Tuesday, September 11, 2012

LIBOR




The London Interbank Offered Rate is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is usually abbreviated to Libor or LIBOR, or more officially to BBA Libor (for British Bankers' Association Libor) or the trademark bbalibor. It is the primary benchmark, along with the Euribor, for short term interest rates around the world. 
Libor rates are calculated for ten different currencies and 15 borrowing periods ranging from overnight to one year and are published daily at 11:30 am (London time) by Thomson Reuters. Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor.
In June of 2012, multiple criminal settlements by Barclays Bank revealed significant fraud and collusion by member banks connected to the rate submissions, leading to the Libor scandal.


Introduction

In 1984, it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps, foreign currency options and forward rate agreements. While recognizing that such instruments brought more business and greater depth to the London Interbank market, bankers worried that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984, the British Bankers' Association (BBA)—working with other parties, such as the Bank of England—established various working parties, which eventually culminated in the production of the BBA standard for interest rate swaps, or "BBAIRS" terms. Part of this standard included the fixing of BBA interest-settlement rates, the predecessor of BBA Libor. From 2 September 1985, the BBAIRS terms became standard market practice. BBA Libor fixings did not commence officially before 1 January 1986. Before that date, however, some rates were fixed for a trial period commencing in December 1984.
Member banks are international in scope, with more than sixty nations represented among its 223 members and 37 associated professional firms as of 2008. Eighteen banks for example currently contribute to the fixing of US Dollar Libor. The panel contains the following member banks:

  • Bank of America
  • Bank of Tokyo-Mitsubishi UFJ
  • Barclays Bank
  • BNP Paribas
  • Citibank NA
  • Credit Agricole CIB
  • Credit Suisse
  • Deutsche Bank
  • HSBC
  • JP Morgan Chase
  • Lloyds Banking
  • Rabobank
  • Royal Bank of Canada
  • Société Générale
  • Sumitomo Mitsui Banking
  • The Norinchukin Bank
  • The Royal Bank of Scotland
  • UBS AG

Scope

The Libor is widely used as a reference rate for many financial instruments in both financial markets and commercial fields. There are three major classifications of interest rate fixings instruments, including standard interbank products, commercial field products, and hybrid products which often use the Libor as their reference rate.
Standard interbank products:
Commercial field products:
 Hybrid products:
In the United States in 2008, around 60 percent of prime adjustable-rate mortgages and nearly all subprime mortgages were indexed to the US dollar Libor. In 2012, around 45 percent of prime adjustable rate mortgages and more than 80 percent of subprime mortgages were indexed to the Libor. American municipalities also borrowed around 75 percent of their money through financial products that were linked to the Libor. In the UK, the three-month British pound Libor is used for some mortgages—especially for those with adverse credit history. The Swiss franc Libor is also used by the Swiss National Bank as their reference rate for monetary policy.
The usual reference rate for euro denominated interest rate products, however, is the Euribor compiled by the European Banking Federation from a larger bank panel. A euro Libor does exist, but mainly, for continuity purposes in swap contracts dating back to pre-EMU times. The Libor is an estimate and is not intended in the binding contracts of a company. It is, however, specifically mentioned as a reference rate in the market standard International Swaps and Derivatives Association documentation, which are used by parties wishing to transact in over-the-counter interest rate derivatives.

Definition of Libor

Libor is defined as:
The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.
This definition is amplified as follows:
  • The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market.
  • Contributions must represent rates formed in London and not elsewhere.
  • Contributions must be for the currency concerned, not the cost of producing one currency by borrowing in another currency and accessing the required currency via the foreign exchange markets.
  • The rates must be submitted by members of staff at a bank with primary responsibility for management of a bank’s cash, rather than a bank’s derivative book.
  • The definition of “funds” is: unsecured interbank cash or cash raised through primary issuance of interbank Certificates of Deposit.
The British Bankers' Association publishes a basic guide to the BBA Libor which contains a great deal of detail as to its history and its current calculation.

Technical features

Calculation

Libor is calculated and published by Thomson Reuters on behalf of the British Bankers' Association (BBA). It is an index that measures the cost of funds to large global banks operating in London financial markets or with London-based counterparties. Each day, the BBA surveys a panel of banks (18 major global banks for the USD Libor), asking the question, “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” The BBA throws out the highest 4 and lowest 4 responses, and averages the remaining middle 10. The average is reported at 11:30 a.m.LIBOR is actually a set of indexes. There are separate LIBOR rates reported for 15 differentmaturities (length of time to repay a debt) for each of 10 currencies. The shortest maturity is overnight, the longest is one year. In the United States, many private contracts reference the three-monthdollar LIBOR, which is the index resulting from asking the panel what rate they would pay.

Currency

In 1986, the Libor initially fixed rates for three currencies. These were the U.S. dollar, British pound sterling and Japanese yen. In the years following its introduction there were sixteen currencies. After a number of these currencies in 2000 merged into the euro there remained ten currencies:

Maturities

Until 1998, the shortest duration rate was one month, after which the rate for one week was added. In 2001, also rates for a day and two weeks were introduced:
  • 1 day
  • 1 week
  • 2 weeks
  • 1 month
  • 2 months
  • 3 months
  • 4 months
  • 5 months
  • 6 months
  • 7 months
  • 8 months
  • 9 months
  • 10 months
  • 11 months
  • 12 months

Fixed rates in USD

There are three Money Markets in the world having interbank offered rate fixings in USD, including:
  • Libor fixed in London
  • Sibor,or SIBOR (Singapore Interbank Offered Rate) fixed in Singapore
  • Hibor, or HIBOR (Hong Kong Interbank Offered Rate) fixed in Hong Kong
The USD Libor in London is the most recognized and predominant one. The USD Sibor was established in January 1988, and the USD Hibor was launched in December 2006. Although these fixings in USD use similar methodology by fixing at 11:00 am at their local times, the results of the three fixings are different.

Libor-based derivatives

Eurodollar contracts

The Chicago Mercantile Exchange's Eurodollar contracts are based on three-month US dollar Libor rates. They are the world's most heavily traded short term interest rate futures contracts and extend up to ten years. Shorter maturities trade on the Singapore Exchange in Asian time.

Interest rate swaps

Interest rate swaps based on short Libor rates currently trade on the interbank market for maturities up to 50 years. In the swap market a "five year Libor" rate refers to the 5 year swap rate where the floating leg of the swap references 3 or 6 month Libor (this can be expressed more precisely as for example "5 year rate vs 6 month Libor"). "Libor + x basis points", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve shifted by x basis points in order to equal the bond's actual market price. The day count convention for Libor rates in interest rate swaps is Actual/360, except for the GBP currency for which it is Actual/365 (fixed).

Reliability and scandal

On Thursday, 29 May 2008, The Wall Street Journal (WSJ) released a controversial study suggesting that banks might have understated borrowing costs they reported for Libor during the 2008 credit crunch. Such underreporting could have created an impression that banks could borrow from other banks more cheaply than they could in reality. It could also have made the banking system or specific contributing bank appear healthier than it was during the 2008 credit crunch.
For example, the study found that rates at which one major bank (Citigroup) "said it could borrow dollars for three months were about 0.87 percentage point lower than the rate calculated using default-insurance data."
In September 2008, a former member of the Bank of England's Monetary Policy Committee, Willem Buiter, described Libor as "the rate at which banks don't lend to each other", and called for its replacement. The Governor of the Bank of England, Mervyn King later used the same description before the Treasury Select Committee.
To further bring this case to light, The Wall Street Journal reported in March 2011 that regulators were focusing on Bank of America Corp., Citigroup Inc. and UBS AG. Making a case would be very difficult because determining the Libor rate does not occur on an open exchange. According to people familiar with the situation, subpoenas have been issued to the three banks.
In response to the study released by the WSJ, the British Bankers' Association announced that Libor continues to be reliable even in times of financial crisis. According to the British Bankers' Association, other proxies for financial health, such as the default-credit-insurance market, are not necessarily more sound than Libor at times of financial crisis, though they are more widely used in Latin America, especially the Ecuadorian and Bolivian markets.
Additionally, some other authorities contradicted the Wall Street Journal article. In its March 2008 Quarterly Review, The Bank for International Settlements has stated that "available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings." Further, in October 2008 the International Monetary Fund published its regular Global Financial Stability Review which also found that "Although the integrity of the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding."
On July 27th, 2012, the Financial Times published an article by a former trader which said that Libor manipulation has been common since at least 1991. Further reports on this have since come from the BBC and Reuters.

Criminal investigations

On 28 February 2012, it was revealed that the U.S. Department of Justice was conducting a criminal investigation into Libor abuse. Among the abuses being investigated were the possibility that traders were in direct communication with bankers before the rates were set, thus allowing them an advantage in predicting that day's fixing. Libor underpins approximately $350 trillion in derivatives. One trader's messages indicated that for each basis point (0.01%) that Libor was moved, those involved could net “about a couple of million dollars”.
On 27 June 2012, Barclays Bank was fined $200m by the Commodity Futures Trading Commission, $160m by the United States Department of Justice and £59.5m by the Financial Services Authority for attempted manipulation of the Libor and Euribor rates. The United States Department of Justice and Barclays officially agreed that "the manipulation of the submissions affected the fixed rates on some occasions". On 2 July 2012, Marcus Agius, chairman of Barclays, resigned from the position following the interest rate rigging scandal Bob Diamond, the chief executive officer of Barclays, resigned on July 3, 2012. Marcus Agius will fill his post until a replacement is found. Jerry del Missier, Chief Operating Officer of Barclays, also resigned, as a casualty of the scandal. Del Missier subsequently admitted that he had instructed his subordinates to submit falsified LIBORs to the British Bankers Association. 
By July 4, 2012 the breadth of the scandal was evident and became the topic of analysis on news and financial programs that attempted to explain the importance of the scandal. On July 6, it was announced that the U.K. Serious Fraud Office had also opened a criminal investigation into the attempted manipulation of interest rates.

(Source: Wikipedia)
 

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