The London Interbank Offered Rate, better known as LIBOR, was once the most important benchmark interest rate for setting the price of overnight and short-term loans that banks make to one another. This reference rate served as the foundation for other types of loans made by financial institutions, including mortgages, auto loans, and financial products like credit default swaps (CDS). All of these and more were tied to the LIBOR in some fashion.
However, since 2021, the LIBOR has been phased out of use, following a series of criticisms and a major scandal involving financial collusion and manipulation by various banks in setting the LIBOR. Since then, several alternatives have been proposed to facilitate the interbank lending market. Here, we look at a few of these benchmark rates.
- The London Interbank Offered Rate (LIBOR) was once the most influential benchmark used to set short-term interest rates.
- Following a rate-fixing scandal, the LIBOR was phased out and ceased to be used in 2021.
- Several alternative benchmark rates have been proposed to facilitate the interbank lending market.
- The Secured Overnight Funding Rate (SOFR) has emerged as a key contender to replace the LIBOR.
- Other alternatives include the federal funds rate, the American Interbank Offered Rate (Ameribor), and the Bloomberg Short-Term Bank Yield (BSBY) Index.
The Interbank Lending Market
Modern banking works using a fractional reserve system, based on the fact that there is very little chance that all of a bank’s depositors will demand to withdraw their deposits all at once. As a result, banks have the freedom to lend out to borrowers a portion of the deposits that they hold.
The amount of such lending that can take place is determined by the reserve ratio, typically set by central banks. If the reserve ratio is 10%, for example, a bank can lend out 90% of deposits while keeping 10% on hand as reserve requirements (so, $100 could create $90 in loans by that bank).
Sometimes, a bank ends up with more than the reserve requirement due to a downtick in lending. Other times, a bank may end up with less than that proportion. As a result, banks with excess reserves can lend those funds on a short-term basis to other banks that need reserves. This is the interbank lending market, which involves loans with terms of overnight up to several weeks in maturity.
The interest rate attached to these loans is determined by the supply and demand for reserves. However, not all banks are active enough in this market, so they rely on benchmark interest rates to peg these interbank loans. That is where the LIBOR came in and where its alternatives are filling in today.
On Nov. 30, 2020, the Federal Reserve announced that the LIBOR will be phased out and eventually replaced by June 2023. In the same announcement, banks were instructed to stop writing contracts using the LIBOR by the end of 2021 and that all contracts using the LIBOR should wrap up by June 30, 2023.
Secured Overnight Funding Rate (SOFR)
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is being adopted as a LIBOR replacement by many of the world’s largest financial institutions. The SOFR is computed from transactions in the Treasury repurchase (repo) market and is seen as preferable to LIBOR-like rates because it is based on data from many observable transactions rather than on estimated borrowing rates set by bank trading desks.
Federal Funds Rate
The federal funds rate is the rate at which large U.S. commercial banks lend to one another. Its target is set by the Federal Reserve’s Federal Open Market Committee (FOMC), but the actual rate is determined in the market. However, this rate is capped by the Fed’s discount rate, the interest rate at which it charges commercial banks to borrow from it directly. Thus, if the federal funds rate were to hypothetically bid up higher than the discount rate, banks would simply borrow from the Fed directly.
The American Interbank Offered Rate (Ameribor) is a benchmark interest rate that reflects the true 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 looks at secured (collateralized) lending, the Ameribor tracks unsecured dollar-denominated interbank yields, and it is intended to aid small and midsize regional banks. Rates for the Ameribor are created from transactions observed on the AFX.
Bloomberg Short-Term Bank Yield (BSBY) Index
The Bloomberg Short-Term Bank Yield (BSBY) Index provides a series of short-term rate benchmarks for banks to use in maturities of overnight, three-month, six-month, and 12-month. Created in 2021 by financial analytics company Bloomberg L.P., the BSBY looks at unsecured lending in a range of products such as commercial paper, certificates of deposit (CDs), demand deposits, and short-term corporate bonds. The index is constructed from observed transactions on Bloomberg’s proprietary trading platforms as well as from feeds from the Financial Industry Regulatory Authority (FINRA).
€STR stands for the Euro Short-Term Rate, which is the benchmark rate at which European banks engage in unsecured euro-denominated short-term lending. The €STR replaced the Euro Overnight Index Average (EONIA) rate in 2022.
The Sterling Overnight Index Average (SONIA) is the effective overnight interest rate paid by banks for unsecured transactions in the British sterling market. It is used for overnight funding for trades that occur in off-hours and represents the depth of overnight business in the U.K. financial marketplace.
Which reference 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 alternatives that look at the unsecured interbank lending market also exist. In Europe, the Euro Short-Term Rate (€STR) will be used (which replaces the Euro Overnight Index Average (EONIA) rate). In the United Kingdom, the Sterling Overnight Index Average (SONIA) is the new reference rate.
Why is the LIBOR being phased out?
While the LIBOR was once arguably the most important short-term benchmark interest rate, it was found to have been subject to rampant manipulation, scandal, and methodological critique, making it less credible today as a valid benchmark. The rate is being phased out so that by the end of 2021, no new contracts could be written using the LIBOR; by mid-2023, all existing LIBOR-based products will be terminated. The LIBOR has been replaced by the SOFR, although several other alternatives, such as the Bloomberg Short-Term Bank Yield (BSBY) Index and the American Interbank Offered Rate (Ameribor), also exist.
How do the new reference interbank rates improve upon the LIBOR?
The LIBOR scandal revealed that having a small panel of banks set a reference rate is not ideal. The new rates like the SOFR instead use actual transactions data to construct benchmark yields for short-term loans.