LIBOR, the London Inter-Bank Offered Rate, is on the verge of being consigned to history – or maybe not!
ICE Benchmark Administration (IBA), the entity that took over administration of LIBOR in 2014 from the British Bankers Association after a major scandal in which bank traders were found to have rigged the LIBOR to benefit their own trading positions, has a plan to strengthen the rate, making it still part of the financial market ecosystem.
Almost 50 years after Greek financier Minos Zombanakis first engineered LIBOR to facilitate an $80 million loan to the Shah of Iran in 1969, the UK and United States have both announced the launch of new localised dollar and sterling derivatives benchmarks.
LIBOR has been a cornerstone of international finance since Zombanakis, the self-made son of a poor Cretan farmer who had also worked on the Marshall plan, was approached by an old friend who by then happened to also be Iran’s central banker, Khodadad Farmanfarmaian.
Farmanfarmaian asked Zombanakis, who had moved to London from the United States to run a newly opened branch of Manufacturers Hanover (subsequently acquired by JPMorgan), if he could facilitate a loan of $80 million as part of Iran’s 5-year plan.
International interbank loans had been left behind with the Wall Street crash of 1929, so fulfilling Farmanfarmaian plea would require some new ground to be broken. The scale of the sum, the equivalent of around $543 million in today’s terms, was too rich a risk for Zombanakis own bank to take on. He did, however, manage to put together a group of banks to syndicate the loan.
The concept Zombanakis came up with to structure the loan, convincing the other banks to come on board, was a floating interest rate updated every few months depending on market conditions. This allowed the banks to fund the loan, including a small spread for profit, in a way that reduced their risk while also providing a competitive rate for the borrower.
It was a win-win scenario, re-launched international finance and the path towards globalisation and one of the most significant milestones in the modern history of the global economy.
The end is nigh
Despite its revolutionary role in the development of international finance, the sun is beginning to set on Libor. On 3 April, the New York Fed launched a benchmark overnight lending rate. The Secured Overnight Financing Rate (SOFR), which is the first milestone of a multi-year plan to transition away from dependence on LIBOR.
SOFR is based on the $800 billion daily overnight Treasury repurchase agreement market. Initially, SOFR will be used as the interest basis for futures trades, with CME Group set to adopt the new benchmark from 7 May. Swaps trading using the SOFR rate will begin later in the year.
In late April, the Bank of England also announced its own LIBOR alternative, the Sterling Overnight Index Average, or SONIA. The new benchmark is based on bank and building societies’ overnight funding rates in the sterling unsecured market.
A ‘working group of major dealers’ chose SONIA over two other alternative systems put to them and their recommendation will go through a market consultation process later in the year. If consensus is reached, the full transition from Libor has been targeted for 2021.
The Eurozone has also been exploring its own LIBOR alternatives but recently abandoned a review of the Euro Overnight Index Average (EONIA). New EU benchmark standards come into force from 2020 which EONIA was considered unlikely to meet. The ECB has gone back to the drawing board.
LIBOR is based on the average rate a contributor bank would be able to obtain unsecured loans through the London interbank market. This is based on actual interbank loans or, where none exist, an estimate of what rate would be offered for such a loan would.
The average comes from a panel of 11 to 16 banks, which independently provide the rate at which they would lend in GBP, USD, EUR, JPY and CHF over seven maturity dates ranging from overnight to twelve months.
However, since the financial crisis of 2007-08, though the process started several years earlier, interbank lending has fallen dramatically. Andrew Bailly, Chief Executive of the UK financial regulator (FCA) estimates there are now as few as 20 ‘certain’ interbank loan transactions over a year. This means the reality is that for some time now LIBOR has largely been set based on experts estimates rather than actual data.
This new reality of financial markets can also be pinpointed as the indirect cause of the LIBOR rate setting scandal, which has resulted in banks involved, being fined over $9 billion dollars for fraud, collusion and manipulation.
An international investigation launched in 2012 uncovered that several banks on the LIBOR panel, most notably Deutsche Bank, Barclays, UBS, Rabobank, and the Royal Bank of Scotland, had been systematically colluding on the estimated interest rates they provided towards the average daily rate.
They were artificially inflating the LIBOR rate for their own profit. During the financial crisis, banks were also found to be low balling. They were providing artificially low LIBOR estimates to improve the image of their creditworthiness.
“LIBOR is a widely used benchmark for short-term interest rates.”
The LIBOR rate, upon which contracts worth a notional $240 trillion are still based, is now set by independent administrators.
However, with the FCA halting the obligatory publishing of the interbank loans it is theoretically based on as of 2021, it is widely accepted that the most likely scenario is that the 50-year old benchmark will cease to exist.
LIBOR possible revival
ABI recent announcement indicates that the company is willing to take a calculated-risk in trying to rescue the damaged benchmark. Their plan is to strengthen LIBOR by introducing new procedures for how global banks derive and submit the quotes used to generate the benchmark.
In the coming weeks, ABI will begin the process of transitioning Panel Banks from submitting in accordance with the current LIBOR methodology to the Waterfall Methodology, with an expectation to be completed by no later than the first quarter of 2019.
The new methodology is structured in 3 levels: transactions-based data, transaction-derived data, and expert-judgement data.
Tim Bowler, ABI President, said: “We are pleased to publish our report on LIBOR’s continued evolution which summarises the reform efforts by the industry and our strategy for LIBOR. This next stage of enhancing the methodology supports the objective of developing a robust and sustainable LIBOR that can continue on a voluntary basis beyond 2021.”