The End of Libor is Nigh

Discussion in 'Economics' started by dealmaker, Oct 31, 2018.

  1. dealmaker



    ByTom P. Davis, PhD, CFA | October 31, 2018

    The London Interbank Offered Rate (LIBOR) has been a mainstay of the financial markets since its inception in the 1980s as an underpinning of the then nascent swap market. Since then, LIBOR has gained fame, and more recently notoriety, and is the reference rate for over $240 trillion in securities globally.

    The shortcomings of LIBOR were not initially apparent, hence the exponential growth in securities that used LIBOR as a reference rate. However, throughout its lifetime, two LIBOR shortcomings arose.

    First, the daily LIBOR fixing was designed to represent the average funding rate of the interbank market, which included the largest banks in the world—Bank of America, Bank of Tokyo-Mitsubishi, Barclays, Citi, Credit Agricole, Credit Suisse, Deutsche, HSBP, JPMorgan, Lloyds, Rabobank, Royal Bank of Canada, Societe Generale, Sumimoto, Norichukin, Royal Bank of Scotland, and UBS.

    However, some of these banks realized that they could actually lock in a funding rate that was lower, and sometimes significantly so—particularly for collateralized swaps, where the true funding rate is the overnight index swap (OIS) rate (for instance, the fed funds rate in the U.S.). This was famously exploited by Goldman Sachs soon after the global financial crisis of 2008, when they figured out that discounting plays a central role in determining par swap rates. Based on this insight, Goldman was able to enter into swaps that appeared to be at par based on LIBOR discounting, whereas the swap was an asset based on OIS discounting. Once the market dislocation occurred, and the market accepted OIS discounting as the standard, evidence emerged that Goldman indeed capitalized on this change, reporting 132% greater collateral postings than the previous year.

    The second shortcoming is that the LIBOR fixing is determined by a poll, which means it is possible for banks to misrepresent their funding rates. Unfortunately, this occurred in the early 2000s (some say this had been happening since as early as 1991). In 2012, civil charges related to the manipulation were investigated, culminating in billions of dollars of fines leveed by the U.S. Department of Justice and the UK Financial Services Authority.

    Therefore, in 2014, the Alternative Reference Rate Committee (AARC) formed to determine a rate that will succeed LIBOR as the reference rate for USD denominated bonds, mortgages and interest rate derivatives. The decision actually came as a bit of a surprise to the market, which expected the U.S. fed funds rate to be the successor, albeit in modified form. In fact, this is exactly the choice taken by the Bank of England, who chose a modified SONIA rate as the successor to GBP LIBOR.
    Clubber Lang likes this.
  2. Overnight


    Good riddance to bad trash, I say.
    dealmaker likes this.