LONDON INTERBANK OFFERED RATE (LIBOR)

15th May, 2023 Economy

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Context

RBI has asked banks and financial institutions to complete the transition from the scandal-hit London Interbank Offered Rate (LIBOR) and Mumbai Interbank Forward Outright Rate (MIFOR).
It has asked banks and financial institutions to adopt by July 1 a widely accepted Alternative Reference Rate, such as the Secured Overnight Financing Rate (SOFR).

LIBOR

LIBOR, the acronym for London Interbank Offer Rate, is the global reference rate for unsecured short-term borrowing in the interbank market. It acts as a benchmark for short-term interest rates.
It is used for pricing of interest rate swaps, currency rate swaps as well as mortgages. It is an indicator of the health of the financial system and provides an idea of the trajectory of impending policy rates of central banks.
In short it is the benchmark interest rate at which major global banks lend to one another.
LIBOR is administered by the Intercontinental Exchange, which asks major global banks how much they would charge other banks for short-term loans.
The rate is calculated using the Waterfall Methodology, a standardized, transaction-based, data-driven, layered method.
LIBOR has been subject to manipulation, scandal, and methodological critique, making it less credible today as a benchmark rate.
LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR) on June 30, 2023, with phase-out of its use beginning after 2021.

Understanding LIBOR

LIBOR is the average interest rate at which major global banks borrow from one another.
It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
ICE benchmark administration consists of 11 to 18 banks that contribute to each currency.
The rates received from the banks are arranged in descending order and the top and bottom quartiles are excluded to remove outliers. The arithmetic mean of the remaining data is then computed to get the LIBOR rate. The process is repeated for each of the 5 currencies and 7 maturities, thereby producing 35 reference rates. 3-month LIBOR is the most commonly used reference rate. The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day.
The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.
Each day, Intercontinental Exchange asks major global banks how much they would charge other banks for short-term loans. The association takes out the highest and lowest figures, then calculates the average from the remaining numbers. This is known as the trimmed average. This rate is posted each morning as the daily rate, so it's not a static figure. Once the rates for each maturity and currency are calculated and finalized, they are announced and published once a day at around 11:55 a.m.
LIBOR is also 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 fluctuate based on the interbank rate. This change in rate helps determine the ease of borrowing between banks and consumers.

Secured Overnight Financing Rate (SOFR)

Secured Overnight Financing Rate (SOFR) is a secured overnight interest rate.
SOFR is a reference rate (that is, a rate used by parties in commercial contracts that is outside their direct control) established as an alternative to LIBOR.
LIBOR has been published in a number of currencies and underpins financial contracts all over the world.
Because LIBOR is derived from banks' daily quotes of borrowing costs, banks were able to manipulate the rates through lying in the surveys. Deeming it prone to manipulation, UK regulators decided to discontinue LIBOR in 2021.
SOFR uses actual costs of transactions in the overnight repo market, calculated by the New York Federal Reserve.
SOFR is calculated differently from LIBOR and is considered a less risky rate.
The less risky nature of SOFR may result in lower borrowing costs for companies.
In addition, unlike the forward-looking LIBOR (which can be calculated for 3, 6 or 12 months into the future), SOFR is calculated based on past transactions, which limits the rate's predictive value on future interest rates.
In addition, SOFR is overnight, whereas LIBOR can have longer tenors.