The rise and fall of LIBOR

The use of the London Interbank Offer Rate (LIBOR) as a reference rate for financial contracts has been a ‘lynch pin’ of the financial system for over a generation. However, evolving market dynamics have highlighted issues with LIBOR and raised doubts about its use beyond 2021. Though regulators have taken steps to develop replacement indices, these also have issues which investors need to be aware of.

The rise of LIBOR

LIBOR has its origins in the 1960s, stemming from the rapidly growing syndicated loan market. The syndicated loan market is where a group of lenders, referred to as a "syndicate", work together to provide funds for a single borrower. The benefit of a syndicated loan is that it allows lenders to spread risk and/or take part in financial opportunities that may be too large for their individual capital base. 

This syndicated loan market gave rise to an independently determined reference interest rate; one that reflected the average rate at which banks could raise funds and that those banks within the syndicate could use within their contracts. This need for an independently determined reference interest is why LIBOR evolved. 

The formalisation of the existing process was completed in 1986, when the British Bankers Association assumed control of the setting and publication of LIBOR. Just before 11am local time each day, the British Bankers Association collects data from a panel of banks on where they could borrow funds from other banks. From these responses, the top and bottom quartiles are discarded, resulting in a trimmed mean of the submissions. The result of this sampling process is that a daily average borrowing rate for banks can be calculated for a range of currencies. 

Over time, LIBOR came to be increasingly used as a reference rate for a broad range of financial contracts/transactions globally. In fact, up until 2018, LIBOR had been used as a reference rate in around US$400 trillion of financial contracts.

The fall of LIBOR

Despite the growth of LIBOR as the standard reference rate for financial contracts, it had an underlying weakness that would ultimately lead to its downfall as financial markets evolved in the wake of the financial crisis of 2008. This inherent weakness lay in the process by which data was collected from the panel of banks. The rates provided by these banks were estimates of where they believed they could borrow rather than the rate at which they actually borrowed. 

That the data collected wasn’t based on actual transactions was not a major problem provided that (a) the panel comprised a large number of participating banks and (b) representative actual transactions were occurring within the interbank market. That LIBOR was not based on actual transactions started to become more of an issue as the source of actual interbank lending shifted fundamentally.

Prior to the financial crisis of 2008, most transactions between banks occurred via the interbank loan market. However, since then, more and more interbank funding has been facilitated via the repo market. The key catalyst for this shift in bank financing was the introduction of a range of regulatory changes designed to ensure greater stability within global financial systems. Over time, we began to see less and less actual transactions within the interbank market. As a result, fewer banks participated in the panel itself while the submissions to the LIBOR estimate increasingly became "expert judgements". LIBOR’s increasing reliance on a smaller number of expert judgements in the rate-setting process meant there was more opportunity for the panel of banks to misstate and collude with respect to LIBOR submissions, allowing them to inflate the returns on over-the-counter financial contracts. 

Unfortunately, and some would say inevitably, this ability to manipulate LIBOR proved too much for some panel participants to resist, thereby fatally undermining the viability of LIBOR as an unbiased/independent reference rate.

Due to the manipulation of LIBOR by members of the banking panel, supervision of the production of LIBOR was transferred from the British Bankers Association to the UK Financial Conduct Authority (‘FCA’) in 2014. Though the FCA has stated that it will continue to produce LIBOR until the end of 2021, it has not guaranteed publication after this date. Even if published beyond 2021, there is still the potential that the FCA may declare that LIBOR is ‘unrepresentative of the underlying market’.

The search for alternatives

Once the issues associated with LIBOR became apparent, the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSC) began to consider what would be required from a replacement reference rate. Though neither body stated a preferred replacement reference rate, they did set out roadmaps for reforms. The key outcome from their work was that any reference rates should be based on:

• Active and liquid markets.
• Observable ‘arm’s length’ transactions.
• Actual borrowing rates with estimates disallowed.

What immediately becomes apparent is that LIBOR, as it’s currently constructed, will fail to satisfy the criteria set out by the FSB and IOSC. For this reason, and despite it still being calculated, the regulators may yet decide that LIBOR is no longer a complying reference rate. What this means for the ongoing calculation of LIBOR, or indeed its use as a reference rate even if it is calculated, remains unclear beyond 2021.

Given the issues and uncertainties surrounding LIBOR, working groups in many major markets have actively sought an alternative to LIBOR. Within these major markets, the chosen alternative has been the use of overnight lending rates with historical averages that act as reference rates for longer time periods. Figure 1 below shows the Overnight Reference Rates (‘O/N RFRs’) endorsed by the regulators in the major markets in which LIBOR is currently calculated.

Potential issues with O/N RFRs

The key advantage with O/N RFRs is that they are based on actual ‘arm’s length’ transactions within liquid markets. However, there are some potential disadvantages with O/N RFRs that investors should be aware of. The two most relevant differences for investors to consider are that O/N RFRs:

• Are daily rates; many of which are secured lending. LIBOR, like most financial contracts, covers unsecured lending of a fixed term.
• For longer periods, these rates are historical averages. This means that O/N RFRs are effectively backward-looking averages, whereas LIBOR is a forward-looking reference rate.

Implications for investors

The issue faced by investors and regulators is that there may not actually be such a thing as the perfect reference rate. While there are material issues with LIBOR, its key attraction for investors is that it is a forward-looking reference rate that incorporates both term and credit premiums. 

In contrast, the alternative O/N RFRs, which simply average actual overnight transactions, do not incorporate forward-looking term or credit premiums. Such a difference means that simply substituting reference rates within financial contracts is problematic and that investors will need to make suitable adjustments when moving from one reference rate to another. These adjustments will prove critical when ensuring the neutrality of such changes. In turn, the ability of investors to make consistent adjustments will be greatly assisted by the development of derivatives markets. This is because derivatives markets referencing O/N RFRs will facilitate the inferring of the market’s expectation regarding the average value of the O/N RFR over a particular ‘forward-looking’ period.

Not already a Livewire member?

Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.