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The Uncertain Future of LIBOR

The London Inter-Bank Offered Rate (LIBOR) is the average interbank borrowing interest rate used by the world’s leading banks (also known as the panel banks). It represents a primary benchmark for short-term interest rates globally and is used to value approximately $US350 trillion in derivatives and other financial products.

Since 2013, the UK Financial Conduct Authority (FCA) has been the primary regulator of LIBOR. However, in 2017, the FCA announced panel banks would not be subject to mandatory LIBOR submission post 2021, indicating declining support for LIBOR as a benchmark interest rate. This was largely expected given that the reliability of LIBOR has deteriorated greatly with an increasing number of attempted manipulations and false reporting cases.

Figure 1. Historical ICE LIBOR (3-month vs 6-month)

Source: Bloomberg, BondAdviser

The most well-known LIBOR scandal dates back to 2012 where an international investigation revealed multiple global-tier banks’ (Deutsche bank, Barclays, UBS, the Royal Bank of Scotland etc.) misconduct in LIBOR manipulation. Barclays was reported to be the first bank deliberately submitting false rates during the global economic upswing from 2005 to 2007 with the intent to artificially reduce borrowing costs. The bank again conducted another manipulation through reporting lower rates following the GFC in 2007. Later on, other panel banks were all more or less found guilty of rigging Libor or ignoring misconduct by employees’ behavior. Consequently, the involved banks were fined a huge amount totaling more than $US9 billion

The severe penalties associated with LIBOR violation underpins the importance of a worldwide adopted benchmark for pricing financial products and the significant consequences of deliberate manipulation of such a commonly used pricing measure. As a result, regulators have made significant improvements to the governance of LIBOR since 2013. However, this didn’t stop the reputation of LIBOR deteriorating and due to its ineffectiveness and inaccuracy, the argument for its removal has been increasing.

Specifically, LIBOR is calculated using a method involving limited transaction data from limited lending volumes. For this reason, the estimated borrowing rates reported by panel banks, as the input of LIBOR calculation, is more of a subjective judgement rather than an objective transactional borrowing rate. This subjectivity not only creates the possibility of market manipulation but reasonably impedes investors from assessing market conditions accurately. The UK regulators believe risk free rates to be the preliminary alternative to LIBOR and working groups made up of the Bank of England and the FCA are in the stage of reviewing a suitable replacement and developing a possibly better benchmark framework.

Figure 2. Historical BBSW (3-month vs 6-month)

Source: Bloomberg, BondAdviser

Australia seems to be facing a similar situation with the bank bill swap rate (BBSW) with the liquidity and transparency being questioned. In response, the RBA suggested that it would support a move away from the National Best Bid and Offer (NBBO) calculation method to the broader volume weighted average price method, broadly in line with LIBOR regulators. While no one is calling for the abolition of BBSW in Australia, the administration and application of BBSW is subject to more refinements and improvements.