The LIBOR is a global interest rate that affects the rates of many loans and investments. Here's how it's set, and why it's slated to end

Karen Fernandez

Sep 30, 2020, 02:52 IST

The LIBOR is a global interest rate that affects the rates of many loans and investments. Here's how it's set, and why it's slated to end

Based on what banks charge each other for loans, LIBOR interest rates are set and issued daily out of London.PeskyMonkey/Getty Images

The London Interbank Offered Rate (LIBOR) is a series of benchmark rates used by lenders to determine other short-term interest rates.
A variety of financial products like CDs and loans like adjustable-rate mortgages are based on LIBOR, especially the three-month rate.
Though often a harbinger of trends in bank lending rates, LIBOR is slated to be phased out by 2021.

Reading the fine print on the terms for a mortgage or a CD, you may come across the phrase "your rate based on the prevalent LIBOR rate."

The LIBOR, short for London Interbank Offered Rate, is a fluctuating short-term interest rate that influences the way other interest rates are set in the world of finance. It serves as a scale for setting the interest earned by debt instruments, like bonds and derivatives, and the interest charged on consumer loans.

An estimated $350 trillion worth of outstanding loans and trading contracts around the world are based on LIBOR.

What is LIBOR?

Somewhat like the US federal funds rate, LIBOR is an interbank rate: It reflects the interest that major banks charge each other when borrowing for brief periods — anywhere from overnight to 12 months.

Actually, there's no one LIBOR. It is based on five major currencies – the US dollar, the Swiss franc, the euro, the pound sterling, and the Japanese yen. Each currency is compiled for loans of seven different durations, ranging from one night to one year (see "current LIBOR rate" below).

In total, there are 35 LIBOR benchmarks administered and published every business day by the Intercontinental Exchange or ICE Benchmark Administration (IBA).

How is LIBOR determined?

The IBA gathers a consensus for calculating the average interest rate every morning. Shortly before 7 a.m., the IBA asks an elite panel of 16 global contributor banks how much they are willing to charge other banks for short-term loans.

Chosen annually, this panel has a tight membership consisting of financial institutions with a significant presence in the London market. For example, only the Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS represent the US dollar LIBOR.

These banks are required to send their answers for each loan maturity period under their country's specific currency. The IBA then calculates the LIBOR employing a standardized, transaction-based, data-driven layered method called the Waterfall Methodology.

Once finalized, all 35 LIBOR benchmarks are published around 11:55 a.m. London time.

What is the current LIBOR rate?

The daily fluctuating LIBOR rates vary, depending on the length of the loan. For example, at the end of September 2020, the USD LIBOR rates for loans were:

OVERNIGHT = 0.08%
1 WEEK = 0.11%
1 MONTH = 0.15%
2 MONTHS = 0.20%
3 MONTHS = 0.25%
6 MONTHS = 0.29%
12 MONTHS = 0.41%

Of all the LIBOR reference rates, the most significant and commonly quoted is the US Dollar Three-Month rate. It is usually referred to as the current LIBOR.

How does LIBOR affect you?

Ordinary individuals and most companies don't get charged LIBOR rates. But the LIBOR does act as a benchmark for many consumer loans, investments, and other financial products, somewhat like the prime rate in the US.

Investments Based on LIBOR

The early 1980s saw the development of a whole host of investments based on interest rates and currency exchanges. LIBOR was originally established to offer an interest-rate standard — a baseline rate — for financial products. Some are sophisticated instruments used by multinational corporations, others are as basic as your neighborhood bank's CD.

Financial derivatives

LIBOR is universally used to price interest rate swaps, a financial derivative in which two firms come to an agreement to trade rates. One company wants to receive a payment with a variable interest rate (like LIBOR), while the other wants to limit risk by choosing to receive a fixed-rate payment.

Certificates of Deposit (CD)

If your CD is LIBOR-linked, the bank will provide you an interest rate premium that rises as the LIBOR goes up, or lowers as it goes down. Some CDs average changes quarterly or annually, which ties your CD to the 3-month or 12-month LIBOR. You have the potential to earn a higher interest rate, compared to a fixed-rate CD, but of course, can earn less too.

Alternative investments

These include sophisticated vehicles like collateralized debt obligations (CDO), a tranche of income-generating assets repackaged to include LIBOR-tied mortgages, auto loans, and corporate bonds.

Loans Based on LIBOR

Lenders use the LIBOR as an index for determining variable interest rates on your financing products, too. Typically, they add a percentage point or two as a constant margin to the LIBOR rate.

Adjustable-Rate Mortgages (ARM)

Mortgages with floating interest rates are one of the most common products based on LIBOR. The interest rate is fixed for the initial period of your mortgage, then resets according to how the market fluctuates during the remaining period of your loan.

For example, if you have a 5/1 ARM, it would have a fixed rate for the first five years followed by an adjustable-rate that resets once yearly. That annual reset probably would be based on the 12-month LIBOR.

Private Student Loans

At many lending institutions, student loans are typically bound to the three-month LIBOR. This is why most student loans are adjusted quarterly. The upside is that most student loan companies put a cap on their interest rates. So even if the LIBOR goes high, your interest rate will not exceed a set ceiling.

LIBOR past and future

LIBOR dates from 1984. The British Bankers Association created it to establish a reliable source for interest rate-based investments.

It grew to become a respected benchmark all over the world—until 2012, when news broke that bankers had been rigging rates for years, mainly to help their derivatives traders.

The scandal led to Britain's Financial Conduct Authority (FCA) removing LIBOR from the supervision of the British Bankers Association and turning it over to the ICE Benchmark Administration.

n 2017, however, FCA made the announcement that it will no longer support LIBOR — the reason being that banks have slowed down lending to each other, making the index less reliable.

LIBOR is set for regulatory phase-out in 2021. After that date, banks will no longer be required to publish their LIBOR rates.

The financial takeaway

LIBOR rates determine the interest rates paid by a variety of investment products and the interest rates charged by variable-rate loans. Trends in LIBOR rates are also often used to estimate the trajectory of central bank rates in the future, and to gauge the overall health of the financial lending system on a global scale.

Replacements for LIBOR after 2021 are already being evaluated. The most likely candidate: the secured overnight financing rate (SOFR), based on transactions in the US Treasury-bill repurchase market.