LIBOR Curve: What it is, How it Works, Criticism

What Is the LIBOR Curve?

The LIBOR curve is the graphical representation of the interest rate term structure of various maturities of the London Interbank Offered Rate, commonly known as LIBOR. LIBOR is a short-term floating rate at which large banks with high credit ratings lend to each other. The LIBOR curve depicts the yield curve for short-term LIBOR rates of less than one year. The transition from LIBOR to other benchmarks, such as the secured overnight financing rate (SOFR), began in 2020.

Understanding the LIBOR Curve

LIBOR is one of the world's most widely used benchmarks for short-term interest rates. It serves as a primary indicator for the average interest rate at which contributing banks may obtain short-term loans in the London interbank market. The LIBOR curve plots rates against their corresponding maturities. The LIBOR curve typically plots its yield curve across seven different maturities—overnight (spot next (S/N)), one week, one month, two months, three months, six months, and 12 months.

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward-sloping curve), inverted (downward-sloping curve), and flat.

1. Upward sloping: long-term yields are higher than short-term yields. This is considered to be the "normal" slope of the yield curve and signals that the economy is in an expansionary mode.
2. Downward sloping: short-term yields are higher than long-term yields. Dubbed as an "inverted" yield curve, and signifies that the economy is in, or about to enter, a recessive period.
3. Flat: very little variation between short- and long-term yields. Signals that the market is unsure about the future direction of the economy.

Although not theoretically risk-free, LIBOR is considered a good proxy against which to measure the risk/return tradeoff for other short-term floating rate instruments. The LIBOR curve can be predictive of longer-term interest rates and is especially important in the pricing of interest rate swaps.

Criticism of the LIBOR Curve

Abuse of the LIBOR system for personal gain was uncovered in the wake of the financial crisis that began in 2008. Massive dislocations in global banking enabled individuals working at contributor banks to manipulate LIBOR rates. In 2013, the Financial Conduct Authority (FCA) of the U.K. took over the regulation of LIBOR. As of December 2020, plans were in place to phase out the LIBOR system by 2023 and replace it with other benchmarks, such as the Sterling Overnight Index Average (SONIA).