Libor rates explained – your step-by-step Libor guide

Libor rates used to be a term to describe a process that many had heard about but thought was uninspiring. That was until the Libor scandal broke into Forex news. The fact that many people were prepared to risk their careers over something so seemingly dull, highlights the importance of it. 

What are Libor Rates?

The London Interbank Offered Rate is the average rate at which banks can borrow overnight from each other. Banks which have a surplus of cash lend it out to others, so as to earn some extra interest. Banks which have a liquidity mismatch, i.e. Need to borrow to cover a shortfall in cash, will bid in the inter-bank market. Theoretically, the lower rate a bank has to pay, indicates the easier access it has to funding. The easier access to funding, the less it needs cash. At times of stress the Libor rate will often rise, as banks become less keen on lending to others who may struggle to pay it back. This was highlighted during the 2008 Financial crisis.

Why are they important?

Many products are priced off Libor rates. In particular a great deal of derivative products but also credit cards and loans. In particular, contracts will have reference to Libor +1 or +2, I.e. 1% or 2% over Libor. If the Libor rate is being manipulated, then counterparties to these contracts will end up paying more. It is not only institutional investors who are affected. Some private clients will ask for the benchmark to their portfolio to be set at Libor +1/2%, so as to mitigate inflation. Just because your portfolio has increased in value does not mean you are richer, as you could of lost purchasing power.

How do  they work?

The banks which are considered to have a significant presence in the London are members of the panel. The selection process is held annually. Each business day eligible banks submit the rates they would charge other banks to borrow overnight. The highest and lowest submissions are discarded and the average is calculated from the remaining numbers. The rates are then published each business day at approximately 1155 London time. There are Libor rates for 5 different currencies (GBP, USD, EUR, JPY and CHF) and 7 different maturities which are listed below:

• 1 day
• 1 week
• 1 month
• 2 months
• 3 months
• 6 months
• 12 months

Manipulation of Libor rates

In 2012, it became apparent that Libor rates were being manipulated by traders who were seeking to benefit from favourable rate submissions. This was serious, as trillions of derivatives are priced off Libor rates. One trader, Tom Hayes, was eventually jailed for this and rate setting is now overseen by regulators. As we have seen before, manipulation such as currency manipulation is not new in markets. Yet the trading advantage that Forex traders were seeking to gain through Libor rates, meant that millions of innocent people were being defrauded.

A warning signal

Libor rates can also be used to identify stresses in the financial system. During the financial crisis they jumped to unseen levels as banks did not trusts each other. The higher the risk, the more you expect in return. Indeed so concerned was the Bank of England to the higher rate of Barclays submissions, the then Deputy Governor of the Bank was alleged to have told them to do something about it. The Bank feared that Barclays would be seen as too weak to borrow and feared a run on it. Sometimes in finance, questionable behaviour is encouraged if there is a greater good: stability.

Conclusion

The city of London is a strange mix of gentlemanly and cut-throat behaviour. Libor rates used to be administered by a trading association which trusted its members to uphold a certain amount of decency, which many sadly took advantage of. The fact that Libor rates are now administered by national regulators, highlights how central they are to the financial industry and why you should understand them! Trading on the Forex presents risks but a smart trader is one step ahead through having done his homework!