The London Interbank Offered Rate, better known as the LIBOR, was once the most important benchmark interest rate for pricing overnight and short-term loans that banks make to each other. This reference rate served as the basis for other types of loans made by financial institutions, including mortgages, car loans and financial products like credit default swaps (CDS). All of these and more were related to LIBOR in some way.
However, since 2021, LIBOR has been phased out, following a series of criticisms and a major scandal involving financial collusion and manipulation by various banks in setting LIBOR. Since then, several alternatives have been proposed to facilitate the interbank credit market. Here we take a look at a few of these benchmark rates.
Key points to remember
- The London Interbank Offered Rate (LIBOR) was once the most influential benchmark used to set short-term interest rates.
- Following a rate-fixing scandal, LIBOR was phased out and ceased to be used in 2021.
- Several alternative reference rates have been proposed to facilitate the interbank lending market.
- The Secured Overnight Funding Rate (SOFR) has emerged as a key candidate to replace LIBOR.
- Other alternatives include the Federal Funds Rate, the American Interbank Offered Rate (Ameribor), and the Bloomberg Short-Term Bank Yield Index (BSBY).
The interbank lending market
The modern bank operates using a fractional reserve based on the fact that it is very unlikely that all depositors in a bank will demand to withdraw their deposits at the same time. As a result, banks are free to lend borrowers a portion of the deposits they hold.
The amount of these loans that can take place is determined by the Reserve ratio, usually set by central banks. If the reserve ratio is 10%, for example, a bank can lend 90% of deposits while keeping 10% on hand. mandatory reserves (so $100 could create $90 in loans from that bank).
Sometimes a bank ends up with more than required reserves due to a decline in lending. Other times, a bank may end up with less than this proportion. As a result, banks with Excess reserves can lend these short-term funds to other banks that need reserves. This is the interbank lending market, which involves loans with maturities of up to several weeks.
The interest rate attached to these loans is determined by the supply and demand for reservations. However, not all banks are sufficiently active in this market, so they rely on reference interest rates to secure these interbank loans. This is where LIBOR came into play and its alternatives fill in today.
On November 30, 2020, the Federal Reserve announced that LIBOR would be phased out and eventually replaced by June 2023. In the same announcement, banks were instructed to stop writing contracts using LIBOR by June 2023. end of 2021 and that all contracts using LIBOR should close by June 30, 2023.
Secured Overnight Funding Rate (SOFR)
The Secured Overnight Funding Rate (SOFR) is a benchmark interest rate for derivatives and dollar-denominated loans that is adopted as a replacement for LIBOR by many of the world’s largest financial institutions. SOFR is calculated from treasury operations repurchase (repo) market and is considered preferable to LIBOR-type rates because it is based on data from many observable transactions rather than estimated borrowing rates set by banks’ trading desks.
Federal funds rate
The federal funds rate is the rate at which the major US commercial banks lend to each other. Its purpose is set by the Federal Open Market Committee (FOMC) of the Federal Reserve, but the actual rate is determined in the market. However, this rate is capped by the Fed discount rate, the interest rate at which he asks commercial banks to borrow directly from him. So, if the fed funds rate were to hypothetically rise higher than the bank rate, the banks would simply borrow directly from the Fed.
The US Interbank Offered Rate (Ameribor) is a benchmark interest rate that reflects the real cost of short-term interbank borrowing. It was created in 2015 by the American Financial Exchange (AFX) in collaboration with the CBOE. Unlike the SOFR, which examines secured loans (secured), Ameribor tracks unsecured dollar-denominated interbank yields and is intended to help small and medium regional banks. Rates for Ameribor are created from trades seen on AFX.
Bloomberg Short Term Bank Yield Index (BSBY)
The Bloomberg Short Term Bank Yield Index (BSBY) provides a series of short-term benchmark rates that banks can use for overnight, three-month, six-month and 12-month maturities. Established in 2021 by financial analyst firm Bloomberg LP, the BSBY reviews unsecured loans across a range of products such as commercial paper, certificates of deposit (CD)sight and short-term deposits corporate bonds. The index is constructed from trades observed on Bloomberg’s proprietary trading platforms as well as flows from the Financial Industry Regulatory Authority (FINRA).
€STR stands for Euro Short-Term Rate, which is the benchmark rate at which European banks engage in unsecured euro-denominated short-term loans. The €STR replaced the Euro overnight index average (EONIA) rate in 2022.
The Average Overnight Index in British Pounds (SONIA) is the overnight effective interest rate paid by banks for not guaranteed transactions in the British pound sterling market. It is used for day-to-day financing of transactions that take place outside working hours and represents the depth of day-to-day activity in the UK financial market.
What benchmark rate will be used to replace the London Interbank Offered Rate (LIBOR)?
In the United States, most major financial institutions have adopted the Secured Overnight Funding Rate (SOFR), although there are also alternatives looking into the unsecured interbank lending market. In Europe, the Euro Short-Term Rate (€STR) will be used (which replaces the Euro Overnight Index Average (EONIA)). In the United Kingdom, the Sterling Overnight Index Average (SONIA) is the new reference rate.
Why is LIBOR abolished?
While LIBOR was once arguably the most important short-term benchmark interest rate, it turned out to have been subject to widespread manipulation, scandal and methodological criticism, rendering it less credible. today as a valid reference. The rate is being phased out so that by the end of 2021, no new contracts could be written using LIBOR; by mid-2023, all existing LIBOR-based products will be terminated. LIBOR has been replaced by SOFR, although several other alternatives, such as the Bloomberg Short-Term Bank Yield Index (BSBY) and the American Interbank Offered Rate (Ameribor), also exist.
How do the new interbank benchmark rates improve LIBOR?
The LIBOR scandal revealed that having a small panel of banks setting a benchmark rate is not ideal. Newer rates like SOFR instead use actual transaction data to construct benchmark yields for short-term loans.