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 rate in some fashion.
However, since 2021, 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 rate. Since then, several alternatives have been proposed to facilitate the interbank lending market. Here we look at a few of these benchmark rates.
- 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 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 LIBOR.
- Other alternatives include the fed funds rate, Ameribor, and the Bloomberg 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 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, say 10%, 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 those 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 LIBOR came in and where its alternatives are filling in today.
On Nov. 30, 2020, the Federal Reserve announced that LIBOR will be phased out and eventually replaced by June 2023. In the same announcement, banks were instructed to stop writing contracts using LIBOR by the end of 2021 and that all contracts using LIBOR should wrap up by June 30, 2023.
The Secured Overnight Funding Rate (SOFR)
The Secured Overnight Financing Rat (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. 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.
The 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 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 fed funds rate were to hypothetically bid up higher than the discount rate, banks would simply borrow from the Fed directly.
Ameribor (short for the American interbank offered rate) is a benchmark interest rate that reflects the true cost of short-term interbank borrowing, 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 mid-sized regional banks. Ameribor rates are created from transactions observed on the AFX exchange.
Bloomberg Short-Term Bank Yield Index (BSBY)
The Bloomberg Short-Term Bank Yield Index (BSBY) provides a series of short-term rate benchmarks for banks to use in maturities of overnight, 3-month, 6-month, and 12-month. Created in 2021 by financial analytics company Bloomberg, LP, the BSBY looks at unsecured lending in a range of products such as commercial paper, 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 Shor-Term Rate, which is the benchmark rate at which European banks engage in unsecured euro-denominated short-term lending. €STR replaced the Euro Overnight Index Average (EONIA) rate in 2022.
The Sterling Overnight Index Average, or 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 LIBOR?
In the U.S., most major financial institutions have adopted the secured overnight funding rate, or SOFR (although alternatives that look at the unsecured interbank lending market also exist). In Europe, €STR will be used (which replaces the EONIA rate). In London, the SONIA rate is the new reference rate.
Why Is LIBOR Being Phased Out?
While 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 LIBOR; by mid-2023, all existing LIBOR-based products will be terminated. LIBOR has been replaced by the Secured Overnight Financing Rate (SOFR), although several other alternatives, such as the BSBY and Ameribor, also exist.
How Do the New Reference Interbank Rates Improve Upon LIBOR?
The LIBOR scandal revealed that having a small panel of banks set a reference rate is not ideal. The new rates like SOFR instead use actual transactions data to construct benchmark yields for short-term loans.