LIBOR

The LIBOR (London Interbank Offered Rate) is a benchmark interest rate at which major banks lend to each other in wholesale markets. Calculated daily for multiple currencies and maturities, LIBOR serves as a reference rate for trillions of dollars in bonds, mortgages, derivatives, and other financial contracts. Despite its dominance for decades, LIBOR faces manipulation scandals and is being phased out in favor of risk-free rates like SOFR.

How LIBOR works

LIBOR is calculated as follows: each morning, a panel of major global banks—usually 16–18 institutions like JPMorgan, HSBC, Barclays—is asked: “At what rate could you borrow unsecured funds in the interbank market?” Each bank submits a number. The highest and lowest submissions are discarded. The rest are averaged, and that average is published as LIBOR for the day.

This is done for five major currencies (US dollar, British pound, euro, yen, Swiss franc) and seven maturities (overnight, one week, one month, two months, three months, six months, 12 months). That is 35 separate LIBOR rates published daily.

These rates are then used to price financial contracts globally. A bank issuing a floating-rate bond might set the coupon as “LIBOR + 1.50%.” A mortgage might be “LIBOR + 0.50%.” Derivatives are priced off LIBOR rates. Trillions of dollars in financial instruments are linked to LIBOR.

The appeal and global reach

LIBOR’s dominance came from its simplicity and global reach. It was published daily, transparent, and accepted worldwide. A borrower in Tokyo could reference LIBOR to set a loan rate with a lender in New York. An investor in Singapore could trade a derivative based on LIBOR with a counterparty in London.

LIBOR was not a rate at which banks actually borrowed from each other (most interbank borrowing is done bilaterally and is not publicly disclosed). Instead, it was a guess, by a panel of banks, about what unsecured borrowing would cost. The fiction worked for decades because the guess was widely believed and widely adopted.

The manipulation scandal

In 2011–2012, it emerged that banks on the LIBOR panel had been systematically submitting false rates to benefit their trading positions. A bank might submit a low LIBOR quote to make its financial condition look better or to profit from derivatives that it held. Internal communications (“we need the LIBOR set at X”) revealed the conspiracy.

Regulators worldwide investigated. Major banks paid billions in fines. Several traders were criminally prosecuted. The scandal shattered confidence in LIBOR and revealed a fundamental flaw: a rate based on guesses from interested parties could never be truly reliable.

LIBOR’s phase-out

After the scandal, regulators decided LIBOR had to go. The Financial Conduct Authority (UK) announced it would stop compelling banks to submit LIBOR quotes at the end of 2021 (with a few exceptions extended to 2023). The reason: LIBOR no longer reflects actual borrowing costs, and there was no good reason to prop it up.

The challenge was that trillions of dollars in contracts referenced LIBOR. What would replace it?

The transition to SOFR and alternatives

The answer varied by currency:

• USD LIBOR is being replaced by SOFR (Secured Overnight Financing Rate), which is based on observed trades in the repo market, not panel submissions.
• GBP LIBOR is being replaced by SONIA (Sterling Overnight Index Average), an observed rate in the overnight secured lending market.
• EUR LIBOR is being replaced by ESTER (Euro Short-Term Rate), based on actual European overnight transactions.
• JPY LIBOR is being replaced by TONAR (Tokyo Overnight Average Rate).

All these replacements have one feature in common: they are based on actual observed transactions, not on estimates or guesses. This makes them more reliable and manipulation-proof.

The transition challenges

Replacing LIBOR is harder than it sounds. Thousands of contracts written before 2021 still reference LIBOR and will do so for years. Regulators have required banks to transition to SOFR and alternatives, but many legacy contracts remain. Market participants have had to build massive operational infrastructure to handle both old LIBOR rates (which still publish, technically, but with far fewer panel submissions) and new rates.

See also