and manipulated over time.

While LIBOR is used as a reference rate in a wide range of lending products, it is actually calculated from a survey of a small number of large banks. Those banks report what interest rates they have recently paid and received in the wholesale funding markets, and the results are averaged and published as LIBOR. People have questioned the way the rate was calculated for a long time, but in 2012, Barclays became the first bank to settle with authorities as a result of being accused of rigging LIBOR for their own benefit. More than ten other banks have also paid settlements and one trader is serving time in prison, but LIBOR continues to be one of the most widely used interest rate benchmarks in the world.

While fraud has been an issue, for the most part regulators believe they have improved governance to a level that has fixed the fraud. The problem today is more an issue of liquidity in the market that is used to set LIBOR each day. To quote Andrew Bailey, CEO of the FCA, in a recent speech on the future of LIBOR, “in one currency–tenor combination, for which a benchmark reference rate is produced every business day using submissions from around a dozen panel banks, these banks, between them, executed just fifteen transactions of potentially qualifying size in that currency and tenor in the whole of 2016.” Basically, usage of the rate has so much inertia that it won’t slow down on its own, but the way it’s calculated is so flawed that an alternative must be forced on the market.

In the wake of the rigging scandals many banks have wanted to cease participation in the survey process that calculates the rate. FCA has used its authority as a banking regulator to force banks to participate to preserve the system that so many institutions and borrowers rely on, but they admit they can’t continue to do this forever. Last week the FCA announced they will mandate participation in the survey process until 2021 to give markets time to come up with an alternative.

In the US that alternative has already been determined and it is a big improvement over LIBOR. It will be calculated from actual transaction data in the repo market for Treasury Securities. The major improvements come from the new rate being harder to manipulate because it comes from real transaction data instead of a survey and it will also be calculated from a very deep and liquid market that will provide better information than a survey of 15 or so large banks.

The new reference rate is expected to be available sometime next year. Until then the survey participants will continue to be mandated to provide the data to calculate LIBOR the same way it always has. It’s possible that LIBOR continues on in some form even after the mandate expires, but that is unknown. Longer term lending agreements that use LIBOR may need to be amended to account for the breakdown of LIBOR as a usable reference rate. This process will continue to evolve so stay tuned to this topic for more information in the future.

Just wait for Congress to use this new reference rate as a reason they need to make sure there is a healthy supply of Treasury Bonds available in the market. CLEVER!