Question

Why has LIBOR played such a central role in international business and financial contracts? Why has this been questioned in recent debates over its value reported? Please try to make it 450 words if possible please, thank you.

Answer 1

LIBOR stands for London Interbank Offered Rate, but its significance spreads far beyond the City of London or even Europe. Indeed, the LIBOR rate it is one of the most globally significant numbers in finance. Banks, financial institutions, and credit agencies all over the world look to LIBOR to set their own interest rates. There are currently outstanding contracts worth trillions of dollars spread across different maturities from overnight to 30 years that all reference the benchmark LIBOR. According to the UK Treasury, the value of financial contracts tied to LIBOR touches $300 trillion. However, this does not include consumer loans or adjustable rate home mortgages. According to the international exchange ("ICE") Benchmark Administration, “In total, hundreds of trillions of dollars’ worth of interest rate exposure is tied to ICE LIBOR.”

Every morning, the ICE Benchmark Administration asks a panel of contributor banks (usually 11 to 18 large, international banks) to answer the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” Banks provide different answers based on the currency and the length of the loan. The rates quoted by banks are annualized interest rates. The ICE Benchmark Association uses these rates to calculate LIBOR using a method called trimmed arithmetic mean wherein the extreme values are excluded.

Importance of LIBOR:

LIBOR offers daily average interest rates for five currencies (the U.S. dollar, euro, British pound, Japanese yen, and Swiss franc) and seven lending periods (ranging from overnight to 12 months). In total, there are 35 different daily LIBOR rates. LIBOR is governed by the International Exchange (ICE) Benchmark Administration. The Administration calculcates the LIBOR rates every day by surveying participating banks.

One of the main reasons LIBOR is used so widely is because of the way the rate is calculated and constructed. LIBOR represents the lowest borrowing rate among banks and big financial institutions. Other rates are fixed on top of the LIBOR. This is often expressed as “LIBOR + X bps” where, bps stands for basis point and X is the premium charged over and above the LIBOR rate by the lender to the borrower. Thus any increase or decrease in the base rate (which is the LIBOR rate) impacts contracts tied to LIBOR or based on it as a benchmark.

LIBOR is commonly used as the floating rate for interest rate swaps, future contracts, mortgages, student loans, and even corporate funding. LIBOR is also used for setting the settlement prices for interest rate future contracts that help companies to hedge interest rate exposure. LIBOR provides a fair idea to central banks and other important institutions about the expectations on interest rates and linked developments.

Reason why LIBOR has been questioned in the recent past:

Until January 31, 2014, the ICE LIBOR was known as the BBA LIBOR (for British Banker’s Association). BBA LIBOR came under fire when Barclays and few other institutions were investigated for manipulating the benchmark rate by submitting false borrowing rates to the British Banker’s Association. This shook the credibility of LIBOR in the financial markets. However, trust in the LIBOR was soon restored when governance was transferred to the ICE Benchmark Administration. Though LIBOR has endured controversies, its daily borrowing rates continue to be some of the most important numbers in finance.