What is LIBOR transition?

FCA recently announced that the LIBOR transition will be completed by 2021 Dec 31st. But what is exactly LIBOR transition? And what does it mean to the general retail traders?

Understanding LIBOR

LIBOR stands for London Interbank Offered Rate. In simple terms, the LIBOR is supposed to be the rate that banks based in London, would lend to each other. However, there would be different rates that banks would lend to each other. One bank may offer a slightly lower rate to another bank who is very credit worthy, but would charge another bank slightly higher. Because of this, the LIBOR is actually an averaged out value of these rates. The LIBOR is still supposed to be a “good representation” of the rates that the banks lend to each other.

How is LIBOR calculated?

LIBOR is currently calculated by the Intercontinental Exchange (ICE). On a daily basis, ICE requests participating banks to submit lending rates. The final rate is calculated using a multi-stage model. 1st, the VWAP of the rates are calculated. A higher weight is given to the rates that are submitted closer to the cut-off time. If there aren’t enough participants at the 1st stage, data derived from historical rates are used. And as a 3rd stage, an expert panel provides an opinion on the rate.

LIBOR rate changes every day. It is also not a single rate. Depending on the term the banks are planning to lend each other, there can be multiple rates. Also, the banks would lend to each other at different rates for different currencies. Currently LIBOR is calculated for the five major currencies (GBP, USD, EUR, CHF, JPY) and for multiple different time periods (e.g. overnight, 1 week, 2 weeks, 1M, 2M, 3M, 6M, 12M).

What is LIBOR used for?

LIBOR is used for pricing various financial products like futures, options, non-deliverable forwards. Retail products like mortgages, student loans, certificates of deposits etc. also use LIBOR as a benchmark. From a non-retail point of view, LIBOR is also used to value trades that deal with interest rate swaps, CDOs, swaptions etc.

What is LIBOR transition?

LIBOR transition is process of moving from LIBOR to a newly benchmark standard, SOFR. The transition came as a result of several allegations and then results of inquiries that the LIBOR rate was manipulated.

LIBOR was a quoted rate and the process did not validate if the rates were actually the rates that each bank lent to each other. As a result many bank were quoting rates that are different to the actual rates that is used in the market. As the quoted LIBOR rate is used for various benchmarks, the banks were directly and indirectly making profits through the incorrect rates.

Starting from around 2008, allegations started turning up that the banks were incorrectly stating the rates and are profiting from it. As the LIBOR rate is also used in the US markets, this initiated legal action in the US as well. In 2012, homeowners in US filed a class action lawsuit against 12 banks. The lawsuit alleged that the mortgage payments were made unnecessarily and incorrectly large due to the rigging of LIBOR rates by the banks.

After a series of lawsuits and investigations, the British Bankers Association agreed to move the LIBOR to be administered by ICE. Barclays was fined for 200 million USD by the CFTC. UBS paid a fine of 1.5 billion USD. However even with the ICE stepping in, there was no guarantee that the quoted rates are anything to do with the actual rates.

The entire series of events that started from 2008 is called the LIBOR scandal.

What is the new rate, SOFR?

SOFR stands for Secured Overnight Financing Rate. Unlike LIBOR, which was a quoted rate, SOFR is calculated based on actual trades that are published in the market. If anyone needs to verify the SOFR rate, they can look at the actual trades carried out in the market and compute it.

This means that unlike LIBOR which was a forward looking rate, SOFR is based on historical facts. SOFR is also an overnight rate. This means that while LIBOR covered multiple tenures, SOFR is always about overnight rate.

What does this mean to you as a retail trader or the general public?

If you are a retail trader, it is possible that you may have used either LIBOR as a benchmark to value your futures and options. In that case, it is a simple matter of changing your benchmark. However as the SOFR is published as the overnight rate, you will have to compute the relevant term rates.

If you are the general public, the matter is mostly an assurance. LIBOR scandal caused a massive distrust in the financial sector. The public were treated unfairly as the rates were manipulated by the banks. Regulators believe that by using a transparent rate, they can provide a fairer view to the market. There is no rule to say that mortgages and student loans have to be pegged to the LIBOR or the SOFR rates. But the public can evaluate their credit position much better with a publicly verifiable rate.