10:03 pm - Monday December 18, 2017

LIBOR Revisited

Do you know?

When LIBOR was born?

Minos Zombanakis, born 88 years ago on a Greek island, remembers well the birth of the interest rate benchmark. “I was, more or less, if you excuse the lack of modesty, the one who started the whole thing,” he laughs, speaking by phone from his village among citrus orchards in Crete.

Zombanakis was running the newly opened London branch of Manufacturers Hanover, now part of JPMorgan Chase, when the bank organized one of the first loans pegged to what he dubbed a London Interbank Offered Rate, or Libor, in 1969.

The $80 million loan, for the Shah of Iran, in 1969 embodied the way cross-border financial markets that had been effectively closed since 1929 were being opened — sowing the seeds for London to flourish as a world financial center.

Libor evolved to meet rising demand around the 1960s for “Euro” currencies — offshore, stateless and often in dollars — that swept London and allowed companies and countries to borrow, deposit and repay while dodging domestic regulation and taxes.

The wave of overseas dollars was triggered in part by the costs of the Vietnam War and U.S. trade deficit.

Zombanakis and others jostled with rivals to organize banks into groups, sharing the risks for massive loans funded through a series of short-term deposits based on floating interest rates. Zombanakis says he devised the formula whereby a group of big “reference banks” within each group would report their funding costs shortly before a loan rollover date. The weighted average, rounded to the nearest one-eighth of a percent plus a “spread” for profit, became the price of the loan for the next period. The Libor formula remains broadly similar today.

Source: Reuters

LIBOR is now officially 28 years old!

To formalize the process, the British Bankers Association, a trade body, took control in 1986 and renamed it BBALibor. Thomson Reuters, parent company of Reuters, was involved in calulating and distributing the rates for the BBA starting from 2005

LIBOR is the rate of interest at which banks borrow funds from each other, in marketable size, in the London Inter Bank Market. It is basically designed as a benchmark rate that would be applied to Eurodollar funds.

By definition Eurodollar is US dollar denominated deposits at foreign banks outside US or foreign branches of American banks. By locating outside of the United States, Eurodollars escape regulations and reserve prescriptions by the Federal Reserve Board.

Since the Eurodollar market is relatively free of regulation, banks in the Eurodollar market can operate on narrower margins than banks in the United States. Due to this reason mainly, the Eurodollar market has expanded largely as a means of avoiding the regulatory controls and costs involved in dollar denominated financial intermediation.

Originally Eurodollar deposits were held almost exclusively in Europe; hence the name Eurodollars. These deposits are still mostly held in Europe, but they are also held in such countries as Hong Kong, Japan, Singapore, Bahamas, Canada, etc.

Regardless of where they are held, such deposits are referred to as Eurodollars (Actually in the cold war period, USSR started accumulating US dollar funds; fearing proscription or blockage of funds in the account if held in the United States it strategically moved its funds to France and particularly to French banks)

LIBOR was compiled by British Banks’ Association in conjunction with Reuters and released to the market shortly after 11 AM London time daily. BBA asks 16 banks to report the borrowing rates offered to them and it takes the middle eight of these and reports the average.

As Libor became a benchmark for trillions of dollars worth of derivatives, traders scented a new opportunity.

In more recent times, there was a temptation to rig rates because there is such a huge derivatives market with billions and billions of pounds of trades linked to Libor. So with just a 0.001 percent tweak, that can make serious money.

It was an open secret by the 2008 crisis that bank were understating borrowing rates. In part, that was to avoid showing signs of financial stress rather than to seek profits: the higher a bank’s borrowing costs, the more stretched the finances, the more worried the investors and customers, the more likely a run on the bank.

There was controversy over the accuracy of LIBOR immediately after financial market crises. Wall Street Journal study claimed that even some big US banks might have been underreporting LIBOR rates as not to reveal how desperate for cash they were due to the current global credit crunch in general and to fund their uncovered losses in particular.

The questions on the accuracy of LIBOR have arisen because of the present turbulent times in financial markets. Some researches have shown a dramatic imbalance between the funding patterns of US and European banks might have fuelled the tensions in money markets. For their increasing dollar funding requirements, the European banks have been depending on US banks.

Bank for International Settlements opined some banks might have understated their borrowing costs to avoid being perceived as lacking creditworthiness. Banks, reluctant to lend to one another because of fears they would need the money themselves, pushed up the LIBOR rate and lifted the cost for inter bank borrowing.

Libor, designed to reflect a bank’s borrowing costs accurately, burst into the headlines in 2012 when Barclays was fined a record $455 million for allowing traders to rig it and for low-balling rates during the 2007 and 2008 credit crunch. Barclays’ American CEO, Bob Diamond, lost his job, and other banks, among them Citigroup, are still under investigation. In the same year, UBS was fined $1.5 billion by regulators in US, UK and Switzerland. ICAP, a broker was also fined for manipulating LIBOR. Citigroup, RBS, Deutsche Bank, JP Morgan were the other banks which were involved and fined.

Due to this regulators and market participants desired for an effective bench mark rate to the London Interbank Offer Rate.

In 2012, the Chancellor of the Exchequer commissioned Martin Wheatley (then managing director of the FSA and Chief Executive-designate of the Financial Conduct Authority (FCA)) to review the framework for setting LIBOR. The Wheatley Review into LIBOR concluded that the existing governance and surveillance frameworks were inadequate to safeguard the integrity of LIBOR. One of the key recommendations of the Wheatley Review was that LIBOR needed to be administered by an independent entity.

UK Government announced establishment of Hogg Tendering Advisory Committee, an independent Committee to select a new administrator for the bench market rate – LIBOR.

The Hogg Committee selected ICE to take over (via a competitive tender process), and the FCA gave its authorisation from the 1st February 2014.

Now ICE is the new administrator for LIBOR.

ICE intends to return credibility, trust and integrity to LIBOR, by bringing together a strong regulatory and governance framework and market-leading validation techniques
ICE has implemented a new post-publication surveillance system and tests designed to assess the credibility of LIBOR submissions and rates

New surveillance methodology has been designed to adjust to changing market conditions and employs sophisticated analytical tools to operate the benchmark price setting process with transparency

Thomson Reuters continues to undertake the collection, some real-time surveillance and calculation services, under the oversight of ICE

Upon transfer, ICE took over from Thomson Reuters as the primary publisher of the LIBOR rates, using a new Secure File Transfer Protocol (SFTP) service.

Data continues to be available via third party re-distributors

On 23 January, the Loan Markets Association published two guidance notes discussing the impact of LIBOR transition to ICE, which are available for their members on their website.

New LIBOR calculation, operation and administration.

LIBOR is designed to reflect the short term funding costs of major banks active in London, the world’s most important wholesale financial market. Like many other financial benchmarks, LIBOR is a ‘polled’ rate. This means that a panel of representative banks submits rates which are then combined to give the LIBOR rate. Panel banks are required to submit a rate in answer to the LIBOR question:

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

Although banks now use transaction data to anchor their submissions, having a polled rate is crucial to ensure the continuous publication of such a systemic benchmark, even in times when liquidity is low and there are few transactions on which to base the rate.

Currently only banks with a significant London presence are on the LIBOR panels, yet transactions with other – non-bank – financial institutions can often inform panel banks’ submissions.

Reasonable market size is intentionally unquantified. The definition of an appropriate market size depends on the currency and tenor in question, as well as supply and demand. The current wording therefore avoids the need for frequent and confusing adjustments.

11 am is chosen because it falls in the most active part of the London business day. It is also sufficiently early in the day to allow the users of LIBOR to use each day’s rates for valuation processes, which may take place in the afternoon.

All LIBOR rates are quoted as an annualised interest rate. This is a market convention.

LIBOR is the ‘trimmed arithmetic mean’ of all of the panel banks’ submissions. This means that the highest and lowest 25% are removed and the rest is averaged (the actual number of banks removed depends on the number of submitters for each currency). The resulting rate is then published to the market at approximately 11.45 am London time.

In order to help ensure the integrity of the rate, individual submissions are not published until three months after the submission date. This helps in two ways: firstly, it makes it harder for banks to set their submissions purely in line with other panel banks rather than at their own perceived funding costs; and secondly, it also protects banks from the negative signalling effects that their submissions might have on market perceptions of a bank’s financial viability. This credit-signalling or ‘stigma-effect’ was one of the conflicts of interest which led to attempted manipulation of the rate.

LIBOR is an essential cog in the financial system. Its importance to the global financial industry and other non-financial companies arises from most corporate debt and interest-rate thinking being “ibor”-based. It is used as the floating rate for many financial contracts, from interest rate swaps to student loans, mortgages and corporate funding instruments. In total, hundreds of trillions of dollars’ worth of interest rate exposure is tied to LIBOR. Given its role as a global funding benchmark, LIBOR is also frequently used for valuing existing positions.

LIBOR determines the settlement prices for some of the most important exchange-traded short-term interest rate futures contracts. These contracts help companies around the world hedge their interest rate exposure. They also provide private sector economists and central bankers with insights into market expectations of economic performance and interest rate developments.

LIBOR is also an important indicator used by some central banks when determining their official interest rate target.

Restoring the integrity of such an important and widely used benchmark as LIBOR requires a combined effort from many organisations, including: the panel banks, the independent administrator (IBA), the regulator and other stakeholders. The FCA now has extensive new powers to supervise panel banks and to take individuals to court for benchmark-related misconduct. This increased regulatory oversight is a welcome development and is mirrored at both the European and the Global levels where the European Commission and the International Organisation of Securities Commissions (IOSCO) have published suggestions for strengthening benchmark governance. Banks have already committed significant resources and capital to improve their LIBOR processes and their internal governance, in line with new regulatory requirements.

As the new, independent administrator, ICE has introduced new surveillance systems and statistical analysis techniques which subject the submissions to much closer scrutiny. These compare the data provided by the panel banks with related markets, their own submission history and that of other panel banks. These tighter checks and controls will enable us to identify potential errors, manipulation and collusion, which will be escalated to the FCA.

ICE has also instituted an oversight and governance structure that emphasises independence, accountability and transparency for benchmark submitters and the administrator alike. It has established an independent Board composed of experienced professionals and experts from the fields of financial markets, financial law and regulation. The Oversight Committee, which brings together key LIBOR stakeholders from users, benchmark submitters and independent industry experts will regularly review the Code of Conduct. The Code has been approved by the FCA as industry guidance for the market, and will continue to evolve in order to reflect changes in the market and best practices.

Do you know what NYFR is?

NYFR is yet another bench mark rate – New York Funding Rate.

ICAP, a bond broker based in the United Kingdom launched the New York Funding Rate – NYFR – on 11th June 2008 – a measure of the average interest rate at which banks lend to one another – may be with an idea to replace LIBOR during those turbulent times. But it could not live up to its mission and role.

LIBOR timelines

Here are some important LIBOR milestones:

1969:

A loan for the shah of Iran becomes one of the first pegged to Libor.

1986:

First official Libor rates published in U.S. dollars, yen and pounds, meeting demand for global benchmarks.

2008:

NYFR was set up mainly as a competitor to replace LIBOR as benchmark

Libor rates spike after the collapse of Lehman Brothers at the height of the financial crisis. Rate setting at this time is central to investigations of rigging.

2012:

Regulatory fines starting with Barclays fined $455 million in a settlement with U.S. and British regulators over rigging rates.

Chancellor of UK Exchequer commissions Martin Wheatley to review framework for benchmark LIBOR

2014

ICE takes over as the new administrator for LIBOR from BBA

You may also want to read these

One Response to “LIBOR Revisited”

  1. Sudhir
    April 18, 2014 at 8:45 am #

    Great insight! Double worth reading this, sets a good start for anyone who wants to follow ibank dynamics.

Leave a Reply