LIBOR: What Was the London Interbank Offered Rate, and How Was It Used?

What Was the London Interbank Offered Rate (LIBOR)?

The London Interbank Offered Rate (LIBOR) was a benchmark interest rate for short-term loans between major global banks. It was phased out in 2023.

From 1986 to the 2000s, LIBOR was a globally accepted key benchmark for the cost of borrowing between banks. The rate was calculated and published each day by the Intercontinental Exchange (ICE), but scandals and questions around its validity as a benchmark rate resulted in it being phased out.

According to the Federal Reserve and regulators in the United Kingdom, LIBOR was phased out on June 30, 2023, and replaced by the Secured Overnight Financing Rate (SOFR). LIBOR one-week and two-month USD LIBORs stopped publishing as of Dec. 31, 2021, as part of the phaseout. Some USD rates are still published using a synthetic methodology, but these rates will cease in Sept. 2024.

Understanding LIBOR

LIBOR was the average interest rate at which major global banks borrow from one another. It was based on five currencies—the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc—and served seven different maturities: overnight/spot next, one week, and one, two, three, six, and 12 months.

Interbank lending is the basis for consumer loans in countries around the world, so it impacts consumers just as much as it does financial institutions. The interest rates on various credit products such as credit cards, car loans, and adjustable-rate mortgages (ARMs) fluctuate based on the interbank rate. This change in rate helps determine the ease of borrowing between banks and consumers.

The combination of five currencies and seven maturities led to a total of 35 different LIBORs calculated and reported each business day. The most commonly quoted rate was the three-month U.S. dollar rate, usually referred to as the current LIBOR.

ICE calculated the LIBOR by asking major global banks how much they would charge other banks for short-term loans. The association took out the highest and lowest figures, then calculated the average from the remaining numbers. This is known as the trimmed average.

This rate was posted each morning as the daily rate, and announced and published once a day around 11:55 a.m. London time by the ICE Benchmark Administration (IBA).

How Was LIBOR Calculated?

The IBA had a designated panel of global banks for each currency and tenor pair. For example, 16 major banks, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS, constituted the panel for U.S. dollar LIBOR. Only those banks with a significant role in the London market were considered eligible for membership on the ICE LIBOR panel, and the selection process was held annually.

In April 2018, the IBA submitted a new proposal to strengthen the LIBOR calculation methodology. It suggested a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology for determining LIBOR.

• The first transaction-based level involved taking a volume-weighted average price (VWAP) of all eligible transactions that a panel bank may have assigned a higher weighting for transactions booked closer to 11 a.m. London time.
• The second transaction-derived level involved taking submissions based on transaction-derived data from a panel bank if it does not have a sufficient number of eligible transactions to make a Level 1 submission.
• The third level—expert judgment—would come into play when a panel bank fails to make a Level 1 or a Level 2 submission. It would submit the rate at which it could finance itself at 11 a.m. London time, with reference to the unsecured, wholesale funding market.

The IBA calculated the LIBOR using a trimmed mean approach applied to all the responses received. Trimmed mean is a method of averaging, which eliminates a small specified percentage of the largest and smallest values before calculating the mean. For LIBOR, figures in the highest and lowest quartile are thrown out, and averaging is performed on the remaining numbers.

Uses of LIBOR

LIBOR has been used worldwide in a wide variety of financial products. They include the following:

• Standard interbank products like forward rate agreements (FRAs), interest rate swaps, interest rate futures, options, and swaptions, whereby options provide buyers with the right, but not the obligation, to purchase a security or interest rate product
• Commercial products like floating rate certificates of deposit (CDs) and notes, variable rate mortgages, and syndicated loans, which are loans offered by a group of lenders
• Hybrid products like collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and a wide variety of accrual notes, callable notes, and perpetual notes
• Consumer loan-related products like individual mortgages and student loans

LIBOR is also used as a standard gauge of market expectations for interest rates finalized by central banks. It accounts for the liquidity premiums for various instruments traded in the money markets, as well as an indicator of the health of the overall banking system.

A lot of derivative products are created, launched, and traded in reference to LIBOR. LIBOR is also used as a reference rate for other standard processes like clearing, price discovery, and product valuation.

A Brief History of LIBOR

The need for a uniform measure of interest rates across financial institutions became necessary as the market for interest rate-based products began evolving during the 1980s. The British Bankers’ Association (BBA), which represented the banking and financial services industry, set up BBA interest-settlement rates in 1984.

Further streamlining led to the evolution of BBA LIBOR in 1986, which became the default standard interest rate for transacting in the interest rate- and currency-based financial dealings between financial institutions at the local and international levels.

Since then, LIBOR underwent many changes. The major one is when BBA LIBOR changed to ICE LIBOR in February 2014 after the Intercontinental Exchange took over the administration.

Currencies involved in calculating LIBOR have also changed. While new currency rates have been added, many have been removed or integrated following the introduction of the euro rates. The 2007–2008 financial crisis saw a significant decline in the number of tenors for which LIBOR was calculated.

Alternatives to LIBOR

Though LIBOR was once accepted globally, there are several other interest rates that are popularly followed around the globe.

For instance, Europe has the European Interbank Offered Rate (EURIBOR), Japan has the Tokyo Interbank Offered Rate (TIBOR), China has the Shanghai Interbank Offered Rate (SHIBOR), and India has the Mumbai Interbank Offered Rate (MIBOR).

LIBOR Rate Rigging Scandal

While LIBOR was a long-established global benchmark standard for interest rates, it was also the subject of a major scandal of rate rigging.

Major banks allegedly colluded to manipulate the LIBORs. They took traders’ requests into account and submitted artificially low LIBORs to keep them at their preferred levels. The intention behind the alleged malpractice was to bump up the profits of traders who were holding positions in LIBOR-based financial securities.

Following reporting by The Wall Street Journal in 2008, major global banks, which were on the panels and contributed to the LIBOR determination process, faced regulatory scrutiny, including investigations by the U.S. Department of Justice. Similar investigations were launched in other parts of the globe, including in the U.K. and Europe.

Major banks and financial institutions, including Barclays, ICAP, Rabobank, Royal Bank of Scotland, UBS, and Deutsche Bank, faced heavy fines. Punitive actions were also taken against their employees who were found to be involved in the malpractice. The scandal was also one of the primary reasons why LIBOR shifted from BBA administration to ICE.

Benefits of Watching LIBORs

Despite the rate-setting scandals, LIBORs provided a useful benchmark for the level of activity in the global economy. A falling LIBOR meant it was easier to borrow money, possibly forecasting an increase in economic activity. A rising LIBOR meant that it was getting harder to borrow money, and that business activity was likely to slow down.

These rates are particularly significant to a prospective borrower. When you borrow money from a bank, LIBORs may account for part of your interest rate. A high LIBOR meant that you could have to pay a higher interest rate on your mortgage or personal loan, while a low LIBOR meant a more favorable rate.

LIBOR Phaseout

Following the rate-rigging scandals, regulators initiated reforms to revise the benchmark rates and ultimately replace LIBOR as the interbank borrowing rate. U.K. banks were no longer required to publish LIBORs after 2021.

The new system was designed to replace the conjecture surrounding interest rates and instead use actual transaction rates. The Secured Overnight Financing Rate (SOFR) replaced LIBOR in 2023.

The SOFR is also a benchmark interest rate used for dollar-denominated loans and derivative contracts. SOFR is different from LIBOR in that it’s based on actual observed transactions in the U.S. Treasury market, while LIBOR used estimations of borrowing rates.

However, SOFR is used in the United States and the U.K., while other countries have their own benchmark rates to replace LIBOR.

Examples of LIBOR-Based Products and Transactions

The most straightforward example of a LIBOR-based transaction is a floating rate bond, which pays an annual interest based on LIBOR, say at LIBOR + 0.5%. As the value of LIBOR changes, the interest payment will change.

LIBOR also applies to interest rate swaps—contractual agreements between two parties to exchange interest payments at a specified time. Assume Paul owns a $1 million investment that pays him a variable LIBOR-based interest rate equal to LIBOR + 1% each quarter. Since his earnings are subject to LIBOR values and are variable in nature, he wants to switch to fixed-rate interest payments.

Then there is Peter, who has a similar $1 million investment, which pays him a fixed interest of 1.5% per quarter. He wishes to get a variable earning, as it may occasionally give him higher payments.

Both Paul and Peter can enter into a swap agreement, exchanging their respective interest receipts. Paul will receive the fixed 1.5% interest over his $1 million investment from Peter, which equals $15,000, while Peter receives LIBOR + 1% variable interest from Paul.

If LIBOR is 1%, then Peter will receive 2% or $20,000 from Paul. Since this figure is higher than what he owes to Paul, in net terms, Peter will get $5,000 ($20,000 - $15,000) from Paul. By next quarter, if LIBOR comes down to 0.25%, Peter will be eligible to receive 1.25% or $12,500 from Paul. In net terms, Paul will get $2,500 ($15,000 - $12,500) from Peter.

Such swaps essentially fulfill the requirement of both the transacting parties who wanted to change the type of interest receipts (fixed and floating).

The Bottom Line

LIBOR, or the London Interbank Offered Rate, was a global benchmark that represented the interest rates on short-term loans from one bank to another; however, the index fell under suspicion in 2012, when some bankers were discovered manipulating the index for their own benefit. LIBOR has since been nearly fully phased out, with the last few rates to cease publication in late 2024.